Most of us don’t want to think about what would happen to our businesses if we were not able to be there one day because of disability or death. Most owners that are key to the organizations know that their firm would be in “real” trouble overnight if something happened to them and there was not a catastrophe plan or contingency plan in place.
We know about planning for our clients and insuring their risks, so what about planning for our agencies to be able to transition in the event something happens to the owners? 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 owners.
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 or 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. This is only true if there are not parties within the agency that have not been designated as “key” and don’t have any stock or a written agreement in place if something were to happen prematurely to the owner.
Finding the Right Party
Finding the appropriate party to potentially sell the business to is typically the first step. The thought process needs to be finding 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 or even a friendly competitor down the street.
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 on key elements of the agreement, with or without a consultant or attorney.
Each contingent buy-sell agreement must be tailored to meet the unique circumstances of a specific 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:
- 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.
- The triggering event needs to be defined. Death is self-evident, but disability needs to be clearly defined.
- 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 is more likely in an internal sale. If external assets (book of business) are sold, the third party cannot write off the purchase of stock. Most third parties also do not want liabilities.
- 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, in an internal plan. Externally, the third party needs to make sure they can handle the terms of the sale, including the down payment required. If there is an earn-out, and usually in contingent buy/sells there are, then based on the price that the parties agree is fair, the time period can be selected and a reasonable earn-out established. Most often, this would be around 30-to-40 percent per year for three or four years, unless there is a down payment.
- Spouses need to be signers to the agreement. The owner’s personal trust or will should be written to factor in the contingent buy-sell as well.
Variations to the Terms
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. In this case, if there is just one owner, the seller might be the spouse. It is often a good idea if the spouse does not have insurance experience to have an industry expert, such as an insurance consultant that performs insurance agency mergers and sales, written into the contingency plan. This person can also be another insurance agency friend that is not purchasing the agency but may be available to guide the spouse and family.
Setting 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. Using a formula is safer, however, it may also eventually become outdated and does not take current circumstances into consideration.
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 be based on some type of pay-out or earn-out of what renews, which usually makes a third-party buyer more comfortable.
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. Seek out proper tax advice.
Securing Key Employees
Whether there is an internal or external sale, it is also important for the agency owner or owners to make sure that key people are taken care of in case of their death or disability to help transition the book of business to the buyer. If there is an internal sale, it is also important that the owners have set in place which of the key people might need to have stock or additional compensation.
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 not only to the agency, but also to the family members, employees and clients. The business may end up being sold at a fire sale price or may not be able to be sold at all.
Proper planning will limit most problems and allow for the successful perpetuation of the agency. Take the time to establish a contingent buy-sell now.
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