Picture this: you and your three siblings grew up on a local farm. Your parents are still living and want nothing more than for it to continue on in the family name, but there’s one problem—you’re the only one that is still working the farm. The other siblings have gone on to other respective careers and don’t desire to go back. When Mom and Dad pass away what is the plan?
So often this situation comes up, especially in family businesses. The question of whether to just pass the business on or require the children to purchase it is often a confusing path. In the situation above, if the farm was just passed on to each child, the four children would each get a percentage of ownership in the farm. It may be hard for the one that stayed to work it feel like that’s a fair bargain. Sure, the sibling that worked it may have an option to purchase the other siblings’ shares, but this could end up being a big chunk of change which may never see return on investment. Instead there’s other ways of doing it.
Typically there’s a few different methods so it’s important to figure out which option is best for you and your situation.
Option 1: The Sinking Fund – this 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.
Option 2: Borrow Cash – this is the path that typically involves going to the bank and getting a loan. This would also involve interest and principal so there’s many things to take into consideration. 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?
Option 3: Installments – 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.
Option 4: Life Insurance – life and disability insurance can be used to provide funding. This can often be the easiest and most affordable path, especially where the family relationship can muddle things. A life insurance policy can be purchased by either partners or buyers for the current owners. When the current owner passes away, the owner of the policy would be provided the money needed to purchase the business by the death benefit. Life insurance can also be purchased where it earns capital- this can be used even if the owner doesn’t pass away, simply decides to retire. You can take the cash value of this policy and use it to purchase the business. Life insurance benefits are also nontaxable adding more benefit to this method. Most owners can determine when they want to retire, if ever. Two events which cannot be controlled are disability and death — uncontrollable, but thankfully insurable.
Common to all of these methods is trust and communication. The key to having a successful buy-sell agreement in place are both of these things.
A well-drafted buy-sell agreement can assure business continuity and when funded through life insurance and disability, can add a sense of peace for the business owner to know that everything will be taken care of.
If you have questions regarding funding your buy-sell agreement ECI is always here.