Consider this scenario: Two business partners have been friends since high school. After going to college, and spending a few years in the work force, the two friends come back together and start a manufacturing business as equal partners. After a tough first couple of years, they finally get a couple of big breaks, and things were going swimmingly. They have 15 employees and three profitable locations. Then, tragedy strikes: A car accident takes one partner’s life. A19-year-old daughter is the partner’s only surviving family member.

It’s a story that happens all too often. Both partners have most of their net worth invested in the business. However, when one of the partners dies, the other doesn’t get to own the whole business. The deceased partner’s 50 percent interest in the company goes to the partner’s daughter — who just isn’t up to running a 15-employee business. She doesn’t have contacts, experience or business skills yet. And she is more interested in completing a nursing degree than in running a business. But although the daughter couldn’t contribute to the business, she was still legally entitled to half of every dividend the company issues.

To meet its responsibilities, the business has to hire a full-time manager to replace what the deceased partner had been doing — at a cost of more than $100,000 per year. That cut deeply into the profits generated by the business. To make matters worse, valuation analysts informed the partner that the market value of the business declined by nearly $1 million.

Eventually, the surviving partner and the daughter had to sell out to a competitor — at a steep discount. There was no money for the business to pay its bills, send half its profits to the daughter and still pay the surviving partner enough to make it all worthwhile.

Succession Planning

Succession planning is the art of thinking through contingencies to ensure that a business that may be providing for many families will be able to remain viable, even when a partner or key individual retires, becomes disabled, or dies. Sooner or later, all businesses will encounter this situation. Many of them cease to exist at that point. Some stagger on for a few years before collapsing. Only a select few small businesses are truly designed to continue providing for all survivors after the death or disability of an owner.

The fact is that if you have a business with multiple partners, and one of them dies, you might find yourself in a similar situation — with a well-meaning but absent daughter (or other surviving relative). More often than not, you could be in business not with your deceased partners’ family members, but with their lawyers. They probably don’t have a commitment to the business – only to their client, and that client isn’t you.

That’s where the buy-sell agreement comes in.

Buy-Sell Agreements

The buy-sell is one of the foundational documents you and your business partners should be drawing up when you open your business. This document sets forth the circumstances under which partners can sell their interest to remaining partners – and defines a fair and mutually agreeable method for valuing the company in advance.

For example, all the shareholders can agree in advance that the company is worth five times the most recent 12 month’s profits. Or they can define the value of a company in terms of the balance sheet — a simple subtraction of liabilities from assets (a calculation known as ‘book value).

By entering a formal buy-sell agreement, each owner is assured that if something happens to him or her, the interests of the family and heirs will be protected. The remaining owners agree to buy out the deceased’s heirs’ interest with cash. Each owner, likewise, is protecting himself against the possibility of being severely economically damaged as the surviving partner was in the example above. Indeed, the lack of a buy-sell agreement hurt both the partner and the daughter.

Eventually, all business owners will leave their businesses through retirement, death, disability, or selling their interests to other owners. Smart businesses plan ahead for every eventuality.

Finding the Cash

Drafting the buy-sell document is only half the battle. The best buy-sell agreement in the world is useless if the business or the surviving owners can’t get their hands on the cash to make it happen. To solve this problem, many businesses turn to life insurance.

In fact, life insurance is the ideal vehicle in this instance: A small premium nets a substantial amount of cash, tax-free, at the precise time when the company needs it most. When there is a life insurance policy in place of sufficient face value on every owner, each individual can be assured that their heirs will be taken care of in case the worst happens. And survivors know that they won’t have to raid the limited cash reserves, or sell valuable assets at a discount, to honor their buy-sell agreement with a deceased shareholders’ family.

Surviving shareholders know they can continue to operate their businesses without interference from outsiders. Heirs know the cash is available to fully compensate them for giving up their interest in the business — and all can get along with their lives.

Structure

If you do choose to use life insurance as the funding vehicle for a buy-sell, there are two main ways to do it: You can have each shareholder own a policy on every other shareholder — a technique called the “cross-purchase” agreement. That can get complicated, though, when the number of shareholders increases. Alternatively, you can have the business itself own a policy on each owner. The method you choose will depend on the number of partners and on the tax and estate planning characteristics of each individual involved. An experienced life insurance professional can help you navigate these issues.

Permanent Insurance

Term insurance will work for a while — and may be the ideal solution in the early years of a business while cash flow is tight. Eventually, though, the term policies on each owner will become more and more expensive and eventually no longer economical.

To solve this problem, some businesses use permanent policies — whole life or universal life policies, which pay a death benefit no matter how old the insured is when he dies. Premiums are higher, but the premiums are designed to be affordable throughout the insured’s life. With whole life policies, premiums are guaranteed level.

These can be useful because these policies build cash value, which you can borrow against tax-free — for any purpose whatsoever. After a few years, these policies can become a valuable source of operating capital for the business. Some businesses own policies on their own executives and key individuals for this purpose. If the owners retire from the business, rather than die, the cash value accumulated over years of service can be easily converted to an annuity to provide a pension for the executive, or a lump-sum payment.

The Disability Contingency

It’s not enough just to plan for the contingency of the death of a business partner. You also have to consider the possibility of disability, as well. Disability normally won’t qualify for a life insurance payout (unless death is expected within a year). But the business would still be damaged from the loss of the contributions of the disabled partner.

To protect themselves, some businesses purchase a disability buyout policy. This insurance policy allows the company to buy out the interests of a disabled partner. Again, an experienced insurance agent can help you design a plan that suits your business’s unique circumstances.