Most companies wouldn’t go into business without some basic types of insurance in place, such as property coverage and a liability policy. For a company with more than one owner, there’s an additional type of risk-management arrangement that needs to be established: a buy-sell agreement.
If your business has yet to create one, you should start the process as soon as possible. A conflict over ownership change can distract a company at the very least — and devastate it at worst. But, even if you have a buy-sell in place, there are a couple key elements to regularly review: funding and valuation.
Evaluate your funding
For many businesses, payouts for a buy-sell agreement are funded with a cash-value life insurance policy or a disability buyout insurance policy. There are two main types of life insurance-funded buy-sell agreements:
1. Cross-purchase agreement. Co-owners buy insurance policies on each other, using the proceeds to buy a deceased or disabled party’s ownership shares. They receive a step-up in cost basis that may reduce taxes if the business is later sold. This option is usually preferable if there are three or fewer business co-owners.
2. Entity purchase agreement. The business entity buys insurance policies on each co-owner and uses the proceeds to buy a deceased or disabled owner’s shares, which are divided among the remaining parties. Co-owners receive no step-up in cost basis with an entity purchase agreement. This option is usually preferable if there are four or more owners, because it eliminates the need for each one to buy so many insurance policies.
Engage a valuator
It’s usually wise to hire a professional appraiser to perform a business valuation when drafting a buy-sell agreement. The valuation should then be updated periodically as circumstances that could affect the value of the company change. In fact, the buy-sell agreement itself should be reviewed by each co-owner from time to time to make sure it still reflects everyone’s intentions.
One specific issue to consider is how the “standard” of value is defined. A business valuation expert can provide definitions for a variety of relevant standards — including fair market value, fair value, book value and investment value. Different triggering events or departing shareholders may require different levels or standards of value.
Customize your agreement
Having a standard, boilerplate buy-sell agreement can be just as dangerous as not having one at all because its provisions may cause confusion or trigger disputes. Yours should be a customized, living document that provides a clear mechanism for equitable ownership change. Our firm can help you review the agreement you have in place or create one if you have yet to do so.
© 2020 Covenant CPA