Understanding Buy/Sell Agreements

Speaker 1: 00:00
Welcome to EWA’s FinLit podcast. EWA is a fee only RIA based out of Pittsburgh, Pennsylvania. We hope all listeners of this podcast will benefit as we deep dive into complex financial topics that we will make simplified for you. And we hope that this really serves as a catalyst so that you can make the best financial planning decisions for your family and also save time. Welcome everybody. This is our, this is our first episode with, with Jimmy Rutenberg here. So I got, the first question I got for Jimmy is did you ever in a million years imagine yourself doing a podcast?

Speaker 2: 00:41
I don’t even know what a podcast is.

Speaker 1: 00:46
Well, it’s, it’s. So anyways, quick introduction. Jimmy. We met over 10 years ago at our former place of broker dealer and did a lot of joint work. Jimmy’s an expert in estate planning, risk management and I was doing a lot of the financial planning. So we were good partners while we were there. And fast forward five years with Jimmy’s son joined the firm a couple years ago and then fast forward five years and Jimmy’s finally made the move, is now a partner at ewa. So big excited to, to get into some really big details about buy sell agreements. Jimmy’s worked with this hands really in the weeds, kind of in the trenches with a lot of business owners, high net worth business owners, closely family held businesses. And so we want to talk about really the importance of why planning and having these agreements is so important. And Jimmy has some real life stories to share with us. And then I know Jamison’s working on one alongside Jimmy right now. So we’re going to talk about some of the, give some high level advice on how you want to structure these things and obviously we’ll welcome any, anyone that wants to discuss this for their business. So let’s start with so Jimmy, you’ve been doing this over 30 years. Give us an example of like a real life example, we don’t need names but of let’s start with the horror story of like you know what, what happens if you have partners in a business? Someone gets disabled, someone dies and now suddenly the partner that’s living is now unexpectedly partners with that person’s wife or family. So yeah, give us, why don’t you.

Speaker 3: 02:23
Give just overview to how you do this. Like what is a buy sell?

Speaker 2: 02:26
Right, right. So a buy sell agreement just to make things very simple is if you are partnered with somebody in a business, you want to have an agreement that really stipulates the three events that can trigger a buyout arrangement and that can either be somebody Wanting to leave the business, which is great. No real emotion there. But the other two can be pretty difficult events. One can be a disability, and one can be a death. Primarily, when you talk to business owners, the majority of the focus is always on the death. Although there should be some discussions about disability, and we do talk about that with our clients. The majority of it is about, okay, if something happens to a partner in the business, what does this look like? Does the business continue to operate as is, and does deceased partner spouse become a partner? Does the deceased partner want his or her spouse cashed out of the business? So there’s a lot of different variables, but they’re all really, really important. And the most important thing about a buyout arrangement is to make sure that you have these discussions in place before a triggering event. Especially if we’re talking about a death. It’s highly emotional, and it’s the last. It’s the very last time that you want to be talking about, you know, what is this worth? What do I get? You know, things of that nature. You have to have partners that agree on that before a triggering event like a death. And unfortunately, I’ve been in scenarios where agreements weren’t in place, and it’s just very, very difficult. It’s difficult for the surviving spouse because, you know, that’s somebody that was, you know, very meaningful to that person in their lives. They weren’t just business partners for the most part. They were, you know, friends as well. So you lose a friend, you’re mourning that, and now all of a sudden, you have to come back and you’ve got to run a business under very, very different scenarios. And without those agreements in place that stipulate everything, it can get really, really, really difficult.

Speaker 1: 04:30
Yeah, no question. Well, do you have a specific example of kind of the fallout that occurred?

