Buy/sell agreements are security blankets for small business owners, but the pacts can breed a false sense of the warm and fuzzies, if not properly handled.

The agreements, of course, spell out how a business will proceed financially when faced with a major change to its structure, such as the death of a partner. But many of them feature an unexpected trap: When an important player in a small business departs, those left behind often lack the cash reserves or the borrowing capacity to execute the provisions of the buy/sell document. In such cases, the survival of a whole company can be thrown into doubt — and along with it the income that a financial advisor would manage for the business owners.

A SAD STORY

Here's a real life story of an unfunded buy/sell agreement.

John and Marcia (not their real names) were partners in Medical Services Unlimited. Both were married — not to each other — and both had grown children. There were no other family members involved in the business.

Medical Services employed 20 nurses and other staff. It had a 401(k) plan, and each owner had over a half million dollars in it — managed by their financial advisor, of course. John and Marcia had a shareholders' agreement that specified that each would buy the other's interest in the event that one of them died. But they forgot one thing: The firm did not have enough cash or credit to fund the business's agreed value — initially set at $2.5 million and adjusted annually for growth.

One sad day, Marcia was hit by a bus while crossing the street, and she died a few days later. Under the terms of the shareholders' agreement, John was obligated to buy her heirs out of the business, but he did not have the cash to do so. Instead, he had to sell the practice for pennies on the dollar, and liquidate his 401(k), just to pay part of his obligation.

What they should have done — and what any rep with an insurance license could have helped them do — was to fund the buy/sell agreement with life insurance.

WHAT KIND OF INSURANCE?

Most limited liability and corporate entities (C corp., S corp., LLC, PC), and many partnerships, have some form of shareholders' or partnership agreement. The owners, with their attorneys, probably created this agreement as part of the original incorporation or business formation process. One of the key components of a complete shareholders' agreement is a funded buy/sell agreement.

Barbara Wells, an attorney with Minor & Brown, in Denver, Colo., has crafted many such agreements. She says they are essential tools for heading off myriad threats to business continuation, including: the death of an owner, the disability of an owner, the divorce of an owner, an offer to buy an owner's interest, retirement, termination of employment, disagreements between owners and bankruptcy.

A buy/sell agreement can be set up and funded to cover all the above contingencies, but the actual type of insurance needed varies with the buy/sell obligation to be covered. Life insurance, for example, is intended to pay at the death of an owner, but can also provide funds (through borrowing against cash value) to cover the departure, divorce, disability or retirement of an owner. Disability insurance comes in several forms, and is used to pay one or more of the following: income replacement, business interest buyout and business expenses. There is also insurance that covers key staff, to provide funds to replace them. What does life insurance cost? It depends — on the type, the amount of cash value to be accumulated, the age and health and gender of the insureds and the riders and benefits, among other factors. But in general, a $500,000 term life insurance policy is probably going to cost a 30-something person less than $20 to $30 per month, while a well-funded universal life/whole life policy could cost the same person $150 to $300 or more per month.

Term Life Insurance

In a situation where the shareholders are relatively young (30s or 40s) and healthy, and have a definite future date when they will leave the business, term life insurance can be a low-cost solution to buy/sell funding. There is no cash value, so the policies can't be used as a retirement or departure buyout means, nor do they work as disability coverage. In many cases the face amount is fixed and there is no cost-of-living increase option, so there may not be enough money to meet the buy/sell obligation (the business valuation). Should you choose to use this form of insurance, it is very important to choose a product with premiums that remain level for the entire period (20 or 30 years in most cases) and one that is “convertible” to a permanent product.

Permanent Life Insurance

If this is a business your clients want to stay in for 20 to 30 years, then leave in style (and be bought out if they die while working there), a well-funded UL/WL insurance plan may be just the ticket. These allow owners to accumulate substantial amounts of cash, take loans to provide buyout and departure incentives and still ensure their heirs get fair value for the business interest at the owner's death. Younger owners may be cash-strapped and need to look at term life insurance for the near term, with a plan to convert the insurance over the next 10 or so years until it is all UL/WL. Universal and whole life insurance are funded to ensure the face amount stays in force for as long as needed. This is particularly important for older owners and for owners who plan to work for many years before leaving the business.

Disability Insurance

Disability insurance comes in several forms. There is an income replacement version, a version that will pay the disabled owner's share of business overhead and a version that will make a series of payments to buyout the owner's business interest. Choosing the right kind of disability insurance is extremely complex and should be done in conjunction with an insurance expert who knows the ropes.

FUNDING BUY/SELL AGREEMENTS

There are several uses of life insurance to fund a buy/sell agreement. The most typical involve using term life or a permanent life insurance product. The most common forms of a buy/sell agreement involve buying out a deceased shareholder's interest. This can be done through either a cross-purchase arrangement or an entity-purchase/stock-redemption arrangement. Another important consideration is the need for insurance to cover the loss of a key employee. Finally, there are instances when the owner(s) wants the employees to take over, and ensure that his or her family gets a fair price for the business — using life insurance and an employee stock ownership plan (ESOP).

The simplest buy/sell arrangement is for each owner to own a policy on each other owner, in proportion to the other owners' business share. However, the number of policies can quickly mount — with three owners there would be six policies involved, with four owners the number goes to 12, and with five the number is 20. This approach is referred to as a cross-purchase arrangement. To avoid having so many policies, the oft-chosen approach is called an entity-purchase or stock-redemption plan. In this case the “entity” (the company) owns one policy on each owner, equal to the value of that person's business interest.

Key employee insurance is normally a death benefit that is paid to the company to cover the obligations to an employee's family and provide the cash needed to keep the company going and find a replacement. For example, the funds from this sort of insurance might be used to buy out the key employee's patents, and pay a signing bonus to the replacement.

FITTING INSURANCE TO THE AGREEMENT

Before you can come up with the appropriate insurance solution, it is important to understand the thinking that went into the structuring of the buy/sell agreement. “Buy/sell agreement terms and the type and term of the insurance often don't match,” says Wells. “This can be a problem if the buy/sell ever needs to be implemented.”

For example, a buy/sell agreement is often structured as a lump-sum payment, yet many disability buyout insurance contracts have a one- or two-year wait and then make payments over a two- to five-year period, she says.

If your client is funding all the options — disability and permanent life insurance — the payout methods are probably not an issue. However, if the goal is to buy an owner out, regardless of the triggering event (death, departure and so forth), there is a need for permanent life insurance and several forms of disability insurance.

How can the registered rep identify possible buy/sell funding candidates in his book? Peter Radloff, vice president of advanced markets at Jackson National Life, suggests looking for business owners who are: professional services corporations (PCs), C or S corps., LLCs or unincorporated partnerships.

What does the typical small business owner want to hear? As Joe Cosenza of New York Life puts it, they need to be “disturbed” enough to see a need to take action. The most straightforward way to do this, according to Radloff, is to point out the loss of control and disruption or interference the owner will have to deal with if another owner dies, or the reduction in the value of the business if he or she dies. By taking care of the funding in advance for the buy/sell agreement, the remaining owner(s) can be sure of maintaining control and protecting the value of the enterprise.

Chances are, the process of arranging buy/sell funding will help you get closer to your business-owner client. If you defuse this potential time bomb, the client will regard you as a canny consultant, not just an investment salesperson.

“The rep should be a counselor, not just a salesperson,” says Radoff. “The need for buy/sell funding is there, the best means to fund it is usually life insurance, and your clients are counting on you.”