The death of your business associate is a terrible idea to contemplate, but it is a risk all business co-ownerships face and need to plan for. Failure to plan can affect the ongoing viability of your business and the family of the deceased owner as well as that of the surviving owner.
Before you can create any plan to accommodate such an event, owners need to understand the business implications of a co-owner’s death (e.g., Can the business continue without the talents of any one co-owner? Will suppliers, creditors and customers continue to view the business the same? Will employees leave?)
Only after you and your business associate have come to a consensus on these important questions can you begin developing an agreement that will lay out an action plan in the event of a co-owner’s death.
While you may want to engage a professional business advisor to help you work through developing the appropriate framework, you will have several basic choices.
You can liquidate the business and distribute the remaining assets among the owners and the family of the deceased owner. This will, of course, result in the loss of steady income and forfeit any sale value that a competitor may find in buying the business.
The surviving owners can take on the heirs (e.g., the surviving spouse) as a new business associate, but that comes with its own drawbacks, including the possibility that the surviving spouse has less experience or knowledge about the business, or may not share a passion for the business. An uninvolved or uninformed business co-owner may wreak havoc on the business operations.
The most practical course of action in most cases is to agree to a buy-out of the deceased owner’s share of the business. This agreement (known as a buy-sell agreement) should set a purchase price or at least a methodology for determining a fair and reasonable price. Setting a price provides a certainty that heirs will receive a fair price without dispute, but the challenge with setting a price is that the value of the business may change over time. Recognizing this, the agreement can either call for a price to be negotiated should an owner pass away (though that may leave owners wondering how fair of a price the surviving spouse may get), have the price updated annually, or indicate a formula in the agreement for determining the buy-out price. Annual updates, or a formula often work best, particularly when established by a professional business valuation firm.
The biggest obstacle to buying out the deceased owner’s spouse or heirs is finding the cash to make the purchase of that owner’s interest in the business. There are some common strategies to do this. One way is to use a bank loan to cover the purchase, but that may be difficult to obtain in view of the uncertainty of the business following the loss of an owner. It may also take considerable time to effect. Another way may be to simply pay the buy-out in installments but that puts inordinate pressure on the business and/or the other owners because the buy-out is done with after-tax profits.
Alternatively, the owners can agree to buy life insurance on the life of each owner in an amount equal to the purchase price of each of their interests. Life insurance has the advantage of providing immediate cash that is generally taxfree to pay for this buy-out. It also avoids the cost of interest associated with the loan option. This is the best choice because the funding can be obtained at a discounted cost (i.e., the premiums for the insurance versus the actual buyout price) and planned for in advance.
Owners should periodically review the value of the business, the buy-sell agreement, and ensure that life insurance coverage is equal to the growing value of the business. Other important events that may cause a buy-sell agreement to be implemented include an owner’s prolonged illness, injury or disability, bankruptcy, divorce and other life events. These events should be planned for as well in the buy-sell agreement.