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Aug 12 2008

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Taking Care of Business: Buy-Sell Funding

Taking Care of Business: Buy-Sell Funding

Business owners face and evaluate risk every day. One tool to consider using is a risk matrix as shown below. The key point is to make sure that your highly critical, low probability risks are minimized i.e. moving from point A to point B.

Probability

Risk Severity

High

Medium

Low

Critical

A

Material

Minor

Insured

B

Risk severity is classified as,

Critical: an occurrence would have a very serious financial consequences which could lead to business failure or bankruptcy,

Material: an occurrence would have a very serious financial consequences but would not lead to business failure,

Minor: little financial consequence, other than minor loss in earnings and manageable expense.

Insured: The risk has been transferred for example to an insurance company.

Risk control strategies seek to reduce the probability by:

(i) Risk avoidance: Avoid situations or activities that put you at risk,

(ii) Risk reduction: take safety precautions when you are at risk.

Then there are risk financing strategies namely:

(iii) Risk sharing: entering into an insurance arrangement whereby risk is pooled among many and

(iv) Risk retention: acceptance of risk rather than implement (i), (ii) or (iii) above.

While the risk that your business partner would suddenly pass away is low probability, the severity would most likely be critical. The solution for incorporated small-business owners is to use a buy-sell agreement.

What exactly is a buy-sell agreement? It’s a contract in which the various owners of a business agree that if one of them dies the other will purchase his/her interest in the business. The parties to the contract may be partners, agreeing to purchase the interest of a partner who dies. They may be a father and son, where the son is to purchase the father’s business on death. Most commonly, however, there are buy-sell agreements between two or more shareholders of a private corporation, who agree to buy each other’s shares in the event of death.

A life insurance policy is a fundamental part of buy/sell agreements because the policy can provide immediate funds to the surviving partners to buy out the deceased or disabled partner. Other advantages of buy/sell agreements that are funded by a life insurance policy include:

Heirs obtain a definitive value for the deceased partner’s interest.

Surviving partners obtain total and unrestricted ownership of the business.

There are many ways to set up a buy sell agreement and many important issues to consider, so be sure to obtain independent advice before making any final decisions. And remember, once in place, buy-sell agreements should be reviewed regularly to ensure that the insurance coverages still reflects the company’s current value.

 

 

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