4 Types of Buy-Sell Agreements
- Cross-purchase agreement.
- Entity purchase agreement.
- Business-continuation general partnership.
Are you helping your business clients get the most out of their buy-sell agreements?
They look to you as a guide and a source of solid advice.
In this video, you’ll learn about four different types of buy-sell agreements and the scenarios that each is best suited to.
Keep reading after the video for more valuable information about the various kinds of buy-sell agreements your business clients may benefit from.
We get a fair number of phone calls from agents who ask us if we have leads that will help them get in front of more prospects.
We probably get three or four calls a week on this and our answer is consistently, “Yes, we do have leads – but not in the traditional sense, because the best leads that we have and that we see come from marketing to business owners.
Let's talk about some of the life insurance opportunities that can be found in business insurance markets.
Over the last several years, we've been getting a whole lot of questions and a lot of plans being
implemented for a buy-sell strategy. There are a number of different types of buy-sell agreements.
I always like to say there are really only a couple of ways to sell your business. There’s selling from a position of power or selling from a position of weakness. Some of these strategies for buy-sell agreements are going to help business owners sell from a position of power versus having to turn to the open market and potentially pleading to the outside market to purchase their business.
These are four of the most common methods of buy-sell agreements that we see.
The cross-purchase agreement
Here’s how a cross-purchase agreement works.
If Dave and I were in business together, I would be the owner and beneficiary of a life insurance policy on Dave’s life, and he would be the owner and beneficiary on a policy on my life.
So, if I passed away, Dave has a death benefit that’s payable to him, tax-free.
In a cross-purchase agreement, Dave is mandated to use those death benefit proceeds to buy my spouse’s shares of the business. In doing so, he gets to step up and my spouse is effectively out of the business. This works well when there are just two partners.
The entity purchase agreement
This works better for businesses that have more than two owners. The policies are owned by the business. A deceased partner’s shares are bought from the surviving spouse.
Before we got to the next two types of buy-sell agreements, it’s important to mention that we get a lot of calls from producers asking which type of agreement the clients should use in terms of purchasing life insurance.
I almost always suggest that the agents don’t answer that but provide information to their clients and let the client’s legal advisor provide the answer as to whether they should cross-purchase or entity purchase or some other form of an agreement.
The agent can get into trouble from a liability standpoint later on down the road.
We can provide recommendations and consideration of the various strategies, but we would never say “This is the best fit for your client,” or “You should go this route.”
We all know that no one client is the same as another. We want to make sure we position that business to effectively meet the specific needs of their client, in partnership with the rest of the team.
Here’s a basic question you can ask business owners: To whom will you transfer or sell your business?
A lot of times, one business owner is of the mindset of going one route and the other owner wants to do something completely different – especially in a family business.
These are the five Ds that we’re typically looking for in a buy-sell agreement.
- Death of a business owner.
- Disability of a business owner. In this case, the disability trigger should be clearly defined. Is it the loss of a limb? The inability to work for six months?
- Divorce. This one is quite often missed. There are some famous cases of business owners who are now in business with their former business-partner spouse or even the former business partner’s spouse’s NEW partner. Those are some of the risks.
- Departure. It could be voluntary departure due to retirement or it could be a forced departure. For example, the loss of a medical license or disbarment.
When we do a buy-sell agreement, we’re looking to make sure these five triggering events are covered.
With this strategy, you’re somewhat employing the cross-purchase method, as well as the entity purchase buy-sell agreement.
In this type of arrangement, the agreement would stipulate that if a partner passes away or leaves the business, the business has an option to buy that owner’s shares. If the business decides not to, then the remaining partners have an option to buy the departing owners’ shares.
The corporation or the business could also buy the shares from one of the partners. It’s kind of a two-way approach.
There are three different steps:
- The business can buy those shares.
- If not, the partners then have the option to buy the shares.
- If the partners choose not to buy, the shares go back to the business. At this point, the business is mandated in the agreement to buy the remaining shares just so that one partner doesn’t still have outstanding shares.
You have some flexibility in this type of arrangement.
A question that we’re commonly asked is, “Where is the life insurance owned in a wait-and-see arrangement”?
The mandatory purchase is held at the business level, so many times, the business will be the owner and beneficiary on those policies so that they’re able to fulfill that mandatory obligation to buy the departing owner shares.
Most often, it’s maybe a partner that wants to have a bigger stake in the business who exercises that optional purchase of the deceased owner’s shares with their own personal capital.
One of the nice things about working with LWT is that we have sample agreements for you. So if you say, “We've got a client that wants to do a wait-and-see buy-sell agreement but their attorney hasn’t drafted one before and doesn't know exactly where to start,” you can provide them with a sample agreement.
It’ll cut down on billable hours since the client’sattorney won’t have to start from scratch.
The business-continuation general partnership
This is a little bit more complex of a strategy. We would establish a partnership – or an LLC for multiple owners. Each partner would make an after-tax contribution to the business-continuation general partnership. That partnership would then purchase one policy on each of those.
The nice thing here is that, if one of those partners passes away, you can easily distribute the policies to those partners without any additional tax.
It's kind of a combination of buy-sell planning and supplemental retirement income planning for those partners.
There's a lot of information here. Obviously, some of it is a little more technical, but what can a producer do and say to their business prospects and business clients to at least initiate and get them to open up and start a conversation about these types of plans and this type of business funding and insurance protection practices?
Here are two questions to ask to get started:
- Do you have a buy-sell agreement? If so, when was the last time that you reviewed it?
- What's your business worth?