Buy-sell agreements and life insurance

In today’s complex business landscape, advisors play a vital role in guiding business owners through critical transitions, and succession planning is paramount among business owners’ concerns. While many business owners aspire to a smooth exit, unforeseen events can disrupt business continuity. A well-structured buy-sell agreement, funded by life insurance, is essential to navigate these transitions, both providing protection and fostering confidence in the future.

As advisors, it is our responsibility to help our business-owner clients understand the options they have available to them. Let’s look at the foundational aspects of these options and examine why they are different from key-person coverage.

A buy-sell agreement is a legally binding contract that dictates what happens to a business owner’s interest in the event of death, disability or retirement. It establishes a predetermined plan for transferring ownership, ensuring a smooth transition and protecting the interests of all parties involved. Life insurance is commonly used to fund these agreements, providing the necessary liquidity for the buyout.

There are two primary structures for buy-sell agreements.

» Cross-purchase plan: In this plan, each owner agrees to purchase the departing owner’s interest. Life insurance policies are typically held by each owner on the lives of the other owners. The proceeds are paid directly to the surviving owners, enabling them to buy out the deceased owner’s share from their estate.

» Stock redemption (or entity purchase): Here, the business itself agrees to buy the owner’s shares upon their death, disability or retirement, with the price or valuation formula predetermined. The business owns the life insurance and is the beneficiary, using the proceeds to purchase the owner’s shares.

Buy-sell vs. key-person coverage: The key differences

Key-person life insurance is coverage on a specific individual whose death would create a financial hardship on the business. The proceeds of the policy are most used to pay out any remaining compensation or bonus due to the key person’s survivors and to stabilize the business and provide a pool of liquidity during the hiring process to replace the key person. 

You may ask whether that means key-person coverage is only for nonowners, and the answer is no. Key-person can be used for owners, but the primary difference is that in a buy-sell structure, the policy is intended to fund the ownership transition of a business. In a key-person policy, the ownership is often left intact and the key-person proceeds are intended for business purposes. 

Building confidence: The advantages for owners and advisors

Buy-sell agreements funded by life insurance offer numerous advantages that instill confidence in business owners about the future of their enterprise.

» Control over succession: Buy-sell agreements ensure that ownership remains with the intended parties, preventing it from falling into the hands of others.

» Clarity and certainty: A buy-sell agreement establishes a clear exit strategy and a ready source of funding for the owner’s interest, removing ambiguity and potential disputes.

» Family protection: Buy-sell agreements provide financial security to the owner’s family by providing liquidity to help maintain their lifestyle and manage estate matters.

» Preservation of legacy: A buy-sell agreement allows business owners to know that their life’s work has a defined value, that the business can continue smoothly, and that their loved ones are protected.

» Cost-effective funding: Life insurance is a relatively cost-effective tool for funding buy-sell agreements, ensuring that the necessary capital is available when needed.

These powerful benefits can allow confidence and certainty in the future for your business-owning client. In addition, that confidence that they have may dovetail with the other planning they are doing with you. 

Bringing up this topic and working on it with your client highlights three great additional benefits.

» Strengthening client relationships: By addressing a critical need and providing peace of mind, advisors solidify their value to business-owner clients.

» Demonstrating expertise: Effectively structuring buy-sell agreements and implementing appropriate life insurance funding strategies showcases the advisor’s knowledge and capabilities.

» Future-proofing businesses: Advisors help business owners establish a resilient framework that can withstand unexpected transitions and ensure long-term stability.

Technology as an enabler

Technology plays a key role in streamlining complex processes. Online platforms are designed to simplify the process of obtaining the life insurance needed for buy-sell agreements, making it more efficient for both advisors and business owners. 

Most often, buy-sell structures are funded with term life insurance. The process to put the buy-sell together requires a few moving pieces and longer discussions. But once the decision is made to move forward and use term life insurance to fund the agreement, that part of the process should be easier. The advent of digital life insurance partners makes the implementation much easier for your client and for you as the advisor. 

Digital life insurance partners provide several benefits.

» Tools and resources: Access to tools that help determine the right amount of life insurance coverage and educational resources on life insurance.

» Comparative pricing: The ability to easily compare pricing across multiple insurance companies.

» Digital efficiency: A fully digital application process that allows advisors to provide clients with dedicated quote links and track progress.

» Client-focused communication: Options for clients to communicate in their preferred way, whether by email or phone.

The indispensable role of life insurance in buy-sells

Life insurance isn’t only a funding mechanism for buy-sell agreements; it’s the cornerstone that makes these agreements viable and effective. Without it, the promises made in a buy-sell often become empty ones. 

Imagine a scenario where a business owner dies, and the agreement dictates a buyout, but the business or the surviving owners lack the cash. Disputes, financial strain, or even the forced sale of the business can ensue. 

Life insurance eliminates this risk. It guarantees that the agreed-upon funds will be available precisely when needed, ensuring a fair and seamless transition. By understanding and effectively using life insurance within buy-sell agreements, advisors empower clients to protect their businesses, their families and their legacies with certainty and confidence.

Bracknell Baker, CFP, CLU, ChFC, and Caleb Baker, CLU, are cofounders of Simplisure. Contact Bracknell at [email protected] and contact Caleb at [email protected].