Buy-Sell Agreement Pitfalls: An Overlooked Resiliency Strategy for SMEs
Current economic uncertainty is driving fears of possible recession, rising inflation and lingering impacts of COVID. While companies of all sizes have prioritized operational resiliency over the past two years, a large gap remains for many small- to mid-size business — succession planning.
Growing companies often purchase additional insurance coverages to better mitigate risks exposure, including that of its board and directors. Yet an often-overlooked component can leave companies vulnerable to financial ruin: the buy-sell agreement.
A buy-sell agreement allows businesses to plan for succession issues following death, disability or retirement of a key person by enabling the owners to specify how, when and at what price each will sell their business interest.
When multiple owners are involved, there is a real risk of losing operational control as shares go to a deceased owner’s heirs. Many companies do not have cash available to buy out a former owner’s beneficiaries, leading to liquidation or uninterested owners joining the cap table.
When companies believe a buy-sell agreement is unnecessary because of their age, size or ignorance, the lack of preparation causes chaos when an unexpected event does occur.
The Small Business Administration reports that nearly 30 million businesses in the U.S. are privately held and nearly 6 million of those have multiple employees. A significant percentage of these companies are owned by older individuals gearing up to transition into retirement, meaning many companies will be sold or ownership structures will be renegotiated.
Frequently, small- and medium-sized business enterprises (SME) find themselves unable to deliver the cash necessary to buy out their partners without the assistance of tools like buy-sell agreements.
In fact, a recent survey by the Exit Planning Institute indicates that less than 50% of SMEs have proper succession plans in place. This staggering statistic highlights a growing concern around the long-term operational resiliency of SMEs. It is imperative that SMEs with multiple owners prioritize succession planning if they want to ensure their business is not thrown into disarray during an owner transition.
Some structures to fund a buy-sell agreement carry more risk than others; options include company savings accounts, loans and life insurance. The last option, life insurance, tends to carry less risk for the organization by ensuring funds are available immediately at a lower cost than a loan might provide.
Cross purchase and entity plans both allow owners to structure life insurance solutions at preset valuations to help pay out the heirs of a deceased owner. With cross purchase plans, each owner purchases a life insurance policy on the others and is a named beneficiary.
In an entity plan, the company purchases life insurance policies on each owner with the company as sole beneficiary. In either case, the beneficiaries receive the life insurance proceeds tax free to purchase the deceased’s business interest from their heirs at a pre-negotiated price.
Establishing a buy-sell agreement early enables firms to think through these scenarios and plan accordingly for everyone’s best interest — company and owners alike.
Ownership transitions are always challenging, but particularly for closely held and operated SMEs grieving the death of an owner. Proper planning helps smooth the transition and protect the financial interests of owners’ families. Firms should explore these types of programs with their legal and insurance advisors. &