Funding a Buy Sell Agreement

When business partners enter into a buy sell agreement, one of the pertinent issues or items for the partners to discuss is how the buy-out will be funded. The purchasing business entity or purchasing party can obtain the funds to purchase business interests from a variety of sources, which are discussed below.

The purchaser always has the ability of self-funding the purchase.  If the purchaser does not have the required cash to purchase the interest, issues may arise whereby the seller will request some type of security interest.  Furthermore, if the purchaser lacks the cash to purchase the interest in full and equity in assets to fully secure the seller, a seller may request the buyer obtain a life insurance policy whereby the seller or the seller’s designee is the beneficiary of the policy until the purchase terms have been complied with.

Apart from a self-funded purchase, the most common source of funds for a buy-sell agreement is insurance.  Multiple types of insurance such as life insurance or disability insurance could be used to fund the buyout of the seller’s interest.  Where the triggering event for the purchase of the applicable interest is death, life insurance on the individual can be a very clean means by which to fund the purchase.  However, what if a disability or the retirement of an individual leads to the need to purchase such individual’s ownership interest?  Under these circumstances, life insurance may not be very useful as a source for funds.  To be useful as a source of funds for a buyout, a life insurance policy may need a significant cash value.

When the buy-sell agreement is between the owners of the business, it will likely be necessary for each owner to carry insurance on the life of each of the fellow business owners.  Therefore, multiple policies may be needed if each owner is separately insured.  Further, consider how many policies may be needed if there were say 8 different partners or business owners? If a redemption agreement is used, the owners do not insure the lives of the other owners, but rather, the business must purchase a joint-life policy or separately insure the life of each owner who the business has the obligation to redeem.

The types of life insurance policies could include term life insurance, cash value life insurance, whole life insurance, universal life insurance and survivor joint life insurance.  In regards to the need to purchase an owners interest because of a disability, the owners should consider disability insurance.  In many respects, it may be more likely for a business owner to be disabled than pass away during a time in their life when they still own the business interests and thus a purchase would be necessary.  Therefore, business owners should consider the need for disability insurance to fund a buyout, in addition to having life insurance available.

This article was written by John McGuire, a business attorney and tax attorney at The McGuire Law Firm in Denver, Colorado. Please remember this article was prepared for informational purposes and you should always speak with a business attorney or other counsel to discuss your specific issues & circumstances.

Denver Business Attorney