Failure to Properly Fund the Buy-Sell Agreement.
A buy-sell agreement should have a source of funding available to allow the surviving owner to purchase a deceased owner’s share of the business. That funding generally comes through life insurance policies. If the agreement is not adequately funded, it provides limited protection to the owners.
Ralph, George, and Michelle each owned one-third of their consulting business. They knew that they needed a buy-sell agreement to ensure the orderly transition of the business, so they had their attorney draft a mutually acceptable buy-sell agreement when they formed the company. They had big plans for the company, so each purchased $500,000 dollars of life insurance to fund the agreement.
Over the next few years, the company grew consistently. Each of the three owners developed a reputation for excellence in their respective niches. They hired additional consultants to add knowledge and depth to the company’s expertise. The company eventually had 22 consultants and 17 support staff members. Revenues and profitability grew each year.
After 18 years, the company had grown well beyond what they had envisioned. Ralph knew that they needed to update their buy-sell agreement, but everyone was busy. They were all at least 15 years away from retirement, so Ralph did not worry too much about the needed changes.
When George was killed in a biking accident, Ralph and Michelle were devastated. He was not only their business partner, but a close and valued friend. It was difficult to think of the firm going on without George.
A business appraisal set the value of the company at nearly $9 million, substantially more than the three owners had dreamed possible when they formed the firm 18 years earlier. The investment portion of George’s life insurance policy had grown, but it was still nearly $2 million short of the amount that Ralph and Michelle needed to buy out George’s widow, Estelle. Ralph and Michelle feared that they would have to liquidate the company to meet their obligations to Estelle.
How to Avoid Mistake #6
An inadequately funded buy-sell agreement is almost as devastating as no buy-sell agreement. While the amount of life insurance may have been adequate at the time the three partners formed the company, that amount was grossly inadequate at the time of George’s premature death.
The solution is to review your buy-sell agreement regularly with your legal counsel – at least every two to three years – to ensure that it still meets your ongoing needs. Part of that review includes determining whether the buy-sell agreement is still adequately funded. If the agreement is not adequately funded, an untimely death may force the survivors to sell the business at a loss to pay estate taxes or to pay off the estate of the deceased owner.
If you have further business related questions, please call our office at 480-733-6800 and ask to speak with Scott Gibson. Scott, an AV rated attorney, handles employment law, trade secrets and restrictive covenants, commercial litigation and intellectual property. He brings with him 27 years of experience and a unique combination of compassion, patience, intelligence, listening ability and commitment.