There are many ways to fund your exit from your small business. You can sell it to someone and “take back” a note for the purchase price, and get paid over time. You can try to sell to a buyer that can get bank financing or has cash. You can gradually give the ownership to your kids over time. But today I wanted to talk about insurance as a funding tool for some buyouts.
I recently had a great meeting with Northwestern Mutual Life agent Ben Worley. We were discussing small business issues, including exit planning and insurance funding. Ben is a wealth of information on this stuff, and he has some pretty great ideas.
Most everyone is familiar with the life insurance funded death buy-out. I want to fill in some details that came out of my meeting with Ben:
There are two good reasons for a business to have life insurance on an owner: key man and buy out. These are separate things, although I suppose you could have one policy to fund both.
With the key man, the insurance proceeds go to the company, and the company keeps them. The funds are used to soften the blow of losing the key man. The company may need to hire temporary help, or it may take a while for the company to cut overhead to account for the lost productivity, or it may take some time to find a new producer to pick up the slack.
To fund a buy-out, the company is the beneficiary, but the company has an agreement with the insured owner (which is binding on the insured’s estate or spouse or heirs or whatever) to buy the deceased partner’s shares. The company gets the money and pays it to the estate or heirs and gets the shares back in return. Obviously, this works best when there are two or more owners, but it can also work if you choose a key employee or employees to take over and give them the ability to buy in at the deceased owner’s death or some such. There are really dozens of ways to set this up, depending on your situation.
Insurance can also be used, however, to fund buy-outs in other ways. A key employee or partner can buy life insurance and then fund it for some number of years, building up a cash value that the insured can borrow against. When it comes time for the exit, the potential buyer borrows that cash value from their policy, and uses it either to fund the buyout or as the down payment for the buy-out, followed by a bank loan or seller take back loan for the rest.
Sometimes, these policies can have changeable beneficiaries, allowing the owner of the business to change the beneficiary if the intended buyer/employee leaves the business for some reason. In the meantime, the death benefit of the policy is a nice employment benefit for the key person – one way to keep a good employee.
This type of setup works best if you have some lead time for the policy to build value. In the meantime, you can build the value of the business by demonstrating profits, growing gross revenues, and building great customer relationships.
If you begin with a targeted sale price, you can ask a business valuation expert what the numbers need to be to get to that valuation, and set goals accordingly. That will tell you how much to fund the policy each year, and you can measure your progress toward both the goal of funding the policy adequately and meeting the price goal.
Each of these life insurance strategies has complicated details and tax ramifications, which makes a knowledgeable professional insurance agent like Ben a must. They also each need clear, well written contracts, so don’t try this yourself or with some junk you found on the internet: hire a good business lawyer (like Ralph Gleaton or John Perkins, if you’re in Greenville).
And if you want a business consultant to help you craft your plan, or to ride along beside you on you journey, call me.