Preface: Buy-Sell agreement funding terms are key to the effectiveness of the agreement. You should properly plan funding to improve the success of your buy-sell agreement.
Funding a Buy-Sell Agreement is the Key to the Agreements Effectiveness
A buy-sell agreement is only as effective as the agreement terms for funding. You can appropriately document in the plan i) how the business will be valued, i.e. valuation methodologies, ii) restrictions on who can participate, i.e. right of first refusal, but if the buyer cannot pay the seller, the buy-sell agreement is ineffective. Funding options for a buy-sell agreement include i) cash ii) owner notes iii) combination of cash and owner notes, or iv) life insurance.
Cash can be obtained from corporate assets, personal assets, or external borrowings. Say that a buy-sell agreement is sparked and cash required. If the purchaser in the buy-sell agreement is relatively young, and has yet to build the capital reserves to purchase with cash say a $1,500,000, 40% business interest that is being liquidated, the company can sometimes borrow against its capital assets to fund that purchase of the business interest; or maybe the company can distribute the cash if an appropriate plan is in place. A little forethought here can help those left-behind. This can be as simple as creating and contributing cash to a reserve account for fund a buy-sell agreement, and/or building equity in the business that can be borrowed against.
Owner notes can be written between buy-sell agreement participants. For instance if a $5,000,000, 50% interest is at stake in buy-sell agreement discussion, a seller note can written that will fund the business interest with-in say a 7 year amortization period, with applicable interest. The risk is that cash flow, and earnings from the company must be adequate to fund the loan payments. Businesses that are managed well and have strong earnings to assets will do well with seller financing. Restrictions can be placed on the acquired interest to protect the seller. Seller notes require an attorney. A business that is highly leveraged and has capricious earnings will have higher risk. With owner notes, the payment terms must cash flow. For instance a note for $3,000,000 payable in 5 years would require after tax flow of $600,000. This is pre-tax earnings of say $1,000,000. If the $3,000,000 is a 50% interest the company must cash flow $2,000,000 to achieve payment terms on the equity acquisition of 50% from cash flow. Before agreeing to terms you must have a realistic expectation of future earnings predicated on historic earnings. Be practical. Don’t project the buy-sell agreement owner’s note on revenue increases of 10% per year.
A combination of owner notes and cash is often practical. Say a $1,200,000 purchase of an interest could be purchased with $500,000 cash payment at settlement from the buyer, and $700,000 on notes from the seller with a 7 year amortization. Whether loans are obtained from owner financing or say a bank, you must realistically plan for working capital requirements too. If your business earns $300,000 after-tax earnings a year for your ownership interest, you cannot expect to draw the entire $300,000 from the business for the buy-sell agreement financing. You will need cash for capital expenditures, development and continuity of the business. Work with your CPA to plan accordingly for cash flow requirements.
Life insurance buy-outs can be complex because there can be differing opinion on whether the insurance is an asset of the business or a separate asset. Life insurance expenses drain capital from the business if never required, and may only be optimal in certain circumstances.
Summary: the terms of financing the buy-sell agreement is key to its effectiveness, and the practical value of the agreement. If you can set the terms, you don’t need to worry so much about the price. When you prepare or update your buy-sell agreement, make sure you give appropriate thought to the terms of financing.