A properly structured Buy-Sell Agreement (BSA) ensures a market for owners’ equity when they leave the business, restricts the transfer of shares to unwanted parties, and lays out a set of rules and processes that mitigate the overall risk of uncertainty when a trigger event occurs. However, without having adequate funding mechanism(s) in place, a well-intentioned buy-sell agreement may not satisfy the shareholders needs when a trigger occurs.
In this post I’ll briefly outline the three most common funding sources that we find when reviewing buy-sell agreements for business valuation purposes.
- Life insurance is the safest bet in case of the death of a shareholder. The proceeds are paid out promptly, and if any additional payment is required one of the other methods can be used to facilitate full payment. Several tax and administrative issues need to be considered depending on whether the shareholders or the corporation owns the policies. The type of policy — term, variable or whole life — is also a consideration. The premiums for whole life are substantially higher than for term, but it builds cash value that can be used even if a death doesn’t occur. The BSA should be specific in how life insurance proceeds are to be treated for business valuation purposes.
- Seller financing is often used in BSA’s. Price and terms of the note should be clearly spelled out: full payment upon a trigger event? Or a down payment, term, and rate? Some agreements adjust the rate annually to reflect market rates, where others leave the rate fixed or pegged to a benchmark rate as of the buy-sell date. What about protection in case of default? My point is that there is no prescribed way. Obviously financing is a negotiation that can be as creative or as simple as the participants deem practical.
- Corporate cash or a bank loan that provides funding is another funding. However, cash isn’t always an option for small, closely-held firms that lack large cash reserves. Securing a bank loan for buyouts is often challenging, especially when a firm has just lost a key executive.
As a fourth option, we occasionally see clients partner with a private equity group to buy out a departing shareholder. By doing this they can also gain access to new capital to support future growth. This type of funding is usually only available to companies with a few million dollars in annual free cash flow. We know a lot of private equity groups and can make introductions when appropriate.
It’s important to point out that these funding options are not mutually exclusive, and are often used in tandem to fund the buyout of a departing shareholder. We recommend that not only should a buy-sell agreement and the valuation be updated every year or so, but also that funding options be reevaluated and updated based on the company’s financial position, ownership and current valuation.
Exit Strategies brings independence and over 100 years of cumulative business valuation and M&A transaction expertise to every engagement. Founder and president Al Statz is available for free confidential consultations. You can reach him via email or by phone at (707) 781-8580.