Once you’ve completed your business valuation; consulted your tax, legal and financial advisors; and created a written buy-sell agreement, it’s time to decide how to fund the resulting financial and other obligations.
First, your buy-sell agreement is probably a binding legal document. You don’t want to be left out there with unfunded or underfunded financial responsibilities.
Second, arranging funding takes time. The best time to start is right away.
Third, the options available are fairly limited and confusing to many business owners since the options involve techniques often outside their areas of expertise.
How do you fund your buy-sell agreement? The two most common options are a sinking fund and life insurance.
A sinking fund —or reserves — is cash or cash equivalent you build up over time. The plan is to have the funds obligated under the buy-sell agreement fully available before a triggering event takes place. The problem? The best-laid plans often go awry — lack of time to accumulate needed funds, failing to start the fund or borrowing from the sinking funds for other reasons. A major advantage of a sinking fund is the potential availability of cash to meet such triggering events as retirement or asset division in the case of a divorce.
The most frequently used option is some form of life insurance to fund the buy-sell agreement. If the life insurance has cash value, that value may be used to deal with such triggering events as disability, divorce or retirement of the insured person. Even better, the amount of the insurance itself is immediately available in the event of death of the insured to buy out their business interest or shares and keep their heirs out of the business.
The most common types of life insurance for funding a buy-sell agreement are traditional permanent life insurance (usually whole or variable); first-, second- or last-to-die life insurance; and term life insurance.
Permanent life insurance is just that. As long as premiums are paid on-time and in full, the policy performs as predicted and the insurance should be around as long as needed. In addition, the policy builds a cash value — subject to interest rates and underlying investment performance — that can be accessed by the policy owner in the form of a loan and used to fund obligations in case of retirement, divorce, disability or other triggering events.
There are three main types of permanent life insurance: whole, universal or adjustable and variable.
Whole life offers a guaranteed rate of return so the cash value at a given point in time is certain, as is the death benefit.
Universal and adjustable life insurance offer both an interest rate guarantee and option to let the interest rate on the cash value float. This float can increase the cash value and/or death benefit, but could also reduce policy values or require additional premiums in a falling or low-interest rate environment.
With variable life insurance, the cash value is invested in equities (rather than interest-bearing options). While there’s significant upside in terms of cash value, there’s a major downside if equities fail to perform over the mid- to long-term. If the intent is to tap the policy value to fund (non-death) triggering events, this option offers the greatest potential return if the risks are acceptable.
First-, second-, or last-to-die life insurance policies might allow your business to insure multiple lives with fewer life insurance policies. If you have four owners and purchase life insurance policies on each of them, you’ll need either 12 policies (each person owns three policies) for a cross-purchase agreement or four policies (the business owns four policies — one for each person) for an entity/stock redemption agreement.
First-to-die policies insure two or more people on one policy, paying a benefit when the first person dies. This can provide an important cash influx at a time the business needs it the most and keep heirs out of the business by paying them cash. Second- and last-to-die policies pay when the last insured dies. If family members are the business owners, this type of insurance can work since the benefit is probably needed mainly for estate purposes.
Term life insurance is a relatively inexpensive way to insure multiple people, as in a cross-purchase agreement. There are two main disadvantages: The term might not be long enough, and the cost of policies for older or less healthy owners is high and unfair to younger or healthier owners who have to pay for those policies.
I’ll provide additional information about each type of life insurance in future columns.
Disclaimer: This column does not offer financial, legal, tax or other advice. Policy performance and needs may vary greatly from the preceding. Policies offered by insurance companies are often combinations of several policy types, so the pros and cons could vary. Consult professional advisors before making any financial, legal, insurance, tax or other decisions or purchases.