How does a buy/sell life insurance agreement actually work?
When taking out a buy/sell life insurance agreement, business partners purchase life insurance policies on the lives on each co-owner but not on themselves. If a co-owner was to die, the other co-owner(s) will be paid a lump-sum benefit that is then paid to the deceased’s surviving family members. This payment allows the owner(s) to acquire the share of business from the deceased while compensating the grieving family members.
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What are the benefits of a buy/sell life insurance agreement?
Some of the advantages of a buy/sell life insurance agreement include:
- Mutually beneficial. Not only does the family of the deceased benefit through this agreement, but the company won’t experience any financial loss.
- Can cover serious illness and injury. Buy/sell life insurance can also be used to cover total permanent disablement or eligible serious medical trauma.
- Various ownership options. Policies can be owned individually, cross-owned (owned on behalf of the lives of other owners), owned by a corporation or on behalf of those insured.
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Why do people have buy/sell insurance agreements in place?
A buy/sell agreement is an integral part in the business planning process. When a partner is unable to continue running the business due to death or disability, this type of insurance agreement can protect the business — especially for the surviving owners. Buy/sell agreements can also provide coverage for events other than death and disability. This can include:
- Divorce or separation
- Retirement
- Change in lifestyle or careers
- Bankruptcy
Features of a buy/sell life insurance agreement
Some of the main feature in a typical buy/sell life insurance agreement are:
- Guarantee to buy the owner’s shares: The trigger events for a buy/sell agreement are always mentioned in the agreement and all the owners offer a guarantee that the shares of an owner will be purchased if any of the trigger events occur.
- Purchaser of owner’s shares: The agreement will state who will buy the shares of the departing owner. The remaining owners may be bound to purchase the shares of the departing owner, or the company itself may be required have a buyout of the shares.
- Valuation of the departing owner’s interest in the business: One of the main features of a buy/sell agreement is the valuation of the shares of the departing owner. The interest is typically valued as per the market rate of shares at the time the trigger event occurred. Since most businesses differ in valuations over the years, the valuation of the shares of the owners is typically reviewed and re-calculated at least once every year.
- How to fund the buyout: The buyout of the shares of the departing owner is typically funded through life insurance policies on the owner’s lives. In some instances, these policies generally include disability and critical illness coverage.
How much coverage should I purchase?
To determine the level of coverage that you and your business partner(s) may need, consider the value of each owner’s share of the business. This value amount should generally reflect the sum insured on the buy/sell life insurance agreement. It’s important that the business owners review this amount on an annual basis to ensure adequate coverage stays in place.
For example, if a business has two owners and each has an equal share of the business that’s valued at $2 million, the amount insured on the life of each partner should be $1 million on a buy/sell life insurance agreement.
Back to topDetermine the value of your business for the purpose of buy/sell life insurance agreement
The value of your business for a buy and sell life insurance agreement depend on business income, tangible and intangible assets. The three types of valuation methods are:
Formula-based valuation
This formula should reflect an industry standard that’s appropriate for the specific business. The value of the business over the years must also be reviewed by using this formula and it’s important that the business owners are subjective when assessing whether or not the result (value) is realistic.
It’s essential to have the business accountant conduct additional assessment on the valuation and provide a confirmation on whether or not it is acceptable on ordinary commercial terms, which may be an underwriting requirement depending on the amounts insured.
Third-party valuation
This is an unbiased process that helps determine the value of a company while taking every owner’s best interest into consideration. Each party involved is allowed to insert their two cents about the buy/sell agreement if only one valuation firm is chosen for the task.
When each owner hires separate valuation firms, the process is taken a step further in order to compromise between the two valuations. Third-party firms back up their valuations with market research and clear analysis of the company.
Negotiation
Before a trigger event occurs, owners of the business can come together to discuss the value of the business amongst themselves. Once the value of the business has been agreed upon, it should be documented and revisited by shareholders each year to keep up with the market price.
Two drawbacks of this method is that it may be hard to come to an agreement and the value of the company isn’t being calculated by business valuation experts.
Back to topOwnership structures of buy/sell life insurance agreements
When life insurance is utilized to fund a buy/sell agreement, the business owners/partners must consider an ownership structure that’s appropriate to their individual situation and company objectives. Three ownership structures for buy/sell life insurance agreements are:
- Sole propeirtorship
- Partnership
- Corporate ownership
Sole proprietorship
In this ownership structure, a key employee takes out a life insurance policy on the life of the business owner. When the owner passes, their share of the business is bought by the key employee using the death benefit.
Cross ownership
With this type of ownership, each shareholder owns an insurance policy on the other owners of the business. So, in the event that an owner passes away or is permanently disabled, the insurance benefit can be used by the surviving owners to purchase the departing owner’s share of the business. A buy/sell life insurance agreement with cross ownership structure also places the requirements for the transfer without compromising the liquidity needs of the company.
Corporate ownership
In a buy/sell life insurance agreement with corporate ownership structure, the business partners do not own life insurance policies on each other. The corporate entity owns the insurance policies on behalf of the owners of the business. So, in the event of death or permanent disability of one of the owners, the entity will buy out the departing owner’s share of the business using the proceeds from the insurance policy.
It’s important to note that once the company purchases the interest of the departing owner, it does not mean that the shares of the surviving owners in the business will automatically increase, as they do not buy the shares in their own names. The percentage of ownership of each surviving owner, however, will increase.
A buy and sell agreement with corporate ownership is usually easier to put in place when there are multiple owners of a company. The company only needs to buy an insurance policy on each of the owners, rather than all the owners buying policies on each other.
Consider the benefits of buy/sell life insurance agreement for your business
Uncertainties, such as death, illness and injury can greatly affect the financial well-being of a business. You and your partners are exposed to the risk of significant financial loss should the other suddenly die or become disabled. However, with a buy/sell life insurance agreement in place, you can eliminate unpredictability and ensure a smooth business transition — even in difficult times.
A buy/sell agreement is a convenient and hassle-free solution for business owners and their loved ones while preserving the continuity of the business.
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