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Creating Your Legacy: Critical Questions to Answer When Drafting Your Buy-Sell Agreement

By October 4, 2022 No Comments

So, you’ve done it. Your lifelong dream of being a business owner is now a reality. You’re running a successful company. But have you considered what happens when you’re ready to retire? Or even worse, what happens if there is a premature death or disability of an owner? While it may seem like a far-off reality, legacy planning for the business you’ve worked hard to build is an essential ingredient in running a successful business for the long haul. And that’s where a buy-sell agreement comes in.

A buy-sell agreement is – in its barest definition – a contract between business owners to provide for ownership succession. It is a foundational tool that helps ensure the business can keep thriving as the organization and its owners grow and change.
Below are some of the key questions to consider when creating your buy-sell agreement.

How will you fund owner exits?

Often, we see that the exiting of an owner can cause the organization to produce a large amount of capital for the owner’s buyout, which has the potential to create financial stress on the company. This can often be mitigated through stipulations in the buy-sell agreement. There are several ways to fund owner exits, including lump-sum payments, installment payments, and gradual stock transfer. Transfer of this risk to an insurance company can also mitigate the capital needed from the business or other owners. Working with a wealth advisor and an attorney can be useful to figure out a good financing option for your organization.

How should you structure any insurance policies held to fund a Buy-Sell Agreement?

While this may seem unlikely, protecting your business in the event of an owner’s death or disability is important. The two most common forms of funded buy-sell agreements are cross-purchase and entity purchase arrangements. Usually implemented in businesses with fewer owners, in a cross-purchase arrangement, each owner purchases an insurance policy on the other. This allows the surviving owner to fund a buyout using the insurance proceeds and increases the tax basis of the survivor. This can also help reduce any subsequent taxes due on a future sale of the business. In an entity purchase arrangement, the business owns the insurance policies on all owners and uses the proceeds to repurchase the shares, which are then retired.

How do you replace owners that have exited?

Typically, when owners start exiting, the business is still going. Therefore, it’s important that the buy-sell agreement lays out the terms of owner transition. For example, who is replacing this owner? What guardrails are in place for the person replacing this exiting owner? How will knowledge transfer work? All of these items should be outlined in your buy-sell agreement to help ensure the business is not negatively impacted by an owner’s exit.

Preparing for the Unthinkable

Due to business slowdowns caused by the unprecedented Covid-19 pandemic, many of our business owner clients revisited their buy-sell agreements. Some were able to temporarily adjust valuations and owner stipulations to keep the business safe while it “weathered the storm.” Consequently, we see more and more agreements include these “failsafe” clauses to protect the business during unforeseen events.

How will you valuate your business?

Your buy-sell agreement should outline how you value the business. There are a few ways one can value their business for legacy ownership or sale. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBIDTA) multiples are one way but are not the only way. From book value to enterprise value, it’s vital to use the right formula for your industry and organization. It is also fairly common to include a failsafe provision that allows an independent valuation expert to appraise the business. And even more importantly, as the company grows, it’s essential to reassess your valuation formula. Of course, it’s not wise to constantly change your valuation formula. However, if your company grows from 20 employees to 200, it may be time to revisit your valuation method. SignatureFD has a fairly simple valuation tool that can help you get started.

How will you create a business prepared for your exit?

Once you’re ready to retire and fully enjoy the fruits of your labor, it’s important that the transition set you – and the organization you’ve worked hard to build – up for success. Will you remain on the board? Will you be passing the organization to family or key employees? Will you be selling the business? These are key questions to consider as you build the legacy terms in your buy-sell agreement.

Are you interested in speaking with someone about your business organization’s legacy? Contact SignatureEntrepreneur at matt.barber@signaturefd.com.

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