business succession

Buy-Sell Agreements

How smart business owners take good care of their business for the long-term

 Key Takeaways

  •  The majority of business owners don’t have succession plans in place.

  • A buy-sell agreement stipulates how a partner's share of a business may be reassigned if that partner dies, becomes disabled or otherwise leaves the business.

  • Key person life insurance (aka Key Man) covers the cost of finding a replacement for the loss of a vital owner of team member.

  • When it comes to succession planning, don’t be a do-it-yourselfer.

 

By Robert Pyle

Business owners are highly driven people. But, a downside to that entrepreneurial passion is that they spend so much time IN their businesses that they have no time to spend ON their businesses. Succession planning is one critical area that often gets overlooked.

According to PWC’s 2019 family business survey, three out of four business owners don’t have documented succession plans in place. I suspect that number is even higher. Even more alarming: over half of U.S. business owners today are over age 50.

If you don’t have a succession plan in place—or if it’s been years since you updated your plan—don’t keep procrastinating. The world moves fast and doesn’t wait around for you to get all your succession planning ducks in a row. Changes in ownership happen every day in all types of businesses for all types of reasons: Death, retirement, disability, divorce, voluntary and involuntary termination of employment; lawsuits, financial and economic setbacks, bankruptcy, selling and gifting interests, just to name a few.  These disruptions often result in: Collateral damage to customer, supplier, banking and employee relationships as well as to long term company goodwill.

Fortunately, most of the painful issues above can be avoided by having a well drafted “buy-sell agreement” in place right from Day One. That’s when all of the owners are still in the “honeymoon” stage and when relations are most amicable. However, it is never too late to put a buy-sell agreement in place. Honesty and open communication are the key to making by-sell agreements work.

What is a buy-sell agreement?

Also known as  a buyout agreement, a business will or a business prenup, a buy-sell agreement is a legally binding contract that stipulates how a partner's share of a business may be reassigned if that partner dies, becomes disabled or otherwise leaves the business. Most often, the buy-sell agreement stipulates that the remaining shares of the business should be sold to the other partners or to the partnership itself.

Buy-sell agreements are typically funded by life insurance that protect the business if an owner dies. That way the owner’s spouse or family doesn’t have to step in and take over the business—something they likely have no experience running. If you’re an owner and you don’t have other owners, a mature child or close relative capable of running your business, then a buy-sell agreement can be used to set up a formal agreement to sell the company to a competitor or to a private equity group at a predetermined price when you leave.

Buy-sell agreements can take many forms (more on that in a minute). What they have in common is that owner(s) agree well in advance to the terms of a potential business at some point in the future. This way, an owner’s family doesn’t have to sell under duress should something unfortunate happened to the owner.


Getting started: Document everything!

One of the first things we advise business owners to do after they start working with us is to document every bill that comes in, as well as how they received the bill (email or paper, etc.), how they paid it (check, bill pay or credit card) and when that service or software contract ends. As an owner, you need to document how all the money flows through your accounts and how you pay all your bills for your house and other personal expenses.

Very important: If you own a sole proprietorship, make sure your spouse knows your master password. If you’re part of a partnership or multi-owner business, make that at least one of the other principals knows your master password. All businesses, regardless of size, need a Plan B in case something happens to the one person who pays all the bills and who understands all the contracts that keep the business running. Also, it’s very important to update all your documentation every year or so--it’s not a one-and-done exercise.

Before you get started, seek out attorneys or CPAs who specialize in succession planning or a business broker who might know somebody who has expertise in succession planning. Some CPAs even have an ABV® credential (Accredited in Business Valuation).


Key person life insurance

The death of a key employee or team member can potentially sink your business if you’re not protected. Key person life insurance (aka Key Man life insurance) provides funds for a business when a key person dies. This type of policy helps address the financial losses that can occur when a key person in the business passes away and money from the policy can be used to find a replacement for the key person or to train someone to take the place of the key person who died or otherwise left the business.