Speaker 2: 04:34
I do, I do. And, you know, I chuckle, not because of the circumstances, but as advisors, we always have to ask our clients all different kinds of questions around their financial plan and their businesses. And in doing it, as long as we’ve done it collectively, you do get a lot of different answers. And, you know, some of them, when you are collectively in a room together, everybody’s kind of saying the same thing and like, oh, yeah, no, the business will be great. You know, we’ll be able to maintain if either I or my partner isn’t there. But then when you get them in a room separately, you get the real story, which is there’s no way this business is going to run if I’m not here. So, you know, you get those stories a lot. But I did have an instance where two partners, business was north of five years, and they really, really were starting to cash flow. Well, and we had been talking about a buyout arrangement for a while. They kept falling back to, we have an operating agreement. And sometimes you hear that a lot with, oh, well, we have an operating agreement. But, you know, sometimes the operating agreement isn’t going to specifically spell out what happens to a shareholder if they pass. And that was the instance here. And there was really no mention of what happens to decedent shares. So it became a mess. And the problem was the deceased spouse didn’t want to come into the business, but her understanding of what the business was worth was very different than what the surviving shareholder thought the business was worth. So obviously, without a shareholder agreement that stipulates how you value and we can get into how that can be done, there also wasn’t any funding mechanisms in place, you know, to buy out, you know, deceased shareholder, spouse. So, you know, the first thing is, okay, what is it worth? Do we come to an agreement on that? Which they weren’t coming to an agreement on that.

Speaker 1: 06:44
What did the. Just to. I want to know names here. But what was the. What was it worth? What did the spouse think, the surviving spouse think it was worth? And what did the existing shareholder.

Speaker 2: 06:55
So, you know, the. I would say the business was probably worth about $10 million. And I think the surviving spouse thought that it was maybe 3x more than.

Speaker 1: 07:08
That or 30 million. So she’s expecting basically a check for.

Speaker 2: 07:11
15 million bucks, or she’s expecting her lifestyle to continue in the manner in which she was accustomed to without any.

Speaker 1: 07:21
Involvement in the business. Just write me a check every.

Speaker 2: 07:23
Yes, yes. Not understanding that some of it is salary, some of it is profit, you know, in the. Profit now. Well, and now you take away. I was just gonna say you took away 50% of what might be generating profit. That 50% was the. The individual who was more the face of the business outside of the business. So we can call that the revenue generator. The other partner was internal, more, you know, keeping the books, which is surprising that there wouldn’t have been more of a firm grasp on these kind of things. But, you know, hey, we can talk to 10 lawyers in town today, and nine of them don’t have wills. So, you know, you never know. So that became a problem, coming to an agreement on what it’s worth. And then once they did come to an agreement on that, it became a real issue on how to fund it. So the Surviving partner had a new partner and it was a bank. And a lot of those scenarios can get challenging as well.

Speaker 1: 08:25
So now that surviving partner has an angry, you know, deceased spouse of the partner not going to get as much as they fund. So they’re fighting a legal battle there. He’s also. He or she is trying to keep the business afloat with double the responsibility.

Speaker 2: 08:41
Correct.

Speaker 1: 08:41
And so it absolutely can be a catastrophe if there’s not a funding mechanism, not a plan in place, not an agreement in place.

Speaker 2: 08:48
Business doesn’t exist anymore because of this.

Speaker 1: 08:50
Well, this was the start of a fallout.

Speaker 2: 08:53
This was the start of. I mean, it was about three or four years after. But you can point to that event.

Speaker 3: 08:59
And then imagine you’re trying to keep the business profitable and run it and you have deceased partner’s spouse trying to come get money. Like that’s impossible to maintain the growth of the business and the revenue.

Speaker 2: 09:10
Yeah, it’s a total nightmare. It’s a nightmare to not have an agreement, and it’s a nightmare to not have an agreement that’s funded.

Speaker 3: 09:17
Yeah, yeah. You’re gonna spend your time trying to figure this out.

Speaker 2: 09:19
I’ve been in countless rooms when shareholders have passed with attorneys, and the first question the attorney always asks is, where’s the money? Where’s the cash? Now, that cash can be in deposits in the company. It can be carrying it on a balance sheet, it can be insurance, it can be anything. But they need cash to work with. Without cash, it’s a problem.

Speaker 1: 09:43
So legally speaking, without in this case, if so, let’s say two partners, both married. In your example, real life example, one partner dies. Just like purely legally speaking. That’s if they were 50, 50 partners before death. The spouse now becomes a 50 partner of that business. Absolutely. So you now have an unexpected partner of a morning spouse who’s had, you know, no training, no experience, but now owns 50 of the company. It’s probably not going to agree with anything you say or do because might.

