Business transitions, particularly transfers of ownership, are complex and often problematic – even when businesses aren’t blind-sided by a tragic death or accident that impacts the company’s leadership. Most small- and medium-sized companies are particularly vulnerable to losing the contributions of an owner or partner. Not only does the loss of these leaders create a management vacuum, but without the instruments in place to thoughtfully direct and fund the transfer of their share of the company, the business may flounder financially as well.
An often-used approach in business continuity plans
, particularly for smaller businesses, is a buy-sell agreement between owners, backed by an insurance policy or policies. In the case of death or disability of one of the owners, the buy-sell agreement guarantees that the remaining partners will buy out the share of the company from any departing partner. The proceeds from the insurance are used to purchase the ownership interest – and ensure that the business remains on a secure financial footing.
Types of business continuity insurance
The primary insurance vehicles that are used as a hedge against risk in buy-sell agreements are:
- Term life insurance. Generally considered the best “value” for the cost you’d pay in premiums, this type of life insurance would cover an insured business owner for a predetermined number of years. The value of the policy would be set at the agreed-upon value of an owner’s share of the company, and would be used to buy out the deceased person’s heirs.
- Permanent life insurance. Also called whole, universal, or variable life insurance, this type of insurance yields a death benefit for the beneficiary of the policy; it also includes a cash value element, should the policy holder wish to cash out of the policy.
- Disability buyout insurance. In the case of disability of a business owner, this type of policy would provide a cash benefit that would enable the remaining partners to buy out his or her interest in the company.
Cross-purchase agreements make it possible for business owners to have peace of mind in knowing that, should a partner exit the business, there’s a clear, pre-determined path of succession and ownership. The partner who leaves can’t sell their share of the company to a stranger, or will it to a relative – either of which could potentially throw a monkey wrench into the business’ operations.
The buy-sell contract is set up so that one or more of the remaining partners in a business agrees to buy the ownership interest or shares of the departing business partner. These kinds of agreements can be set up to cover any situation where one partner is exiting the business, including retiring or simply moving on. Business continuation insurance simply provides the funding to make this possible when one of the partners dies or is disabled.
The cross-purchase contract dictates how the shares of an owner will be divided and/or purchased by the remaining owners. It may use a formula or a dollar amount in calculating the price of the buyout.
Using an insurance model under a cross-purchase agreement, every shareholder in a company would take out an insurance policy or policies on the life or health of every other shareholder, paying the premiums out of their own pockets. It’s obvious that for a company with a large number of shareholders or partners, this strategy could be difficult to fund and manage.
Entity-purchase or redemption agreements
Entity-purchase agreements offer much the same benefits as cross-purchase agreements in creating a clearly defined ownership succession process. But in the case of an entity-purchase agreement, sometimes also called a redemption agreement, the company itself purchases the shares of the business that were owned by a partner who dies, retires, or is incapacitated.
When business continuation insurance is used as a financial hedge, the company owns the insurance policies that are taken out on each partner. These policies are valued at each partner’s stake in the business. This type of business succession plan, and the insurance that backs it, is a particularly compelling solution for companies with multiple partners.