Under most plans, the company purchases a life insurance policy on the key people and the company pays the premiums on the policy. If the key person passes away, then the proceeds from the policy are payable to the company. Determining the amount of life insurance to purchase can be challenging. You could use the cost of replacement, a multiple of compensation or a contribution to profits method. Again, don’t try to do this yourself. Consult with a life insurance specialist that works with business owners. If you would like a referral to professionals who can help, please let us know.

Don’t think you’re big enough for a Buy Sell Agreement? Think again

You may think your business is too young or too small to need a sophisticated transition agreement. Just understand this: If you’re business is too large for your spouse or outside family members to take over, then you need a buy-sell agreement. If the business is your family’s only source of income, then you need a buy-sell agreement. If your business is potentially “sellable”—i.e. it has recurring revenue in the form of contracts or agreements with customers/clients that pay you on a regular basis--you need a buy-sell agreement.

Most common types of buy-sell agreements

1. Cross Purchase Agreement. Each co-owner agrees to purchase the equity from the estate of the co-owner that passed away. The sales price is agreed upon in advance and life insurance is used to fund this type of plan. Each co-owner has separate polices on each of the other co-owners and they each pay the premiums.

2. Entity redemption arrangement. In this type of agreement, the business (not the individual owners) takes out life insurance policies on the co-owners and the business pays the premiums. When a co-owner passes away, the company can then purchase that owner’s equity with the life insurance proceeds.

3. Hybrid plan. Under this plan, the business has the first option to purchase the equity of the co-owner that passed away. If the business does not elect to purchase the late co-owner’s equity, then the remaining co-owners have the option of purchasing the deceased owner’s equity.

If you don’t have a child or key employee(s) to assume ownership of the business, you can sell to a business consolidator in your niche. You could also have an agreement with a competitor to buy your business at a pre-determined price.   There are many other types of buy-sell agreements which I’ll discuss in a future article. Regardless of which structure you choose, make sure you have something in the agreement ties the sales price to the business’s revenue or profit. That way the predetermined sales price can be adjusted fairly if the business grows (or declines) substantially between the time the agreement was made and when it is actually sold.


Update regularly

Like your estate plan, you also want to have a business valuation every three or four years. In addition to CPAs, check with the trade associations or professional societies in your business. They can be great resources for finding business valuation professionals that specialize in your niche.

Cautionary tale

If selling to an outside owner or a competitor, you may get a nice offer for your business in the form of an installment sale rather than the one-time purchase. A typical scenario for an installment sale of a $1 million business is 30 percent ($300,000) paid to the owner upon closing and the remaining $700,000 paid over five years ($140,000, plus interest). If you’re the owner, you could potentially pay less in taxes when you close and theoretically earn more money when the interest payments are factored in (please consult with your tax professional). However, there is also more risk involved in an installment sale than a one-time transaction. The buyer could run into hard times, the economy could go in the tank, and the new owner might be unable to make the payments to you each year, leaving you out in the cold.

You should thoroughly investigate you buyer and to make sure they are qualified. This could involve an expensive background check. As the seller, you will need a larger emergency fund on hand in case the buyer is late on the payments or worse, defaults. You want to ensure there is a good transition after the sale and that your clients are comfortable with the new owner.  If not, there is always an outside chance that you will have to take over the business and go back to work.


Conclusion

Succession planning can get overwhelming quickly for time-pressed business owners. It takes coordination with the other owners and with specialized legal, accounting and financial advisors to make sure you’re doing everything right. Then you need to check every few years to make sure the agreement is still valid and reflective of the business today. If nothing else, avoid the two most common but dangerous mistakes that business owners make: Procrastinating and being a do-it-yourselfer. You’ve worked too hard to build your business to throw your employees and family into a bad situation. If you or someone close to you has concerns about an eventual business transition, please don’t hesitate to contact me.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

 

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

Don’t Sell Your Business--Downsize It

Key Takeaways:

  • You don’t have to sell your business all at once.

  • You can keep 80 percent of your income and work one day a week.

  • You will end up with a lot more money at the end of 5 to 10 years.

  • You will be working only with clients and customers that you enjoy and value.

