Funding Your Buy-Sell Agreement

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, when adequate funding mechanism(s) aren’t in place, this well-intentioned agreement may not work as intended.  I will briefly outline three common funding mechanisms that we see in our review of buy-sell agreements for business valuation purposes.

Life insurance is the safest bet in case of death. 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 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 also 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 loan that provides funding is another funding alternative. However, cash isn’t always an option for small, closely held firms who lack large cash reserves. A loan is a possibility however, it may be a challenge to obtain bank financing to buy out an owner, especially when a firm has just lost a key executive.
As an aside, we occasionally see management partner with a private equity group to complete the buyout of a departing shareholder and gain access to new capital to support future growth. This type of funding is usually opportunistic and is not a viable option for most small closely-held businesses.
It’s important to point out that these funding options are not mutually exclusive and often one or more are 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 two, but also that funding options be evaluated. A company’s financial position and current valuation both impact funding needs and options. Therefore, financing alternatives need to be adjusted along with changes that occur in the company.
Exit Strategies brings independence and well over fifty years of cumulative valuation and transactional expertise to every engagement. For a free confidential consult, email Jerry Matecun or call him at (949) 287-8397.