Business owners today are either not taking advantage of buy-sell agreements, or worse, they’re not properly funding their current policies. This is likely due to a lack of information on the topic. Have you talked to your clients about how to protect their business?
Unfortunately, there are just too many misconceptions about the proper funding techniques and how to take advantage of them. Of course, there are business owners out there who have taken steps to protect themselves. They enter into buy-sell agreements with their partners and successfully shield themselves from unforeseen pitfalls. But simply purchasing a life insurance policy is not enough. Before you approach potential clients about buy-sell agreements, you need to know the basics.
We sat down with Paul Sanfilippo, a Brokerage Director here at Pinney Insurance, to find out more about this kind of business agreement.
What is a buy-sell agreement, and why are they important?
In a business buy-sell agreement, owners are provided an exit strategy in case something happens to one or the other. These policies are important because they serve as protection for the surviving partner in the event of a death and/or the healthy, working partner in the event of a disability or major injury to another owner.
Think about it. If two or more individuals enter into a partnership to do business, and one of them suddenly passes away, what happens to the surviving owner? First, half of his business now transfers from his partner to his partner’s family (likely his spouse).
This means Partner X now must pay Partner Y’s family, even if they don’t bring anything to the table.
To get Partner Y’s family out of the business, a buyout agreement will cost Partner X 50 percent of what the company is worth. So say we’ve created a company worth $10 million. You’ll need $5 million to payout my family in the event of my death.
Disability works the same.
If Partner X becomes permanently disabled and can’t return to work, not only does Partner Y have to pay him, but he also has to find and pay for his replacement. That becomes costly and can sink a company.
Who can take advantage of this?
All business owners can. Start-ups, small business or big—every business owner should have a Buy-Sell agreement in place. These can be done between two partners or multiple owners, and the percentage of shared interest can be split however the partners want. For example, it can be done 50-50 or 51-49 for two in a cross-purchase arrangement. Likewise, it can be done 70-20-10 or 60-20-20 for three, as seen in an entity purchase arrangement.
What are the biggest misconceptions regarding Buy-Sell policies?
- They aren’t funded properly. You have an agreement in place, but now you have to fund it. There’s two ways to do so. First, you can use a sinking fund—stick $500,000 in a bank to use as collateral. Or, you can buy a life insurance and a disability policy to protect the rights of the owners. Companies create their own insurance groups called “captives” that pay their premiums to the insurance captive to protect against risk. Instead of paying premiums to insurance companies, that money comes right back to them. This is sophisticated high-end planning.
- There’s a lack of appraisal on a regular basis. Business owners should get their business valued and revalued every three years or so because what it’s worth now won’t be the same forever. So you have to make sure you have the appropriate amount of coverage at all times. At the time of death, the amount owed to family is not based on the initial arrangement; it’s based on the value of the business today. So if our company is worth $1 million at the time of agreement and I put $500,000 aside, I’m going to be in trouble when the company is worth $10 million at the time of death because now I owe $5 million. As you can see, I’m $4.5 million short because I didn’t properly fund and I didn’t re-evaluate the company’s worth.
- The disability portion is skipped. Business owners are so focused on death that they don’t even consider the disability portion. But this is equally important. An individual is 3 times more likely to become disabled than to die during their working career. If you become injured and you’re out for a year or two, I now have to pay you to sit at home and I have to pay your replacement. I’m now paying double. That can easily bankrupt a company.
At Pinney Insurance, we pride ourselves on being the only full-service digital BGA in the marketplace.
We've partnered with many organizations that provide solutions for you, the agent, to succeed. Not only can you utilize proven and effective strategies, you can provide your clients the peace of mind needed to properly protect their business.
We’ve put together a successful turn-key process that allows you to get back to working with business owners. Best of all, this process creates a starting point for discussions with your clients’ tax and legal advisors. You’ll be able to provide an informal valuation of their company. Analyze existing policies and agreements to show potential challenges, spotlight future problems, or confirm that the companies objectives and agreements are up to date.
Pinney Insurance takes care of the behind-the-scenes procedures so you can get back to the more important aspect of sales: building real, worthwhile relationships with your clients. For more information, call us at 1-800-823-4852 or e-mail your Brokerage Director.