Protecting your business against the ‘5 Ds’

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.



To avoid becoming stale, a buy-sell agreement should be reviewed every three years (at the very least) in order to reflect changes to business value, family dynamics, and ownership interest. While not crafting a buy-sell causes cracks in the foundation of a new venture, Klein notes that not updating the buy-sell can be just as damaging.

“The buy-sell agreement is integral because what we see is that everybody has an operating agreement and a lot of them have a buy-sell agreement, but they haven’t looked at it in well over sometimes decades — [usually] five, 10, 15, 20 years,” Klein explains. “They incorporate it, they work really hard to get all these documents in place, and then they just went to work and forgot all about getting the business valued so that, in the case like the five Ds — death, disability, divorce, departure, and disqualification — if one those things happened to an owner or a partner, a lot of times the language just isn’t there. There can be misunderstandings when things go wrong.”

A buy-sell agreement also should be re-evaluated any time there is a material change, so a new valuation would drive that, notes Aime. “If the valuation changes drastically, then the buy-sell agreement needs to be updated,” he counsels. “If ownership changes, including the percentage of ownership changes, then the buy-sell agreement should be updated. Any major material change should trigger it, and in most cases the most common material change is the value of the business. If there are no ownership changes and the business hasn’t been revalued, then in the owner’s eyes there really is no reason to update those documents. If a business goes from a $1 million valuation to a $5 million valuation, then clearly there is a material change that needs to be addressed within the buy-sell.”

Projecting growth is part of the calculation, Powers adds. “One of the things that we do on a daily basis for business owners is help them realize in their planning what the projection of that company is going to be,” he explains. “You buy enough life insurance and DI buy-sell insurance for the future because at any time, if you and I own a business, let’s say it’s worth $1 million and it’s $500,000 each, or 50-50, and we’re projecting that it’s going to grow to $10 million over the next 10 years. If we only buy $1 million in insurance, it may become uninsurable. You might get some type of illness where no insurance company is going to cover me when I apply for the next $1 million, let alone the next $9 million. So, it’s important to project and to plan correctly for the growth of that business in order to fully fund the buy-sell.”

Nathan Brinkman, president of Triumph Wealth Management, called buy-sell agreements “probably one of the most under-utilized areas” in business planning, in part because “nobody loves insurance.” At times, Brinkman finds that opening conversations and talking about this topic can be dicey because it’s about a part of someone’s life that they don’t want to think about — i.e., what happens if I die or become disabled?

There is, however, one exception to that rule. “I do find that people will act on the death element of things because obviously it’s a known event,” Brinkman says. “What’s more difficult is planning around things like a disability. An insurance company is going to ask these questions, but a broader scope of this would be what happens of somebody goes through a divorce? What happens if they do something stupid and get themselves in legal trouble?”

In those events, you want to make sure the relevant documents within the business cover this, particularly with multiple owners. If you’re a sole ownership group, or person, there are other people who are dependent upon this business — your employees, vendors, and clients. To not protect them is irresponsible. “People, when given a choice, will [do that], but I can’t tell you how many times I get a phone call and the person says, ‘I just had a heart attack, maybe I should think about disability income insurance or life insurance.’”

By that point, it’s a little late.

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