Running a business with other people can be very rewarding and successful. Utilizing each of your unique abilities often leads to the best business outcome. This is usually because you and your fellow owners have unique skills that complement each other.
However, it’s important to consider what happens when one of the business owners is ready to leave the company, either voluntarily or involuntarily. For example, let’s say your partner wants to leave the business, becomes incapacitated, or even passes away. How do you address this new situation? A possible solution is a buy/sell agreement.
Buy/sell agreements are common among multiple owner businesses. In their simplest form, a buy/sell agreement is a contractual obligation for the owner (or the owner’s estate) that exits the business to sell their ownership either to the other owners (often called a “cross sell” agreement) or back to the business itself (often called a “redemption” agreement). Such a plan often allows for the remaining business owners to maintain at least their percentage ownership and control of the business upon another owner’s exit.
Many times life insurance is used to “fund” buy/sell agreements as they are usually used for protection should the business owner die unexpectedly. With a “cross sell” agreement, each owner purchases a life insurance policy on each of the other owners. When one of the owners dies, an income tax-free death benefit can be used to purchase the deceased owner’s share of the business. With a “redemption” agreement, the business purchases life insurance policies on the lives of the owners. When one of the owners dies, the business can use the life insurance death benefit to purchase the business interest from the deceased owner’s estate. If life insurance isn’t appropriate or if one of the owners is uninsurable, a pre-negotiated installment sale can be utilized allowing the remaining business owners to buy out the exiting business owner over a term of years.
The sales price for buy/sell agreements is usually an agreed upon formula designed to represent the fair market value of the exiting owner’s share. These formulas are often multiples of EBITA (earnings before interest, taxes and amortization), some value based on the “book value” of the company, or some other applicable impartial business valuation method.
If you’re a member of a multiple owner business, consider creating or reviewing your existing buy/sell agreement. Preparing a business exit strategy can be just as important as the daily operations of the business. Your Benjamin F. Edwards Financial Consultant can help with strategies and products to help you achieve your business planning goals.