In our last article, we discussed two deficiencies in a typical Buy-Sell Agreement:
- Failure to consider how the sudden and permanent absence of the deceased owner’s resources (e.g., financial assets and/or talents) threaten the business’ existence.
- Failure to address more common lifetime business exit events (e.g., divorce, incapacitation, termination of employment) with as much detail as they address death.
Each of these failures can ruin an otherwise successful business nearly instantaneously. In this post, we’ll go a step farther by looking at how a poorly structured Buy-Sell Agreement can be the worst thing business owners can do to their financial futures. It’s important to remember that most business owners believe that any Buy-Sell Agreement will protect them, their businesses, and their families from unexpected events. Our goal is to challenge that assumption and show advisors what they must do to disabuse owners of this idea.
Bad Buy-Sell Agreements Can Jeopardize an Owner’s Family’s Financial Security
The most significant and common problem with planning for the financial future of an owner’s family is ignoring the effect an owner’s death or incapacitation can have on financial stability. Most families of business owners rely heavily on the business to support their lifestyles; likewise, the business often relies heavily on the owner for success. If the owner goes away for whatever reason, both the business and the family can feel the effects. It’s up to advisors to make sure that those effects are as positive as possible.
Traditionally, advisors view providing for the decedent’s family as an estate planning topic rather than a business continuity concern. But Exit Planning Advisors take a slightly different tack. Exit Planning Advisors emphasize preserving financial security when an owner exits business ownership whether during lifetime or at death. Essentially, they roll estate planning issues into the overall Exit Plan. They use strategies to position owners to secure the income they want for themselves and their families no matter what. Whether that means exiting as planned or adjusting to a sudden death or incapacitation, a proper Exit Plan addresses the issue.
So, Exit Planning Advisors pose one key question when reviewing their clients’ Buy-Sell Agreements: “Will your family receive as much income if you were to die tomorrow as they would if you were to exit as planned?” When owners truly consider this question—rather than assuming that the answer is “Yes”—they often find a chilling answer.
Buy-Sell Agreements seldom provide financial security for a deceased owner’s family. Even worse, Buy-Sell Agreements typically cause income shortfalls to the deceased owner’s family.
If Buy-Sell Agreements Are So Dangerous, What’s the Point?
The traditional purpose of a Buy-Sell Agreement is twofold:
- To make sure that the surviving owner(s) can continue to do business unimpeded by the decedent’s family.
- To allow the decedent’s family to receive fair market value of the decedent’s ownership interest, in cash, in exchange for transferring all ownership to any surviving owners.
When we say that Buy-Sell Agreements should allow surviving owners to continue doing business unimpeded by the decedent’s family, here’s what we mean:
- The decedent’s spouse and/or children can’t interfere with business operations.
- Ownership remains with those who built the business.
- Employees, customers, lenders, and others are more likely to remain on board when they know that plans are in place to seamlessly transfer ownership to a remaining owner.
Generally, the concept of unimpeded ownership is a good thing for co-owners to think about when discussing a Buy-Sell Agreement. But what about fair market value? Will that standard provide the cash that the decedent’s family will require to live the lifestyle they currently enjoy? It’s extremely rare for Buy-Sell Agreements to consider this question.
Exit Planning Advisors hold Buy-Sell Agreements—and any related agreements—to the higher standard of achieving each owner’s needs. For Exit Planning Advisors, every transfer event, including a buyout at death pursuant to a Buy-Sell Agreement, must achieve the departing owner’s financial security goals.
Financial security is seldom addressed in Buy-Sell planning discussions, much less in the Buy-Sell Agreement itself, which means that typical Buy-Sell Agreements are often the worst thing owners can have to protect their financial futures.
A Common Problem: Fair Market Value Falls Short
A simple example illustrates the problem that arises when a Buy-Sell Agreement provides “only” the fair market value of a decedent owner’s interest.
