A fictional finance story for business owners to learn about buy-sell agreements.
Stan and Leigh are owners of Fabulous Adventure Comics, LLC, the largest comic book store in Texas. And that’s really big! Stan and Leigh have been 50/50 business partners for a long time. Plus, the comic book store has done exceptionally well. They have a huge inventory that turns over quickly thanks to counter traffic and online sales. The LLC owns its building as well.
Last year, the business was valued at $2.3 million, and profits were running at about $250,000. Stan and Leigh took a salary of $100,000 per year from the business. The most significant debt that the comic book store has is a $200,000 line of credit. Right now, the line of credit has a balance of $120,000. Stan and Leigh expect that debt will be zeroed by the end of the year.
The Big Crash!
Earlier this year, Stan had a big health scare. He was in a car crash that put him in the hospital for almost two weeks. He recovered and is doing fine now, but it was one of those happenings that makes a person really think about what is important in their life. Stan’s married with two teenage children. He worries about what would have happened if he had died.
Would his wife have to work with Leigh to keep the comic book store running? One of the big problems is that Leigh and Stan’s wife Harley don’t get along at all.
After Stan’s brush with death, Leigh was the one who came forward and said she wanted to make some plans in case something terrible happens to either of them in the future. She was pretty blunt with Stan and told him that she could not work with Harley. In short, Leigh wanted a written agreement that would allow her to buy Stan’s share of the business if he kicked the bucket before her!
Stan was reasonable. He agreed to give Leigh the first right of refusal. That is, he agreed that he would put it in writing that if he died that his estate would sell his share of the business to Leigh first. Then, if Leigh declined to buy his share of the company, his share of the business could go on the open market.
Leigh was happy with that concession, but she had one more request. She wanted to be able to have the ability to stop the sale of Stan’s shares if she disagreed with whom his part of the business was sold.
After a bit of reflection, Stan realized that Leigh’s request was not out of the ordinary. Many business owners want to know who they may be partners with in the future. Leigh put it to Stan this way. What if somebody wanted to buy Stan’s share of the business who wanted to only carry DC comics instead of Marvel? One of the reasons that Stan and Leigh got along so well was that they both loved Marvel Comics. If a new business owner came in and wanted to change the culture of the business, it could be devastating! So, Stan agreed. He would give Leigh the right to nix any future partners.
But Stan carried it one step further. He said what happens if I don’t die, but Leigh wants to retire and sell her part of the business. Could they put the exact same requirements for a lifetime sale of the company? In other words, each partner would have the right to refuse a new partner in the business. They both agreed.
Show Me the Money!
Their agreement was well and good, but Stan and Leigh realized something important. Neither one of them had enough money to buy the other one out. They both knew that if they wanted to sell the business, they could get over $2 million. But neither one of them had a million dollars to buy out the other.
They both had met with their accountant and banker about the value of the business. Their accountant, Abacus Fenton, Abbey for short, was a crackerjack CPA that had worked for one of the Big Four accounting firms. She came up with a formula for valuing their business. Abbey was the one who said the business’ sale value was $2.3 million. Their banker, Walter Profit, looked at Fabulous Adventure Comics’ books and agreed with the value. He said he knew he had other customers who would love to buy the comic book store if they ever wanted to sell the business outright.
Stan & Leigh Needs Life Insurance
Since neither Stan nor Leigh had enough cash to buy the other partner out in the event either died, they knew they needed life insurance. But they were not exactly sure how to buy the insurance. Should the business buy life insurance, or should the partners purchase life insurance on each other?
They were excellent questions, and Leigh knew exactly who to call, her financial planner Ben Plannin. Ben was a Chartered Financial Consultant and instantly knew the answer. So Leigh called Ben and explained what they wanted to do. Ben told her that what they needed was a buy-sell agreement. Ben said that they had two choices. First, the business could buy life insurance, and if one of them died, then the death benefit would be paid to the business. The company would then pay the deceased partner’s estate for their share of the business. At that point, the remaining partner would own the entire business. Ben said that the method of setting up the life insurance was called an entity purchase arrangement.
The other alternative was to have each partner buy life insurance on each other. They would then name themselves as the beneficiary. Then put in the buy-sell agreement that they would purchase the deceased partner’s share of the business. Ben said this type of buy-sell agreement to buy life insurance was called a cross-purchase.
This is the way
Ben explained that since there were only two partners, the cross-purchase buy-sell agreement would probably be the best way to buy life insurance. However, he said that if they ever started to bring in more partners, the entity purchase buy-sell agreement would be more straightforward because there would be fewer life insurance policies. So, Stan and Leigh decided that they would each buy a life insurance policy on each other for $1.250 million. That was half of the value of the business, plus half of the potential debt from their line of credit debt.
They also agreed that they would peg the value of the business on the formula that Abbey used rather than only rely upon the life insurance. If the company’s value went over the life insurance, they would make arrangements to pay the difference. If the value was under the life insurance death benefit, the partner that owned the life insurance would keep the difference.
What about disability?
Leigh brought up another point that she had a big problem with while Stan was recovering from his accident. She told Stan she had a tough time doing his and her work. And she wasn’t too happy that Stan kept taking an income even though he wasn’t working. Even more, Stan kept taking an income for two months without setting foot into the store.
Leigh told Stan that a few weeks was reasonable. In reality, she was running the entire business and paying Stan for his recovery. Stan said he completely understood how she felt and even offered to reimburse Leigh for his time off. She declined his offer but made a suggestion. Leigh wanted to get insurance that would pay the owners’ income in the future if they were incapacitated. Plus, she wanted to see if they could get some sort of insurance to help pay for some of the overhead expenses she had to foot while Stan was out of work. Stan agreed, and they would get Ben Plannin to help set up the business owners’ disability insurance.
What I do defines me.
After talking for what seemed like hours, it appeared that the two partners had come to an agreement on planning how their business could continue in the event the worse happened. Finally, Leigh turned to Stan and said, “all that’s left to do is put everything we’ve talked about into a written document and get the insurance.”
Stan looked at her and said, in the words of the smartest superhero, The Batman, “It’s not who I am underneath, but what I do that defines me.” We need to take action now and call our lawyer, Luca Avvocato and set an appointment for next week to finalize the details.
Leigh looked at Stan with the most serious expression and said, “Well, Stan, you’re wrong about something. And your right. You know Brainiac is smarter than Batman. But you are right. We need to call Luca.” Stan shot back and said, “Leigh, you know Brainiac is a super villain and not a superhero!” Leigh said, “You’re right. He is a super villain. But let’s call Luca and Ben now. Maybe we can get this all done on the same day.”
All the characters in this story are fictional. The circumstances are factual. If you need help creating a buy-sell agreement, send an email to Van@RichardsFinancialPlanning.com