If you own a business with one or more partners, you may want to consider establishing a Buy-Sell agreement that is funded with life insurance.
A Buy-Sell life insurance agreement protects a business from the unforeseen death of a partner by providing the business with a lump sum of cash. This money is then paid to the deceased owner’s family, buying their share of the business, and allowing the company to continue operating without liquidating or selling assets.
In this this article, we’ve explained everything you need to know about establishing a buy-sell life insurance agreement in four easy steps.
Quick Article Guide:
1. What is a Buy-Sell Life Insurance Agreement?
2. Step 1: Determining the Value of Your Business
3. Step 2: Calculating Each Owner’s Share of the Business
4. Step 3: Does Every Partner Need Insured? What to Do When a Partner is in Poor Health
5. Step 4: Information to Have Available with You When You Call
6. A Real-Life Example of How Buy-Sell Agreements Work
7. What if Our Company Needs Additional Funding to Replace Our Lost Business Partner?
8. We Can Help with All Your Buy-Sell Life Insurance Needs
A Buy-Sell life insurance agreement is commonly used by established businesses with two or more owners as a method to settle the business’ equity if an owner were to pass away. With a Buy-Sell life insurance agreement, each owner purchases a life insurance policy that provides a death benefit equal to their ownership share in the business.
If a business owner were to pass away, the death benefit from their life insurance policy will be paid to their surviving family buying out their share of the business. This is designed to provide the deceased’s family with a source of income while allowing the business to continue to operate. Without Buy-Sell life insurance agreements, businesses are often forced to shut down and liquidate in order to reimburse the surviving family for their share of the business.
A Buy-Sell life insurance agreement also establishes a contingency plan for your business, and it prevents you from being forced to work with your business partner’s spouse or family members. In addition, it provides you with peace of mind that your spouse or dependent family members will not be forced to work with your business partner(s) in order to make ends meet.
The first step to establishing a buy-sell life insurance agreement for your business is to determine the overall value of your business. There are three commonly accepted methods for calculating a business’ value, these are; Book Value, Market Value, and Capitalization of Earnings.
Book value – The book value of a business is essentially the business’ net worth. It is calculated by adding all the company’s assets minus all liabilities.
Market Value – The market value of your business is the value that a willing and knowledgeable buyer is offering to pay you for your business. If the market value of your business is higher than the book value of your business, the difference is referred to as “good will” value, and most insurers will offer you the higher amount.
Capitalization of Earnings – A business’ capitalization of earnings is calculated by averaging the previous year’s net revenue. If the business is young, this estimate may also rely on forecasts of future earnings. Most service-based companies that do not own a large amount of physical assets like; equipment, buildings, and property, utilize the capitalizations of earnings formula.
Once you’ve determined the value of your business, you need to calculate how much each owner’s share of the business is worth. If each owner owns an equal share of the business, simply divide the value of the business by the number of owners. If each owner owns a different percent of the business, you’ll need to multiply the percent of the business they own by the total value of the business.
As an example: Let’s assume the ABC Trucking Company is worth $6,000,000 and has three business owners. A owns 45%, B owns 30%, and C owns 25% of the business.
Owner A: 45% x $6,000,000 = $2,700,000
Owner B: 30% x $6,000,000 = $1,800,000
Owner C: 25% x $6,000,000 = $1,500,000
After you’ve determined how much each owner share of the business is worth, each owner should apply for a life insurance policy with a death benefit that is equal to their share of the business. This is also commonly referred to as an; entity purchase, stock purchase, cross purchase, partnership insurance, or stock redemption.
Your business structure, and the number of business owners your company has, will determine the type of Buy-Sell agreement you need to establish.
Cross Purchase Buy-Sell Agreement:
If your business has two owners, you will probably want to establish a Cross Purchase life insurance agreement. With a Cross Purchase agreement, you are buying a life insurance policy on your business partner, and they are buying a life insurance policy on you. You and your partner will be listed as the payor and the beneficiary of the other’s life insurance policy.
If either business owner passes away, a death benefit will be paid to the surviving business owner who will in-turn pay this money to their deceased partner’s surviving family. This provides the deceased partner’s family with an income, and buys out their interest in the company, preventing their surviving family members from becoming involved in the day-to-day operations. It also prevents the company from being forced to liquidate or sell off assets, to pay the deceased owner’s family their share of the business.
Stock Redemption Buy-Sell Agreement:
If your business has more than two partners, you’ll probably a want to avoid a cross purchase buy-sell agreement. This is because each owner would need to purchase a policy on the other two owners, and with just three owners, you would need to purchase six life insurance policies:
• Owner 1 would need to purchase policies on owner’s 2 and 3
• Owner 2 would need to purchase policies on owner’s 1 and 3
• Owner 3 would need to purchase policies on owner’s 1 and 2
Instead, corporations or businesses with multiple owners usually establish a Stock Redemption Buy-Sell agreement. With a Stock Redemption agreement, the business is listed as the payor, and owner of each partner’s life insurance policy. One policy is purchased on each owner, and if any of the owners die, the corporation collects the death benefit from their life insurance policy.
