Protecting your business against the ‘5 Ds’
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Disaster protection sounds like a no-brainer, but business operators often don’t think about protecting the business from the disability or death of an owner or key employee until it’s too late. When it’s too late, it’s really too late because a forced liquidation of the business could be the result if you’re not prepared for an unfortunate event.
Protecting the business from the disability and death of an owner or key employee is one of six pillars identified in MassMutual’s 2018 Business Owner Perspectives study. Yet there is a strong tendency to procrastinate on this vital task, as more than half of the survey respondents say they rarely or never think about it, and only about 40 percent say they have the requisite buy-sell agreement in place.
“I think that [procrastination] is true of life in general,” says Tim Powers, president/CEO of MassMutual Wisconsin. “Most people don’t think about their own mortality or morbidity. I think we all tend to think we’re not mortal and that nothing bad is going to happen but, ultimately, we know that we’re not going to be here sooner or later. The planning is very important and so is making sure key employees know that planning is taken care of.”
Not buying it
The aforementioned buy-sell agreement is especially important in protecting the business. While the buy-sell agreement derisively has been called the business equivalent of a prenuptial agreement, operators would be lost without a fully-funded and signed buy-sell in place. Buy-sells protect the business from the five Ds — death, disability, divorce, departure, and disqualification. When properly executed, this legally binding agreement can ensure the continuity of the business when ownership changes hands; it requires one party to sell and another party to buy ownership interest when a triggering event takes place.
They have to be fully funded in accordance with the current value of the business, and so updating your business valuation on an annual or semi-annual basis is a key component. The usual funding mechanism is an insurance product, usually life insurance in combination with disability buy-out insurance. Failure to fully fund the agreement can result in the remaining owners being forced to liquidate business assets or take operating cash out of the business to purchase the aforementioned ownership interest from the departing owner or his or her family.
As noted above, one of the risks is that the business might have to be liquidated if ownership isn’t prepared. According to the MassMutual study, of those with a buy-sell agreement in place, only 35 percent say it’s funded with life insurance and only 18 percent say it’s funded with disability buy-out insurance. Sad to say, but the rest are funded with cash flow from the business due to the lack of pre-planning. If you’re in a position where you have to liquidate, and you don’t have any other options, “you’re basically driving down the value of your business because you’re in this position where you have to sell assets, or you have to use operating cash,” says Andrew Klein, financial advisor and CEO of Focal Point Financial Strategies. “It puts you in a really tough spot to get value for your business if you have to do it in an immediate situation.”
“We do a lot of buy-sell agreements,” states Powers. “A lot of them are funded with insurance or a sinking fund. Both of those are very easy to set up, and we see a lot of them in legal documents, but they are unfunded. The buy-sell agreement really doesn’t have a lot of power unless it’s funded correctly. That’s where the planning comes in.”
Even if the buy-sell agreement is fully funded, the question of leadership transition remains, notes JP Aime, financial advisor and president of Focal Point Financial Strategies. “Who takes over the role of that business owner within the organization?” Aime asks. “You talk to them and ask them who can do what you do in the business? Very often, they say, ‘Well, nobody can really do what I do in the business.’ The follow up question is: Why do you think that’s the case? The answer we typically get is, ‘I’ve never trained anybody to do what I do.’”
A disability buy out is an often-overlooked piece of the buy-sell arrangement, Aime adds. “In most cases, the operating agreement has been in there, but there isn’t a funding mechanism. “So, there is a way to do that,” he says. “There is insurance in the marketplace that doesn’t pay a monthly disability claim. It pays a lump sum based on the parameters set out within the buy-sell. So, death happens 100 percent of the time, but while someone is active in a business, disability is a much more likely event than a premature death.”
By way of example, Powers says a lot of the businesses will have a buy-sell agreement, and it will be funded with life insurance but not with disability insurance (DI). So, if a business owner in Wisconsin slips on the ice during the winter, cannot work, and remains in the hospital for a prolonged period, there is no claim on that life insurance. A partner might have a single partner, and that partner is now in the hospital, and if that partner is a key, active owner, the business is going to suffer. “If they had DI in the buy-sell, there would be a claim, and the insurance company would pay out money to help get somebody else while the other person disabled,” Powers explains.