Family Business Buyout Strategies

Most family businesses do not have a succession plan in place. Is this because they do not care about their businesses? Maybe they do not think it is important? In our experience it is neither of these reasons, but rather it is that business owners don’t know, what they don’t know. Most do not consider or think about what happens when a key person retires, when a partner dies or retires, or a partner or key person becomes disabled.

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Here Is A Common Example...
Just as an individual has a will developed to direct his/her estate after death, a buy-sell agreement is a binding road-map specifying the disposition of a business interest in the event of death, disability or retirement, providing a “market” for the family business interest. 

There’s no public market for a family business as there is in the stock market for a publicly traded company, so a properly created and implemented buy-sell agreement can solve that problem. When family members are involved in the business, it is more important to have a succession plan with specific details as to what occurs after the occurrence of certain triggering events.

Here Are A Few Ways A Buy-sell Agreement Can Solve Problems:

If the purpose of an agreement is to provide a ready market after a triggering event, the owners should consider the best funding vehicle. What makes a buy sell agreement valuable is the funding with insurance. Here are a few common ways to fund a buy-out agreement:

A sinking fund is where owners agree to set aside funds from their earnings. The fund will be subject to income tax as it grows and viable so long as there is plenty of time before the funds are needed for the buyout.

In this context, borrowing involves interest and principal. Would creditors become concerned after the primary owner is out of the picture? Would a loan be made at all? Would the interest payments be at a premium? Would significant collateral be required to secure the loan? Could collateral requirements jeopardize other business loans or bonding requirements?

The installment sale is a “fail safe” mechanism and is in virtually every buy-sell agreement. This allows the surviving owners to pay the departing owner’s interest over time, typically relying on distributions of profits to the owners who then make payments, or the business uses earnings to pay its obligation to the departing owner or estate. Consider whether allocating current profits to a buyout over time may place a strain on the business’s financial resources or whether the cash flow may prevent the successors from expanding.

Common to all three of these methods is trust. Regardless of the reason for leaving the business, the owner must trust the surviving owners to meet their obligations and trust the business will continue to grow and produce profits. Let’s be honest, working with family can be great and we can assume trust cannot be tighter with family, but the reality is ‘stuff’ happens…There is a better way than the three ways mentioned above, that allows the business to leverage and tie up less cash, while completely eradicating the trust issue.

I have known the proprietor of East Coast Financial for over 20 years and from the day I met him, to shortly after when he managed my money, I knew he and his organization is one I could trust.

– Robert Leaman | Former Owner Compressed Gas Solutions

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Depending on the type of life insurance policy used to fund the buyout for the family business, the policy may be considered an asset, similar to a sinking fund, creating a tax deferred growth vehicle while providing a lump-sum death benefit regardless of when death occurs. An asset is only created on the businesses balance sheet if Permanent Insurance is used, if term insurance is used then the additional tax deferred growth asset benefit is not applicable, but term insurance is normally the cheapest way to fund a buy sell agreement.
A well-drafted buy-sell agreement can assure business continuity, but without a properly planned for buy sell funding method, success after a future triggering event is left uncertain.
Life and Disability Insurance is the best way to leverage cash and to divert the ‘trust risk’ to a third party (the insurance company). Life and disability insurance can be used to provide buy sell agreement funding and we found that they are normally the best way for relatively healthy owners to accomplish funding the agreement.

 

Most owners can determine when they want to retire, that is something you can plan for. But, no one can determine when an owner may fall prey to disability and death — These last two events are uncontrollable…that is the bad news. The good news is they are insurable!

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Family Business Buyout Strategies
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