Like a Cross-Purchase agreement, these funds are then paid to the deceased owners’ surviving family, allowing the company to reimburse them for their share of the business. This method is easier to manage and more cost effective with multiple owners, but it still protects the corporation from selling assets to redeem an owner’s share of the business.
To effectively utilize a Buy-Sell life insurance agreement, all the owner’s lives must be insured for an amount that is equal to their ownership share of the business. If one of your business partners has health issues that would otherwise prevent them from qualifying for coverage, we can help. We are experts are finding the most affordable life insurance options for applicants who are a high risk for life insurance.
Our in-house underwriting team provides more than 50 years of collective experience and we work with more than 60 top-rated life insurers. Each insurance company sets their own underwriting guidelines, and some life insurers provide more relaxed guidelines with some health issues than others. By matching you with the company that offers the most lenient underwriting for your condition, your much more likely to get approved, even if you’ve been declined before.
There are also some insurance companies that offer leniency with businesses that need to fund a Buy-Sell agreement because they’re hoping to gain business from multiple owners who may be in better health. Over the years we’ve helped thousands of clients in less than perfect health, and we can help you too.
In the unlikely event that an owner’s health is so poor that our 60+ companies will not offer coverage, the other owners still have an option to purchase their policies, but the life insurance company will require a letter that explains how the uninsurable owner’s share of the business would be paid out if they died. This predetermined amount is usually paid to the owner’s heirs as a schedule of payments overtime, minimizing the financial impact to the business.
There are some basic requirements needed when applying for coverage to fund your Buy-Sell life insurance agreement. Most business owner’s will apply for a 10-year term, but you can also apply for a longer term if needed.
In addition to the length of the term, and amount of coverage needed, here’s what’s required for each owner’s application:
• Each owner’s first and last name, date of birth, and ownership share of business. The life insurance company will verify that all owners are being insured.
• The approximate value of the business and how it was calculated (book value, market value, or capitalization of earnings).
• A copy of the company’s buy-sell agreement, provided by your corporate attorney. This can be collected after the policies are approved and beneficiaries are named.
• An overview of the business/industry and appropriate financials to support the value of the business (balance sheets, income statements, tax returns, etc.)
• The businesses address, taxpayer ID, and any other statements which can provide financial insight into the business.
Once each application has been completed and the coverage has been approved, the insurance company will mail a copy of each policy to your business for safekeeping.
Family Smile Care is a dental practice owned by dentists; Dr. Mason, Dr. Swanson, and Orthodontists Dr. Aragon. Dr. Mason and Dr. Swanson each own 30% of the business, and Dr. Aragon owns the remaining 40%. The dental practice was recently valued at $5.4 million dollars.
To correctly set up the buy-sell agreement, each partner purchased a life insurance policy for the equivalent to their ownership in the business. Dr. Mason and Dr. Swanson, each applied for $1.6 million in coverage, and Dr. Aragon, $2.2 million.
The company pays for the policies, and if one of the business partners passes away, their share in the business will be bought out by the company through the proceeds of their life insurance policy. This amount will be paid as a tax-free lump sum to the named beneficiary, and in this group, each business partner listed their spouse as their policies primary beneficiary.
Would your business suffer from financial loss if an executive or employee with specialized skills suddenly passed away? Also known as “key-person” insurance, businesses commonly purchase life insurance for executives and important employees in addition to the coverage they purchase to fund their buy-sell agreements. Unlike Buy-Sell agreements which provide the deceased business partner’s family with money, key-person insurance is designed to provide the business with money
If an executive or key-employee dies, the life insurance proceeds are commonly used to locate, hire, and train a new employee to take this over this person’s duties. Key-person insurance can also mitigate the loss of income to the business can expect to encounter due to the death. To learn more about purchasing life insurance to protect your business from the loss of a key employee, please read our article, “Buying Life Insurance for A Key Employee.”
At Term Life Advice, our experienced agents have helped hundreds of business with their Buy-Sell insurance needs, and we can help you too. We can walk you through the process of purchasing life insurance coverage for each owner, and we’ll compare rates and underwriting guidelines from dozens of highly rated life insurers to make sure we match each owner with the best option available.
By pre-qualifying our applicants, we’re able to ensure that they are matched with the best company for their unique health profile. This saves the business money, and it decreases each owner’s chance of being denied coverage. If your blood work results are different than expected, we can move your labs to the next best company available, and you won’t have to complete another exam.
Our agency even offers affordable no exam term insurance policies to qualifying applicants under the age of 70. Most importantly, we offer the best customer service in the industry, and we’ll make sure every step of the process is handled professionally. We’re business owners ourselves!
If you have additional questions about setting up a buy-sell life insurance agreement to protect your business, or if you’d like accurate quotes for your business partners, give us a call today at: 855-902-6494. You can also request a free instant quote online below to compare thousands of options from dozens of highly-rated insurers in less than a minute.