In this article, we explain how to fund a buy-sell agreement. We answer the question, “how do buy-sell agreements work?” and explain alternative methods to raise capital for buy-sell agreements, such as: using life insurance to fund a buy-sell agreement, using a cash account to fund a buy-sell agreement, using a bank loan to fund a buy-sell agreement, and using installment payments to fund a buy-sell agreement.
A buy-sell agreement is an agreement between owners of a closely-held corporation, LLC or partnership to provide a plan for one of the owners’ exiting the business. The event that triggers the buy-sell agreement may be the death or disability of an owner, the owner’s desire to sell his or her shares, the company’s desire to involuntarily terminate an owner’s interest in the company, an owner’s retirement, or an owner filing for bankruptcy or divorce.
For more on buy-sell agreements generally, check out our article: Buy-Sell Agreements for Closely-Held Corporations, LLCs and Partnerships Explained.
A good buy-sell agreement will usually provide the following terms for each of the triggering events that it covers:
If the company or the remaining shareholders are going to be required to purchase an exiting owner’s stock, or even if they will simply have the right of first refusal, it is important that the agreement provide for where the money for the purchase will come from. Failure to do so puts the company in a position where it has to raise a large amount of capital on short notice in order to meet its obligation. This situation also does not give the exiting owner any certainty that the company will be able to meet its obligation to purchase his or her stock.
Below are several alternative methods for raising capital in order to fund the purchase of an exiting owner’s stock pursuant to a buy-sell agreement.
Life insurance is one of the most popular methods to fund a buy-sell agreement. In this scenario, the company purchases insurance on the life of each of its owners. When one of the owners passes away, the company receives a death benefit from the insurance policy, which it uses to purchase the deceased owner’s stock. The deceased owner’s heirs are generally happy because they receive a certain lump sum payment for the owner’s interest in the company without having to engage in the management of a business they are unfamiliar with. The remaining owners are generally happy, because they do not have to worry about taking out a loan or raising cash to purchase the deceased owner’s stock and they will not have to be in business with the deceased owner’s heirs.
If the policy is to be owned by the owners themselves rather than the company, this presents a problem in a situation with more than two owners. Each owner would need to purchase life insurance on each of the other owners, which is inefficient. This can be resolved through setting up a trust to own the life insurance policies on behalf of the owners.
Although using life insurance to fund a buy-sell agreement is easiest when the triggering event is the death of an owner, life insurance policies can also be used to fund other triggering events if the policy permits withdrawal of cash value or loans against the policy.
Another way to fund a buy-sell agreement is to require in the agreement that the company keep a sufficient amount of cash on hand or in liquid investments to fund all or part of the purchase of a departing owner’s interests. The downside of this approach is that the company will be tying up capital that it could otherwise be investing to grow its business. For this reason, this method may be most effective if used in combination with a loan or installment payments (both of which are discussed below), such that the retained cash can provide for a certain percentage of the purchase and serve as a downpayment.
Using a bank loan to fund a buy-sell agreement allows the owners to run the business at maximum efficiency prior to the triggering event occurring. The company does not have to pay monthly life insurance premiums or stash part of its income in a cash account.
However, using a bank loan may be problematic, because a business banks may be hesitant to lend to a business that is losing a key principal. This problem may be resolved by maintaining a line of credit sufficient to cover part or all of the purchase prior to the triggering event occurring.
A bank loan is also problematic because it will require periodic payments that may place stress on cash flow during a period when the business may be weakened after losing an owner.
Installment payments are generally structured in one of two ways:
Installment payments to the seller prevent the stress of the company being required to raise a large sum of cash on short notice. However, like a bank loan, they will be an ongoing cost to put a strain on the business’ cash flow.
In addition, this structure may not be ideal for exiting owners, because they will not receive an immediate payment. This can be moderated via a downpayment from the company. Installment payments make a lot of sense in retirement scenarios or in scenarios that the company wants to disincentivize, such as an owner’s desire to sell his or her stock or the company’s desire to terminate an ownership interest for cause. For more information on how to use a buy-sell agreement if an owner is retiring, check out How to Use Buy-Sell Agreements to Plan for an Owner’s Retirement.