    

Succession planning is a hot topic today. The problem is that the only solution in most cases is either to sell or close your business. But, I want you to consider another option for the business you’ve worked so hard to build: the “wind-down strategy.” With a wind-down strategy, you essentially downsize your business.

How great would it be if you could keep your finger on the pulse of your business while reducing the amount of time you actually work by 80 percent or more! Just one important caveat: The wind-down strategy works best for professional service firms, but elements of this concept can work for all types of businesses.


Focus on the best 20 percent of your customers or clients


The first step is to take is look at your book of business. Who are you best 20 percent of customers or clients? This doesn’t necessarily have to be your largest clients, but many of the larger clients tend to be your best clients, too. After you put your list together, add up how much of your firm’s revenue these top clients account for. If you’re like most firms, it will be at least 80 percent of the total revenue.

If you are servicing 100 clients that produce $750,000 per year in revenue, then your wind-down will probably account for $600,000 in annual revenue. Think about this for a second. Eighty percent or more of your revenue probably comes from a very small group of clients or customers. How great would it be to spend your day taking care of only your best and most profitable clients?

It’s not a dream.

Put together a pro forma statement of what your downsized firm would look like


Now look at your business and see which types of expenses would remain if there were only 20 clients to service instead of 100. I bet you would cut a huge chunk of the costs out.

Overhead would go way down, as would the hassle of trying to take care of 80 so-so clients. You no longer have to put in 60-hour workweeks. Now you can work 10 or 15 hours and make a greater profit with 20 clients than you used to make with 100. That means you can take weeks of vacation at a time. Having a smaller business or practice allows you to do other things while keeping the lion’s share of the income from the former business or practice.

Compare this to selling


Let’s say you find a 10 to 15 hour-workweek attractive. Who wouldn’t? If this became your reality, guess what? You might not be so anxious to unload your business.

Let’s say you could sell your business for $1 million to a buyer that agreed to put 40 percent down in cash and would finance the remaining $600,000.

Don’t you think you would enjoy having something fulfilling to do one day per week? Suppose you could take home $400,000 per year instead of hoping you might get paid the money you’re “owed” from the complete sale of your business?

Let’s think about this for a second. You can earn $400,000 in cash and then hopefully the remaining $600,000 over seven or eight years with a lot of risk involved. Or, you can get $400,000 per year for as long as you want--with almost no risk. How? The wind-down should produce about $400,000 per year in profits. That means the business would take in $800,000, have $400,000 in costs and leave $400,000 for salary and profits. Remember, there are only 15 or 20 clients left to worry about. That means you’ll have little or no administrative costs. You could even find an outsourced solution for your administrative and overhead help

Isn’t getting $400,000 per year for working 10 to 15 hours a week an attractive idea?

Find a new home for the lower 80 percent


Of course, you need to figure out what to do with your B and C list--the remaining 80 percent of customers or clients who have relied on you for advice for years? Some of them may have started with you when you first opened your business. Can you just stop servicing them?

No. You’re not going to neglect them. You are going to find a good new home for them at another well-suited firm. And, you’ll do the right thing by offering to backstop those transferred customers or clients if there’s a problem at their new firm.

Over time, reduce the 20 percent


If you adopt this 20/80 wind-down strategy, you are likely to continue working way past normal retirement age. When you reach 70, you might want to work even less than the 10 to 15 hours per week that you’re working now.

Not a problem. Just follow the same winnowing down process. From your Top 20 percent list, be willing to let go of a few more clients—perhaps they’re on you’re A-List, but not the A+ List.  Find a good new home for them. Eventually you’ll get to the point where you have just five very, very good customers or clients. You love them and they love you.

The key here is to understand how your overhead works. Instead of having full-time staff, your business will be moving to part-time staff. You might even be able to find another similar business that’s willing to let you operate under their roof if you help them pay for their overhead.

If you do this, not only have you reduced the amount of time you must spend working,  but you’ve eliminated staffing and other fixed overhead.

