Planning for when … The benefits of contingent buy-sell agreements

As insurance professionals, agency owners understand that everyone faces risks and that one way of limiting losses when a loss occurs is to have insurance. Likewise, when an individual owns a business, there needs to be some contingency plan put in place to prevent the equity in that business from evaporating overnight upon the owner’s death or disability. Such a plan is called a contingent buy-sell.

The purpose of the contingent buy-sell is to have a known buyer with known terms to allow for the orderly sale of the business. It is an attempt to prevent a “fire sale” or total collapse of the business upon the death or disability of the owner.

Contingent buy-sells are similar to “regular” buy-sells. It is an agreement between an owner of a business and someone else to sell the owner’s interest if and when some triggering event occurs, such as the death or disability of the owner. The contingent buy-sell can, and often does include parties outside of the business as the potential future buyers.

Finding the appropriate party to potentially sell the business to is typically the first step. The thought process needs to be to find a party that can run the business, retain the accounts, preserve the equity and pay a fair price. This person might be another stockholder, an employee of the firm or even a friendly competitor down the street.

Take time in the selection process. Remember, the other party is the one that will be buying the business and once the triggering event occurs, it might not be reversible. After the other party is properly screened, the next step is for the two parties to work the key elements of the agreement.

Basic facts
Each contingent buy-sell agreement must be tailored to meet the unique circumstances of the particular situation. Competent legal and tax advice must be used to draft an effective document. The following are some common elements that a contingent buy-sell agreement should include.

1. The recital should have a specific commitment that the owner agrees to sell and the buyer agrees to buy the interest in the agency.
   Variations, such as first-right-of refusal need to be clearly stated at some point in the agreement.
2. The triggering event needs to be defined, death is self evident, but disability needs to be clearly defined.
3. An agreement as to what is being sold and how to determine the assets and liabilities of the business interest that will be transferred. The sale of stock versus assets (book of business) needs to be well thought out.
4. A stated purchase price or a method to determine the value, such as an appraisal needs to be included. This should also include terms outlining any payout structure and the funding mechanism, such as life or disability insurance, if any.
5. Spouses need to be signers to the agreement. The owner’s personal will should be written to factor in the contingent buy-sell as well.

   The buy-sell can have variations to the terms; such as the seller can sell to another party (not the stated buyer) if offered a higher price. In some cases the “buyer” might just manage the firm until an orderly sale can take place.

Establishing the purchase price
The establishment of the purchase price can often be the weakest link in any buy-sell agreement. Stating a specific price is very dangerous. It must be updated annually and based on reasonable assumptions. The best method to determine the purchase price is to require a professional appraisal at the appropriate time as an option to the formula if it becomes unrealistic. Current debts or obligations will need to be part of the equation. The purchase price can be paid in a lump sum or it can based on some type of payout.

Disability buy-out agreements
Disability is often termed “a living death.” As in the case of death, a disabled owner presents the issue of retaining business and often management of the firm. Disability buy-out agreements must be carefully crafted. The determination of what constitutes a disability must be clear and inclusive.

All agreements must take into consideration any tax consequences. Thorough estate planning must be part of the process. Determination of the deductibility of insurance premiums or any other funding techniques must be established and included in the analysis of the plan. If premiums are deducted as a business expense, benefits are not tax free to the recipient. Since tax treatment will vary, proper consul is recommended.

Every business needs to have an arrangement for the death, disability or retirement of the owners. The damage that occurs when a firm does not plan for these events can be devastating. Proper planning will limit most problems and allow for a successful agency perpetuation.

Bill Schoeffler and Catherine Oak are partners at Oak & Associates. The firm specializes in financial and management consulting for independent insurance agents and brokers. They can be reached at (707) 935-6565, by e-mail at bill@oakandassociates.com, or visit www.oakandassociates.com