Entrepreneurs are generally good at one thing when they start their business and that’s generating top line revenue. Once they create enough top line revenue then they begin to think about how to drive bottom line profitability in their business. As the equity value of the company grows, most owners never consider some very important planning items because they believe they are invincible. What happens if my business partner(s) get divorced? What if they die? What if they become disabled? Do I want to be working with my partners kids or spouse? One of the key considerations for most business owners is whether or not to get a buy-sell agreement and get key person insurance.
A buy-sell agreement is a legal contract that provides for the sale of an owner’s stake in a business at a ‘trigger’ event. The sale of an owner’s interest could actually trigger for many reasons including retirement, death, disability, divorce, bankruptcy, or even a conflict that various owners cannot resolve. Normally, the buyout is done with the other owner’s, but it could potentially be with a third part. It is a smart idea in my experience to get these legal documents drafted early on in a relationship as they are far more arduous to set up down the road.
Why do you want to set up a buy-sell? First and foremost, you want your family or heirs to get the true value you should be getting for what you built in the business. We don’t expect bad things will happen in our businesses, but the majority of the time relationships don’t last forever….even in family businesses. If the documents are not set up appropriately, the business could even wind up in the hands of other people you don’t really want to own the business. Most importantly, do you want to have your partners to actually have to look for another buyer on short notice? Probably not.
Buy-Sell agreements can be funded or unfunded, but the smartest thing to do is either buy term insurance or permanent insurance to fund the buy sell. Essentially, the insurance will be paid into the company and then the buy-sell agreement will trigger the company to pay your family for your share of the business and then the equity in the business will be redistributed amongst the remaining owners according to the agreement. With buy-sell agreement, the valuation method is important to establish early in the process if you don’t fund the buy-sell agreement, so the valuation formula is all set to calculate your share of the company upon a triggering event. An example of this is to say that the business is worth….2x revenue or 4x net cash flow to make sure there is a consistent valuation.
In my experience, key person insurance is often not considered by business owners when they set up a buy-sell agreement. Yes, it is true that an owner’s family will get paid out and bought out…but what about the company? The company can suffer short term when an owner is absent because they may have played a key role in marketing, sales, or management. In a technology company, you may have an owner that has specific coding skills that could be tough to replace. Key person insurance is a life insurance policy that will be paid into the operating account of the business to give the company a chance to hire a new person into the role of the prior owner or cash in the bank to give the company time to design a new plan on how they will manage the company.
There are many ways to get these types of agreements set up, but whether you have one partner in the business or many you should take a look at making sure you have funded buy-sell agreements set up today. The last thing in the world you want to be faced with is working with the spouse or kids of a partner who know nothing about how your business works.
If you want to set up a time to discuss the best way for you to set up a business will, please go to oXYGen Financial to set up an appointment.
