Disability insurance is key in buyout agreements

Does your business have a partnership? Do you have a written buy/sell agreement? Like many partnerships, is it backed by life insurance?

If you are like most business partnerships, you probably don't have it funded with disability insurance. But why? Have you considered that the disability component is actually MORE important than life insurance?

Life insurance is fairly common in the use of insured buy/sell agreements, but what if a business partner doesn't die, but becomes totally disabled instead? Because of modern medicine, the likelihood of getting totally disabled are higher than that of dying prematurely.

People aren't dying like they used to from things like heart attacks, cancer, and strokes. But just because they are alive, that doesn't mean they can make a living and run a business. In fact, according to the National Safety Council, Injury Facts 2012 edition, you are 240 times more likely to get disabled from an accident than to suffer a fatal one.

While disability insurance is more important than life insurance due to the risks of a disability occurring, life insurance is often used but disability insurance is forgotten or missed. Why? It's because there is a lack of awareness by both business owners and insurance and financial advisers alike. There are more life insurance professionals than disability. Because the risks of getting disabled are so much higher than dying prematurely, a little over a thousand carriers sell life insurance, but they opt out of providing disability insurance. There are only about 12 major disability carriers.

Before getting into the importance of life insurance, here's a recap of what a buy/sell agreement is, and why it's important. Business partners should have a written agreement in place that spells out what happens if a business partner dies or become totally disabled. Business partners agree on a sales price ahead of time so there is no arguing about it later.

A written agreement is made that if one business partner dies or becomes totally disabled, the surviving partner or business will buy them out. This way, the surviving business owners can move on, unencumbered by a huge debt. Conversely, it enables the disabled business partner or spouse or family of the deceased to be cashed out and move on with their life.

Is this really all that important? Ask yourself, if a business partner dies or becomes totally disabled, do you really want to be in business with that partner's spouse or children? Because like it or not, if you don't have an agreement in place and a way to make a buyout happen, you are in business with them in the event of an accident.

Would you rather buy them out and move on? Or, if you died or became totally disabled, would you want to worry about how your partner would be able to pay you or your family what you had coming? What if your partner simply went bankrupt?

What if your skill sets were completely different, for instance one of you is the inside brains of the operation, and the other one is the outside sales and marketing person? Could they run it on their own? Would you or your family get paid? Would it make more sense to have a good attorney draft a rock solid and clearly written buy/sell agreement with provisions for both a premature death and total disability?

But where is the money supposed to come from? Most businesses simply don't have this kind of capital lying around. The most logical choice for a lot of businesses is usually getting life and disability buyout insurance. If you have a buy/sell agreement and it's not funded with insurance, it can get really messy and expensive, especially if you have to borrow the money.

This reminds me of a case I recently worked on. Let's say you have two business owners, both male, age 35, and they own equally a business that is worth $4 million.

First, let's look at their options if either one of them happens to die prematurely or becomes disabled. Like most business owners, they simply don't have $2 million in liquid cash ready to go, earmarked for this purchase. So that means they'd have to borrow the money.

Using a loan amortization schedule of $2 million at 4.95 percent interest, over 10 years or 120 months, it would cost just a little over $21,000 per month. That's net after expenses and tax. Think about the gross sales that would be needed to create this kind of cash. After 120 months, that's a total payout of more than $2.5 million. That's pretty brutal and not real doable for most people, right?

Now we look at premiums for both life and disability insurance. A $2 million life insurance policy, with a 10-year term on a male nonsmoker in good health is around $46 per month. A good disability carrier can offer a disability buyout policy that pays out the $2 million over 5 years at about $33,330 per month tax free for about $365 per month. That's quite a bit more than the $46 per month for the life insurance, but as discussed, it's because the risk is so much higher, so the premium is more.

However, the combined price for both a $2 million life insurance policy, and a $2 million total disability policy for the purposes of insuring a buy/sell agreement is just over $400 per month, which really doesn't seem like much compared to what you would have to gross in sales before expenses and taxes to cut a check for a little over $21,000 per month for 10 years, right?

Once presented with the facts and asked if they think having a clearly written, bullet-proof buy/sell agreement, funded with both life and disability insurance makes sense, most cognizant business owners answer with a resounding "absolutely."