FUNDING A BUSINESS BUYOUT
The Colonial Furniture Co., a hypothetical company, VA, is a closely-held corporation whose corporate attorney, accountant, and insurance agent have developed an answer to the question “What would happen in the event of a stockholder’s death?”
Initially, it appeared to Colonial that there were several viable alternatives to help execute a buyout—including borrowing. However, most business owners would agree that they would have a difficult time borrowing money for buyout purposes. Banks today are often reluctant to make business loans, especially if a key individual will no longer be a participant in company operations. In addition, private investors might be wary of investing funds in a company that is experiencing a complete management adjustment. Funds borrowed from a bank, or received from a private investor, will place an added burden upon the business’s cash flow and reserves.
A few business owners have suggested that they might include their partner’s heirs on the payroll, continuing to provide the same salary in addition to the value of the benefit package. The desire has ethical and moral value, but only serves to increase business and family conflict. Remaining owners and the new vocal heirs may become adversaries over time.
An Effective SolutionUltimately, Colonial concluded the following:
The total amount of funds needed to execute a complete buyout must be available at the time of a death, disability, or retirement of an owner.
Valuation of the purchase price should be based upon either a book value, a formula value, or an agreed sum.
The least expensive method of funding the agreement should be used.
After considering these three factors, Colonial’s team of financial professionals realized that the best solution for them was quite apparent. They would formally adopt a buy-sell business continuation agreement. The funding vehicle would be a life insurance and disability income policy. The two policies Colonial Furniture would select would provide a guaranteed amount of money at the exact time the “buy-out” would take place. If a corporate stock redemption agreement is used, Colonial would carry life and disability income insurance on each stockholder. If a cross-purchase agreement is used, each stockholder would own life and disability income policies on the lives of the other shareholders.
One advantage of life and disability income policies is the inexpensive outlay and accumulation of policy values, which may be targeted for other purposes. Lacking these funding vehicles, the availability of liquid assets, reserves, emergency funds, lines of credit, and net worth become major considerations. The buy-sell business continuation agreement is a powerful instrument in helping to assure that the hopes and dreams of its original founders may continue unabated.