Your prospective or new client has a buy-sell agreement.
After signing it she checked “Solve business continuity problems” off her list and now resists your request to review the agreement. She sees your request as a thinly veiled opportunity to generate fees. You know, however, that many, many of these agreements create more problems than they solve, and only partially solve “business continuity problems,” but how do you communicate that?
Let’s start with a quick review of the seven most common deficits (or holes) in the typical buy-sell agreement.
Hole 1: Overlooks Challenges to the Business
Most buy-sell agreements don’t address the challenges that the business, the owners, and the deceased owner’s family will face after an owner exits. They only address the transfer of ownership at an owner’s death and, perhaps, disability. For example, if the surviving owner does not have enough assets to satisfy the personal guarantees previously made by the deceased owner, once that financing is pulled, the business may not be able to continue. Or, if the deceased owner was the company’s rainmaker or COO and no one is able to step into those roles, the business may be unable to survive.
At best, a buy-sell agreement dealing with the transfer of ownership at death (and sometimes disability) only ensures that the surviving owners own all of the company and that the deceased owner’s estate receives fair value, in cash, for the transfer of ownership. It leaves other major issues unaddressed.
Hole 2: Ignores Common Lifetime Exits
Does the agreement cover lifetime exits of an owner? The disability, divorce, bankruptcy, termination of employment or retirement of an owner, or business dispute among owners, can trigger the need to transfer ownership and are more likely to occur than the death of an owner.
Hole 3: Neglects the Decedent’s Family
Most buy-sell agreements focus exclusively on the benefits they provide to the survivor, rather than on providing for the needs of the decedent’s family. Even if the deceased (or disabled) owner’s family receives buy-sell proceeds for the full value of their loved one’s business interest, that amount is rarely enough to support at the same level as did their loved one’s lifetime income. The fundamental exit goal for every business owner (maintaining financial security after exiting the business) is rarely achieved from the proceeds received via a buy-sell agreement.
The financial shortfall for the deceased owner’s family is caused by the transfer of ownership (and with it the right to a continued stream of income from the business) and the loss of decedent’s compensation. Buy-sell agreements aren’t designed to address that problem, but they can cause it because the decedent’s income rights terminate with ownership transfer. The question that you must ask and help owners to resolve is: “If you die, what will replace your income stream for your family?” There are many possible answers to this question that may involve re-structuring the buy-sell agreement.
Hole 4. Isn’t up to the Task
Many buy-sell agreements are too simplistic to manage the complex nature and relationships of the owners who sign them. For example, companies with multiple owners often don’t want to treat all owners in a similar fashion. Or one owner subject to the agreement may be uninsurable. In family businesses non-business considerations may affect the design of buy-sell agreements.
Hole 5: Cookie-Cutter Valuation Formula
The valuation methodology (e.g. agreed-upon value or book value) is simplistic. While perhaps such a formula is adequate when a business first forms, it does not adjust sufficiently to account for business growth.
Hole 6: Outdated
Agreements may not have “sell by” dates, but they should. When they lie at the bottom of dark drawers, un-reviewed in light of current business circumstances and the changing desires of owners, they can yield some very ugly surprises. Owners rely on buy-sell agreements to manage emotionally charged situations and if those agreements don’t account for changes in the business, they cause huge problems for everyone involved.
Hole 7: Poorly Implemented
If insurance funding is lacking, insufficient, or beneficiary and ownership of insurance is incorrect, there is no way that the agreement can serve its purpose.
Opportunities For Advisors
- When you suggest to a client that you review his buy-sell agreement, describe the gaping holes that you think might apply. Consider offering to provide a “second opinion” on suitability of existing buy-sell. You will find that the holes and your clients will be better for it.
- Using questions to frame the discussion of the buy-sell review provides a terrific gateway to an owner’s Exit Planning goals. For example, you might ask, “Have you given thought to someday leaving your business? If so, what amount of income do you want post-exit? If you died today, would the proceeds from your current buy-sell plus your existing personal assets make that happen?”
- Even well-drafted agreements are drafted too narrowly (trigger events are death and perhaps disability) and do not consider all, or even the most likely, transfer scenarios. You have the opportunity to explore and help create effective solutions.
- Owners generally do not consider the consequences to them if they become the remaining owner. For example, discuss with your clients who co-own businesses what each wants to happen if either decides to leave. You may find that the remaining owner does not want to be a sole owner. This is an opportunity to engage all owners in an Exit Planning discussion and engagement.
- Because comprehensive continuity planning involves professionals not ordinarily consulted in the preparation of buy-sell agreements, you must have these collaborators (and potential referral sources) on your Advisor Team—
- Exit Planning advisor
- Valuation expert
- Business consultant
- Financial Planner
Buy-sell agreements, at best, provide partial solutions for the surviving and deceased owners (and their families). Few owners are aware that even well-drafted agreements:
- provide but a partial replacement of the deceased owner’s income stream or
- protect business from the loss of the personal guarantor or the owner indispensable to business operations.
Instead, agreements typically focus on the death (and perhaps disability) of the owners and ignore the likeliest transfer event—the retirement or other lifetime departure on one owner.
We will discuss each of these “holes” in future articles. Watch for case studies that will illustrate how using BEI’s Exit Planning Process highlights the challenges and crafts solution.
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