Wilbur Wilburn and Chuck Charles were equal co-owners of Wilbur & Chuck’s Fabrication. According to a recent appraisal they’d gotten, the business was worth $5 million. They each received annual salaries of $375,000. The business had an additional $1 million of EBITDA that the owners retained in the business to fund its robust growth.
One day while on holiday, Chuck drowned. His estate received $2.5 million from a life insurance policy Wilbur had taken out on Chuck’s life, which was worth exactly Chuck’s half of the business’ value.
Before Chuck’s death, Chuck, his wife Lynn, and three children lived on his $375,000 salary. After Chuck’s death, Lynn’s financial planner suggested that $100,000 per year was a reasonable withdrawal rate from Chuck’s $2.5 million policy, based on a 4% withdrawal rate. This meant that the surviving Charles family would have its income cut by almost 75% following Chuck’s death.
Despite Chuck’s estate receiving the full value of his ownership, the financial blow that Chuck’s death dealt was devastating. The Buy-Sell Agreement did exactly what Chuck and Wilbur thought they wanted it to do, but Chuck’s family still got crushed.
Obviously, the Buy-Sell Agreement was flawed in its design, since it ended up hurting Chuck’s family despite transferring the fair market value as planned. The flat value of Chuck’s ownership interest ($2.5 million) ended up being worth less than the yearly income ($375,000) the business produced for Chuck and his family. What could Wilbur and Chuck have done to make the Buy-Sell Agreement address such a huge shortfall? The following is one strategy they could have used:
- Upon an owner’s death (in this case, Chuck’s), controlling interest is transferred to the surviving owner (i.e., Wilbur). The balance of ownership is retained by Chuck’s family in a trust.
- Each owner purchases life insurance on their own life using a respective trust, rather than purchasing life insurance on the other owner’s life. For example, assume that prior to his death, Chuck Charles had created an irrevocable life insurance trust (ILIT) funded with a $2.5 million life insurance policy on his life for his family’s benefit.
- Result: Wilbur Wilburn controls the company. Chuck’s family has a large minority interest and a proportionate share of distributed income, plus income from the $2.5 million of life insurance proceeds.
This is just one of many solutions to the problem of an ill-fitting Buy-Sell Agreement. The point is that most owners need better Buy-Sell Agreements, and it’s on advisors to explain that in terms they understand and care about.
The Fairness of It All
Some estate planning advisors might view this concept as unfair to the surviving owner. “Why should the survivor be forced to use the company to support the decedent’s family?” they might ask. We would counter that a traditional Buy-Sell Agreement is much less fair to a decedent’s family than a properly planned Buy-Sell Agreement is to the surviving owner.
After all, in our case study, Wilbur Wilburn has the benefit of continuing his $375,000 salary. He also has the benefit of adding Chuck’s salary to the $1 million EBITDA, which is now all Wilbur’s. Meanwhile, Chuck’s family lives on $100,000 a year, which is just barely over a quarter of what they were living on prior to Chuck’s death.
In short, fairness depends on whom advisors represent. Exit Planning Advisors never assume that their clients will be the surviving owner within the Buy-Sell Agreement. To do so is a dereliction of their duties to prepare owners for their business exits, regardless of how they exit.
There are alternative strategies Exit Planning Advisors use to remedy to this situation. One involves providing additional income to the decedent’s family via the acquisition of additional life insurance on each owner’s life for the benefit of each owner’s family. If the owners are readily insurable, this is the least expensive solution.
- Property designed and funded Buy-Sell Agreements are important tools in transferring business ownership upon the death of a co-owner. But as standalone documents, they typically fail to ensure that the decedent owner’s family continues to enjoy the income it did during the owner’s lifetime.
- The standard for Exit Planning is that all of an owner’s goals and aspirations must be met, whether the transfer of ownership occurs during lifetime or at death. Achieving that standard when business owners die before their planned exits requires much more than a standalone Buy-Sell Agreement.