Passing the Torch: Understanding Business Continuation Agreements for Closely-Held Businesses

Ask yourself, if you, a partner or a co-owner were to retire, become disabled, or die today, could your business survive? At some point in the life cycle of a small business, one or more of the owners or principals will die, become disabled, or retire. When this happens, one of two things will take place: (1) the business will be continued by the family or by other owners, or (2) the business will be sold or liquidated. 

Without adequate planning, your business may be negatively impacted or forced to close in a relatively short period of time. Why? Not because you did something wrong; it is because you did nothing.

Business Succession Planning is a crucial step in making sure that the transfer of your company or business interests is successful. The goal is to get out of the business in the event something unforeseen happens; or if it is an intentional event, to ensure a smooth transition or continuation of the business.

The purpose is to try to spell out up front what should happen to prevent tense negotiations later. You do not want to have to negotiate when there is a crisis. Leverage changes and that may not reflect what is in the best interests of the business or the remaining owners. In other words, a proper plan helps assure that sufficient funds will be available to help provide the most financial flexibility in the event of retirement, death, disability, or other separation from business. It also helps protect yourself and your business from economic loss and increase the likelihood of success. 

A proper plan is achieved through a buy-sell agreement, also commonly known as a business continuation agreement, which is a written guide to help through your business succession planning, by helping to mitigate conflict and speed up the transition. The purpose is to spell out the process by which the business will either be taken over by family members or other owners, or sold or liquidated.

So what exactly is it? A business continuation agreement is a legally binding contract that can be used with all types of businesses, which stipulates that, at death, retirement, disability, or other withdrawal of a principal, his or her shares of the business must be sold to remaining partners, shareholders, or to the business itself. Life insurance may be purchased to help fund agreement at death or retirement, and disability insurance is critical in providing funding in the event of a long-term disability.

Some key provisions include stipulations that each owner will not dispose of his or her ownership interest during their lifetime without first offering it for sale to other owners. The agreement will also stipulate who will be selling and who will be buying, and which state’s laws will apply. It will also contain a formula for establishing the purchase price at the time of death, retirement, or disability. The agreement will also address the methodology for making changes to or terminating the agreement, as well as establishing a process by which insurance coverage is to be updated. It can also establish a definition or a set of factors for determining when “disability” is attained. 

So what is a business worth? Often, the owner of a business does not know what the business is actually worth. In fact, most business owners either over- or under-value their businesses by at least 50 percent. In preparing a proper business continuation agreement, it is important that a methodology be established for the accurate evaluation of the business. Several methods for evaluating the worth of a business are available, each dependent on the type of business and agreement created.

There are a number of different agreements, each as varied as the businesses they seek to protect. For instance, under a cross-purchase agreement, the individual owners of a business agree to purchase the interests of the other owners. Each individual is the owner and beneficiary of an insurance policy on each of the other owners, and each individual pays the premiums on the policies he or she owns. Policy proceeds or cash values are used to purchase the interests of the owners at death, disability or retirement. 

Under an entity business continuation agreement or stock redemption agreement, the business entity itself agrees to purchase the interests of the individual owners. The business entity is both the owner and beneficiary of life and disability insurance policies on each owner, and the business pays the premiums for the policies. Policy proceeds or cash values are used to purchase the interests of the owners at death, disability or retirement.

Under a wait-and-see agreement, the business has the first option to purchase ownership’s interest of deceased principal. If the business does not exercise this option, then the business principals have the option to purchase the deceased principal’s ownership interests. If the business principals do not exercise the option to purchase the deceased principal’s ownership interests, then the business must purchase those interests. 

When does a business continuation agreement kick in? A proper agreement will include “triggering events,” which automatically determine when it becomes effective. Triggering events can typically be categorized into uncontrolled, controlled, and third-party imposed. Uncontrolled triggering events are the most common and include death and disability. Controlled triggering events can be more anticipated, and include retirement, termination of employment, and an “outside” offer to purchase the business or an owner’s interests in a business.  Third-party imposed triggering events are the least common, and include bankruptcy and divorce. 

How is an agreement funded? The most important criteria for funding a business continuation agreement are: (1) providing liquidity for the departing owner; (2) offering financial security at the time of a payout; (3) minimizing the risk to the remaining owners; and (4) minimizing the tax costs for payments made at the time of departure. There are numerous methods for funding an agreement, all of which require careful analysis of a host of variables by a trained professional. 

So what should I do now?

• Evaluate the ability of your business to survive death, disability, retirement, or other triggering event
• Review and update existing business succession plan
• If a plan does not exist, contact an attorney to discuss what are the best options for devising a plan for your business
• Contact insurance broker to ensure adequate coverage