Buy-Sell Agreements:
Funding and Payment Terms
A. FUNDING
There are numerous ways to fund a buy-sell agreement depending on initial capital, cash flow, number of owners, and other personal or financial factors. Here are the primary funding options:
1. The Buyers Use Their Own Money with a Single Payment
Although ideal, this is the most unlikely means of purchase. The company may not have sufficient cash reserves to fund an entity purchase agreement. Owners of small businesses typically have their money working in the business and therefore need to look to other sources to fund a cross- purchase agreement.
2. Installment Payments
Installment payments to the seller or the seller’s heirs are a straightforward method that allows more cash flow for the business to operate. As with any commercial transaction, payment over the course of a longer term effectively delays completing the sale. That delay creates risk for the parties that the buyout will never materialize. At the same time, the seller or seller’s heirs do not have large chunks of money to fund a retirement, satisfy debts, settle an estate, or invest in other opportunities.
From the buyer’s perspective, an installment sale makes payment easier. But the installment obligation can prevent the business from securing other loans to grow the business because credit may be negatively impacted. Moreover, the longer the term of the payments and greater the obligation, the more adverse the effect on the credit rating of the business will be.
3. Life Insurance
One of the most commonly used methods is to take out life insurance policies for an entity purchase agreement or each owner can purchase a policy on the life of each other owner for a cross-purchase agreement. An advantage of funding a buyout with a life insurance policy is that it allows for a large lump sum payout, unlike an installment payment plan that can leave the purchase unsettled. A lump sum payout is particularly important on the death of an owner because of the often short notice to make the purchase and the need of the estate or heirs for cash.
Life insurance policies also involve an independent third party, which mitigates some of the inevitable emotional strain between owners having to negotiate payment terms. Premiums create a fixed cost for the buyer and subsequently can ease some of the concerns around funding being unpredictable. There are also tax advantages with the payout of a life insurance policy. A CPA or tax attorney can advise you on the details.
The life insurance policies can be term or whole life insurance. With a term policy, the premiums are often lower so may allow a business with little cash flow to operate more efficiently. A term policy provides coverage only for its term after which the policy expires without building up any cash value.
A whole life insurance policy, on the other hand, accumulates a guaranteed cash value that can be used to fund the buy-sell agreement for trigger events other than the insured’s death. A comprehensive policy also can include riders for chronic illness, long-term disability, or long-term care.
There can be disadvantages to insurance funding, however. Owners with preexisting conditions may require higher premiums or may be uninsurable, and, with a cross-purchase agreement, healthier, younger co-owners may have to pay disproportionally higher premiums for their older co-owners.
4. Sinking Fund
Owners can decide to extract a certain portion of business profits and allocate them to fund the buy-sell agreement. This method is generally referred to as a “sinking fund.” The advantage is that a sinking fund is easy to administer. However, funding can be unpredictable depending on the growth of profits. Because it operates as a savings account, the fund gives the business the instant liquidity it needs to execute the buyout quickly. Obviously, without knowing when a trigger event may occur, there is always the risk of insufficient funding. A sinking fund can be a good option when it is cost-prohibitive to insure a business owner, or for retirement purposes where the retiree can project a timeline for leaving the business.
5. Borrowing Funds
When the time comes to buy out an owner, the buyers can always apply for a loan. Much like the installment payment plan, this can be advantageous for situations where the business has minimal cash flow, but aside from negatively affecting credit, interest costs and carrying debt may prohibit growth of the business.
B. PAYMENT TERMS
The terms for paying the purchase price to the departing owner can vary and may be negotiated depending on the price and the buyer’s choice of funding options. In an entity purchase agreement, for example, installment payments based on profits or a promissory note can function as payment terms. The typical options for payment terms in the buy-sell agreement are as follows:
1. Full Cash Payment in a Lump Sum
For example, the buyer will make full cash payment for the seller’s ownership interest to the seller within 30 days of the date the company/buyer provides a notice of intent to purchase. The parties can negotiate the timeframe for payment if administrative demands require it (e.g. by lengthening it 60 days).
2. Monthly Installments of Principal and Interest
The buyer pays the seller the purchase price for the ownership interest in equal installments over a term (e.g. 60 months). That price includes interest added to the amount of each installment computed at an annual rate of (e.g. whatever the negotiated percent is) and compounded annually on the unpaid continuing balance of the purchase price for the ownership interest. Then the parties will set the payment schedule according to whatever is feasible for the buyer and whatever gives the seller assurance the buyer will be able to meet the full purchase price. For example, there may be a “down payment” and subsequently the buyer will make monthly or quarterly payments until the full purchase price, together with any interest owed, is paid.
3. Customized Schedule for Payment
The buyer and the seller negotiate a schedule that does not involve regular payments, but rather relies on the buyer paying the seller the purchase price for the ownership interest according to customized terms. For example, additional payments may be tied to milestones such as a particular product going to market or the company hitting certain revenue goals.
