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Small Business Insurance: About Buy-Sell Agreements

small business insurance

Small business insurance

Few small business owners would argue that they need small business insurance, but most are confused about what type of coverage they need. In order to define actual needs the business owner must first determine several things. Of which, one of the most important is determining how much the business is worth and how much insurance the business owner can afford. But beyond that business owners that are in business with one or more partners have additional concerns. This includes what would happen to the business if one of the owners would retire, become disabled or die.

The questions surrounding such issues mount as one begins dissecting the potential possible outcomes. Surviving owners would of course want to continue business practices in much the same way they are accustomed to and a retired, disabled or deceased owner would want fair and prompt compensation for his or her family. This is what Buy-Sell Agreements establish. When the agreement is developed a purchase price is determined. This eliminates any surprises or misunderstandings.

Trigger Events

Triggering events are defined. A triggering event is the type of situation that leads to a buyout, whether the buyout is optional or mandatory. A death or disabilities are the most common events provided for in Buy-Sell Agreements. But the agreements can and should also include terms that specify if an owner has a desire to sell his or her interest in the business that it should first be offered to the other owners.

A Buy-Sell Agreement will generally address the issue of the retirement of an owner in that the retirement will trigger a mandatory buyout. Retirement conditions are often negotiated between owners.

Other Unforeseen Events

Even the best planning cannot prevent some of life’s unfortunate obstacles. Many businesses have dealt with an owner’s divorce or bankruptcy and either event can have a direct impact on the business. In fact, these events can subject the business to interference from outsiders. One way to offer protection from this is allow the owners the option to compel the affected owner to sell his or her shares to the remaining owners or the business entity itself.

Funding

One of the concerns that business owners have is how they will manage the funding for buyouts upon an owner’s death. To offset this the business entity itself often purchases life insurance policies on each business owner. This is referred to as an Entity Redemption Arrangement. The business is the beneficiary of the policy and uses the funds to purchase the owner’s interest with the life insurance proceeds.

Another type of funding, known as Cross-Purchase Arrangements, provides that each surviving owner becomes personally obligated to purchase the departing owner’s interest. In this case, each owner would have an insurance policy on the lives of the other owners. There’s also a Wait-And-See Arrangement, which allows more flexibility in options at the time of a triggering event, but this arrangement can get complicated in that the options are so varied.

Valuation Methods

Determining a fair market value of a business is an essential element when developing a Buy-Sell Agreement. In essence this is the price that the property passes between a willing and knowledgeable buyer and seller.

A common method of determining value is known as the net asset value method. This method is based on the net worth, the assets of a business. Liabilities are considered as well as other items documented in a company’s records for accounting purposes.

Capitalization of earnings is sometimes used as a way to estimate an acceptable rate of return on a purchaser’s investment in light of the risk associated with the business then applying such a rate of return to the anticipated earnings stream of the business, based on its average net earnings over the past years.

The discounted cash flow method attempts to adjust earnings for any noncash expenses, and subtract a reasonable amount for future capital expenditures and liability payments to project the future net cash flow. One other method, referred to as the sales-multiple valuation method, is often used in establishing a fair price for a service business – a business where tangible assets and products are not significant. This method merely attaches an industry multiplier to an average stream of revenue.

About The Author

Debbie Allen of The Things Women Want has written several books, ebooks and thousands of articles and reports. Debbie has a background in Psychiatric Nursing, Nurse Education and Organizational Development which has resulted in several areas of interest and specialty.

About author

Ivan Widjaya
Ivan Widjaya 2537 posts

Ivan Widjaya is the Owner/Editor of Noobpreneur.com, as well as several other blogs. He is a business blogger, web publisher and content marketer for SMEs.

Funding Note

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  • Cheers, Mary :)

  • I like your blog! Especially love the name. Can’t wait to read more posts!