Make Sure You Fund the “Buyout” Clause

Most Partnership, Shareholder, and Operating agreements contain “survivor”, “disability” and other types of “exit” clauses. These are essential components to any agreement because, the reality is, it is physically impossible for anyone to remain in the business forever. Maybe you won’t get along as well as you imagined. Perhaps another passion will arise that takes precedence over the current business. A personal bankruptcy may force an exit. Or worse, disability or death may end the partnership abruptly. Your operating agreement or other business contract should include details about what will happen in any of these circumstances and more.

Of course, you hope the “trigger” events never happen. Everyone would like to believe from the start that the business will be a massive success, and a fulfilling experience in every way. Reality is, things happen and you need to be prepared.

The first step is addressing these issues, and what should happen next in the business agreement. The best practice for “what happens next” usually involves one partner purchasing the other partner(s)’s shares. That prevents potentially uncomfortable results like suddenly having a new partner (heir) with no interest or experience in the business. Or one who wants to sell at any price, despite the current circumstances.

Of course, having the plan for the events that might trigger a buyout and a method for determining fair value at the time is great. Yet all that is useless if you don’t have a plan for funding the buyout. Here are several ways to fund the buyout, and their pros and cons for you to consider:

Each Partner Hopes They Will Have Sufficient Liquidity If The Need Arises:

Of course, hope is not a strategy – and more often than not, partners do not have sufficient liquid assets or cash available when a buy-sell agreement is triggered.

Each Partner Establishes A Buyout Fund:

This plan could also work, but would be very difficult to achieve in practice. At best, it would be awkward to require each partner to prove they have sufficient liquidity every month. At worst, it would be very difficult to remedy a situation where a particular partner was out of compliance. Adding to the degree of difficulty is the fact that the funds would be created using after-tax dollars.

A Bank Loan Funds The Buyout:

As the saying goes, the best time to get credit is when you don’t really need it. Banks and other lenders rarely loan money to a business in distress, and losing a partner for whatever reason, puts the business in distress. Therefore, this is probably the least viable strategy unless you can secure a sufficient, low-cost line of credit well in advance and keep it open for this purpose.

The Business Funds The Buyout:

In this scenario, the company itself would put the funds required to facilitate a buyout into an escrow account. These funds would come from the operating profit, and the amount would be based on the buyout valuation formula. The amount in escrow would be increased as the business grew. This is a fair and viable way to fund a buyout clause, but it might have a negative impact on cash flow and the ability to grow the business.

Insurance Funds The Buyout:

Insurance is the most common way to fund a buyout clause. In fact, there are specific insurance products designed for this very purpose. They can be supplemented with key person death or disability policies, and provide the security of knowing there is funding to execute the buyout when needed. Plus, many policies have the flexibility to be re-purposed if they are no longer needed. In addition to a buyout for cause, there are also policies that can help a partner wind down active participation in the business. Wouldn’t it be great to be able to fund your lifestyle without negatively impacting the partners who are still active?

There are many ways to fund a buyout clause or buy-sell agreement. Be sure to work with a professional who takes the time to understand the needs and concerns of the business, and has the independence required to provide you with the best products available to meet your goals. Then revisit the plan annually, or whenever a material change in your business occurs – whichever is more frequent. This will help ensure that you and your business are well positioned for whatever life brings you.

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At Absolute Conclusions, we pride ourselves on staying informed of the best practices and best plans available. Our core goal is to help you create and maintain your legacy. Our independent status enables us to align completely with your interests, and we can also offer fee-based consultations, insurance audits, and reality-checks to provide further peace of mind. Please remember that the buy-sell agreement and funding plan should be reviewed annually, and at any time a significant change in the business size or scope occurs. If you have any questions or feedback on this article, click the Schedule a Call button to set up a no-cost, no-obligation consultation.

Please note: This document is intended to provide introductory information on the subject matter. Absolute Conclusions does not provide tax and legal advice. You should consult with independent financial, tax and/or legal professionals before making financial investment or planning decisions.