Buy-Sell Agreements: Why Your Business Needs a Prenup
Once you get your business up and rockin’, it’s easy to think that it will always be that way. Profits will roll in, customers will continue to love you, and your business partner will always be by your side.
But what happens when your business partner gets divorced, suffers from bankruptcy, or worse yet, passes away suddenly? Your business can be exposed if you aren’t careful.
The good news is, you can easily protect your business, and your business partners, in one easy step.
The Business Prenup
Love them or hate them, we all are familiar with prenups. If there’s one thing we know about divorce, it’s that it is messy and ridiculously expensive. A 40-50% average divorce rate keeps lawyers in business and living the good life.
While you traditionally think of prenups in marriages, a business can also have a prenup, known as a buy-sell agreement for closely held or family businesses.
The buy-sell agreement is a legal document that your lawyer will draft which specifies what happens to your business interest in the event of death, retirement, bankruptcy, disability, or any other unexpected event. (If the thought of hiring a lawyer makes you panic and has you envisioning huge bills with lots of zeros, not to worry. Drafting a buy-sell agreement is a pretty standard practice.)
This super important agreement is good for any business structure, and although it is usually best to put in place at the start of a business, it can be incorporated at any point in time. Obviously, since we don’t have a crystal ball for our lives, the sooner the better is always advised.
Just like a marriage prenup dictates how you will split up marriage assets, a business prenup does the same.
The actual document will spell out how you wish to sell each partner’s share of the business and for how much. This information is incredibly valuable to your business to avoid any gray area with other family members that you might not want to have an ownership piece in the business.
You would be surprised at who appears almost from nowhere in the case of death or divorce involving a business partner. It’s possible that an ex-spouse could claim ownership in the business, and in a moment’s notice suddenly be your decision-making partner. Yikes!
What About the Funds?
That’s great, but where does the cash come from to buy out your partner?
Most buy-sell agreements are funded with the purchase of a life insurance policy on each of the partners. You certainly don’t have to use life insurance, but most business owners find it to be the most cost effective way to fund a buy-sell agreement and ensure that the cash will be there when you need it. Life insurance also provides tremendous leverage.
Term insurance is easy and cheap if you are in good health, and can do the trick to fund your buy-sell agreement. There are several companies that even offer term insurance online like PolicyGenius and Haven Life. Working with an insurance broker is always a good option though as they can make sure you are getting the right type of insurance for your business needs.
The two most popular methods for life insurance are:
A. Cross-Purchase, which allows for you to own policies on each other. In the event of death, you would receive the funds to buy out your other partner with a step up in basis. This method can get tricky when you have multiple business owners, as each partner has to own a policy on every other partner.
B. Entity Purchase, which allows for the company itself to buy the shares of the partner who passed away, but receives no step up in basis.
Back to the Lawyer
A buy-sell agreement is not a document that you want to whip up over pizza and beer. You’re going to need to use a lawyer, or at least have a lawyer glance over any template buy-sell agreement you may use. This shouldn’t require hours upon hours of work for your attorney.
The most important factors for you to consider are how you will value your business ownership, what course of action you wish to take in the event of an unforeseen event and how you plan to fund the buy-sell agreement should it need to be exercised.
As with everything in business, it’s yet another set of decisions to make. However, this one decision could save you a bottle full of headache medicine down the road.