Reality check: is your buy-sell agreement properly funded?

A well-funded and written buy-sell agreement can significantly reduce the risk of owner disputes and potential litigation. When was the last time you reviewed your company’s buy-sell agreement?

Buy-sell agreements ensure the continuity of a business in the event of the death or disability of an owner. Generally, upon an owner’s death, disability, involuntary departure (e.g., bankruptcy) or voluntary departure from the business, that owner offers his ownership interest to the other owners and/or company for mandatory or discretionary purchase. Buy-sell provisions can be agreed to among owners in a stand-alone document or be incorporated into an operating agreement or shareholder agreement.

Types of buy-sell agreements

Quite often these buy-sell obligations are funded by life insurance policies, wherein either the company or the individual co-owners purchase a life insurance policy on each co-owner. While buy-sell agreements can take many forms, there are typically two main structures:

Cross purchase plan
Each owner purchases a life insurance policy on another owner, then pays the related premiums and is the designated beneficiary of the policy. Upon the death of the insured, the other owner receives the death benefits and uses the funds to purchase the decedent’s share of the business. The buy-sell agreement must mandate the purchase of the decedent’s interest by the remaining owner(s).

Redemption plan
The business purchases separate life insurance policies on each owner, then pays the related premiums and is the designated beneficiary. Upon the death of the insured, the company receives the death benefit and uses the funds to purchase the ownership interests of the decedent. The buy-sell agreement must mandate the purchase of the decedent’s interests by the company. 

Structure the agreement carefully

Each buy-sell agreement has numerous moving parts that must coordinated with precision to be effective. If the terms of the life insurance policies do not correlate with the provisions of the buy-sell agreement there could be a windfall to the surviving owner. Many form/template agreements state that upon a triggering event the remaining owners or company “may” purchase the subject interest. However, without making the buy-out mandatory (i.e. “shall”), there is no assurance the buy-sell provisions will work as originally intended.

For example, Joe and Joan each own 50% of Business, LLC, valued at $2 million. Each buys a $1 million life insurance policy on the other, then pays the related premiums and is the beneficiary of the policy. The LLC suffers and its value declines to $1 million. Joe dies and Joan receives the $1 million death benefit from the life insurance policy on Joe’s life. However, the buy-sell agreement provides Joan the option to purchase Joe’s interest. Joan declines, thereby triggering the LLC’s obligation to purchase Joe’s ownership interest through a promissory note paid over time. Joan keeps the $1 million death benefit rather than using such funds to purchase Joe’s interests from his family or estate. This results in a windfall to Joan to the detriment of Joe’s family, who, in lieu of a lump sum, remains as a passive owner, draining cash and resources of the business without contributing anything of value.  

A business owner cannot predict the future but can prepare for it by making sure the buy-sell provisions and life insurance terms for the business are properly structured. To discuss further or to have an experienced attorney review the terms of these provisions for your business, please contact an attorney from the Corporate Transactions & Business Law practice group.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client Alert authored by: Christina M. Mermigas, Principal