Funding a Buy-Sell Agreement

A buy-sell agreement is a legal contract that specifies how a business owner’s interest in the business will be transferred in the event of death, disability, retirement, or other triggering events. (Click here to see why a buy-sell agreement is necessary.) A buy-sell agreement can help protect the business and its owners from unwanted disruptions, disputes, or losses of control. However, a buy-sell agreement also needs to be funded, meaning that there should be a source of money available to buy out the departing owner’s shares. There are several options for funding a buy-sell agreement, each with its own advantages and disadvantages.

Some of the most common options are:

• Cash: The business or the remaining owners can use their own cash reserves to fund the buy-out. This is typically the simplest option but not always possible due to the amount of cash needed for a buy-out or during times when cash is tight.

• Borrowing: The business or the remaining owners can borrow money from a bank or other lender to fund the buy-out. Interest, credit, and collateral are all considerations with this option.  

• Installment sale: The departing owner can agree to receive the buy-out amount in installments over a period of time, either from the business or the remaining owners. An installment sale can reduce the upfront cash burden and provide some tax benefits, but the departing owner is assuming risk of default by the payor.

• Deferred compensation: The business can agree to pay the departing owner a certain amount of compensation over a period of time, either as a lump sum or as an annuity.This option can provide a steady income stream and tax deferral for the departing owner, but it also creates a liability and a cash flow obligation for the business

• Life insurance: The business or the remaining owners can purchase life insurance policies on the lives of each owner, and use the death benefits to fund the buy-out in the event of death. This option can provide a cost-effective and tax-free source of funds, but it also requires premium payments and underwriting.

The choice of the funding option depends on various factors, such as the type and value of the business, the number and age of the owners, the availability and cost of capital, and the tax implications.

As always, it is advisable to consult with a professional advisor, such as a lawyer, an accountant, or a financial planner, to determine the best option for your specific situation.