Conclusion

Let’s say you only use this wind-down strategy for 10 years, starting in your late 50s or age 60. Instead of selling your business and hopefully getting $1 million over seven years, you’re going to earn $4 million over 10 years while working part-time.

What’s not to like? If you have any questions, please feel free to email us or give us a call at 303-440-2906.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

 

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

Smarter Business Exit Strategies

Too many business succession plans don’t work out as planned, but smart owners can get back on track and stay that way for the long-term.


Key Takeaways:

  • Most business owners create unnecessary risks for their families, employees and clients by failing to fund business succession plans.

  • Every business owner should establish a clear vision for his or her transition and look for ways to improve after-tax returns.

  • Business owners can reduce the costs of succession plans by 50 percent by using pre-tax dollars to pay for insurance.

 

Many successful entrepreneurs, especially Boomers, may be thinking that now is the right time to exit their businesses. Unfortunately, business transitions don’t usually go as smoothly as expected. The failure rate of succession plans is now at eyebrow-raising levels. But it doesn’t have to be this way.

What motivates most business owners to think about a business succession plan?

Scary stories about failed companies motivate business owners to consider implementing a business succession plan. Despite the obvious need, few plans are actually designed, drafted and funded properly. High professional fees and insurance costs often take the blame when business owners are asked why they did not implement a succession plan.

Why do so many succession plans miss the mark?

Most business succession plans fail. According to Harvard Business Review, only 30 percent of the businesses make it to Generation Two and a mere 3 percent survive to generate profits in Generation Three. Estate planning experts such as Perry Cochell, Rodney Zeeb and George Hester came up with similarly disappointing numbers. Given this dismal success record for family business transitions, it is no wonder that 65 percent of family wealth is lost by the second generation and 90 percent by the third generation. By the third generation, more than 90 percent of estate value is lost despite the efforts of well-meaning advisors. It does NOT have to be this way.

What is the biggest problem business owners face when they try to implement succession plans?

Unless a business succession plan addresses tax issues, company owners can lose much of their wealth to taxes on income, capital gains, IRD, gifts, estates and other taxes. In most successful businesses, the company will generate taxable cash flow that exceeds what is needed to fund the owner’s lifestyle. This extra cash flow is usually taxed at the highest top marginal state and federal income tax rates. When the after-tax proceeds are invested, the growth is subject to the highest capital gains rates. Ultimately, when the remaining assets are passed to family members or successor managers, there could be a 40 percent gift or estate tax applied.

How can owners and their advisors solve this tax problem?

Every business owner should establish a clear vision for his or her transition and look for ways to improve after-tax returns. Tax-efficient planning strategies are needed to guide decisions about daily operations and business exit strategies. An astute advisor can help you find ways to fund business succession agreements in ways that generate current income tax deductions while allowing the business to generate tax-free income for the business owner and/or successors.

What are some other ways to reduce taxes?

There are many tax-advantaged business succession techniques that give business owners a competitive edge. Qualified plans provide tax deductions in the current years, but they are not typically as tax-efficient for funding a buy-sell. More advanced planning strategies involving Section 79 and Section 162 plans can provide tax-free payments for the retiring executive or death benefits for family members, but limit the tax deductions when the plans are funded. There are very few options when owners seek up-front tax deductions, tax-free growth and tax-free payments to themselves and/or their heirs.

Bottom line

Advanced planning strategies allow business owners to fund business continuity plans more cost-effectively. Business owners should work with advisors who can design a plan that can convert extra taxable income into tax-free cash flow for retirement and/or the tax-free purchase of equity from the business owner’s estate.

Once the plan has been designed, experienced attorneys will draft legal documents to facilitate the tax-efficient plan funding. This integration of design, drafting and funding helps ensure effective implementation of the strategy as well as proper realization of benefits under a variety of scenarios. An experienced advisor should be able to help you quantify how planning costs are just a small fraction of the expected benefits. More important, these financial benefits bring peace of mind to the business owner, the owner’s family and to key executives. Great clarity and confidence results from having a business continuity plan that has been designed properly, drafted effectively and funded tax-efficiently.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

 

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.