Speaker 2: 10:21
Not even understand anything you say or do.

Speaker 1: 10:22
Yeah. And plus that’s. You’re. Now you’re former. Let’s just say these are two males. Late husband was probably coming home to you every day talking about how horrible a partner and distresses.

Speaker 2: 10:35
I don’t know that anything’s possible. Yeah.

Speaker 1: 10:39
So there’s probably a jaded experience coming in and then that spouse is gonna come in like a. At least from the experience I’ve seen. I’ve seen this go south is like a wrecking ball of I want my money, I want it now.

Speaker 2: 10:52
Yeah. And all kidding aside, the, the, the c. Spouse, she’s scared.

Speaker 1: 11:00
Right? Am I okay?

Speaker 2: 11:02
Yeah. Am I okay? Okay. I just lost my life partner, so I’m mourning that. But now how am I paying my bills? So it’s just like I said in the outset, it’s a very emotional time. And it’s not the time to be dealing with financial issues where there needs to be agreement. Those discussions have to happen before a triggering event.

Speaker 1: 11:29
No question. No question.

Speaker 3: 11:31
Why don’t we go through an example? Hypothetically, let’s say that the three of us are partners, 30 million dollar business. How can we structure this? What would we do? What’s the proper way to do it?

Speaker 2: 11:41
Well, that won’t be good because Lori completely trusts Matt, so it’s probably not a good example.

Speaker 1: 11:48
So let’s say it’s a third. A third, a third.

Speaker 3: 11:50
Let’s assume we’re all married mat assume we all have spouses.

Speaker 2: 11:54
Okay.

Speaker 1: 11:56
So the right way to do this. So there’s basically two ways. There’s called an entity plan where basically the company would own life insurance on each individual. And this is the most simplified way to do it. Let’s say, you know, we each have a stake that’s worth 10 million. So the company would own $10 million policy on each of us, end up with the understanding that if one of us passes, that 10 million would, would go to the surviving spouse. So let’s say I’ll pick up myself. Let’s say I die, the company receives 10 million. You two collectively decide, okay, buy out Matt’s spouse for 10 million and then you’re now 50, 50 partners. It’s clean. The only issue with the entity is plan is if the business valuation occurs after death, which it will now the business is worth 30 million plus another 10 because the business owns that 10 million of life insurance and now the business is worth 40. Now you, you know, my hypothetical spouse you owe 13.33 million to and you only have 10 million of cash. So you’re still, this is like if you want a quick band aid, simplicity and just something quick, this will solve like 80% of the concern. But it’s not, it’s not the most efficient from a business valuation perspective. It’s not efficient tax wise because you’re also not, you two are not getting a personal step up in basis of that. So the right way to do this would be. So if you’re going to say I need something quick, I need something simple. The other advantage of an entity plan is that if there could be a difference, like let’s say I’m not in good health and you guys are in perfect health. Well, if we wanted to fund this for life insurance, maybe the company’s spending 10,000 on my policy and 2,000 each on your policy if it’s a term life policy. But if it’s an entity plan, it’s more simplified as far as like it’s a business expense, we’re agreeing to all and there’s no right. The right way to do this would be a cross purchase plan. So James, give us a high level on what is a cross purchase plan and what are the specifically the valuation and the tax benefits of doing it this way.

Speaker 3: 13:55
Essentially, instead of it being business owned, they’re personal owned policies. So I would own a policy on you, on Jimmy. Make sure I explain this right. Matt dies, policy gets paid to me so it doesn’t go on the business’s balance sheet. I then purchase pays to me and Jimmy, Jimmy and I purchase the equity from the spouse.

Speaker 1: 14:15
So in this example, you would own. We would each own five on each other. So there would be a total of six policies in place individually.

Speaker 2: 14:22
That is the other advantage of an entity purchase. If you are going to use insurance to fund your agreement, it’s less cumbersome.

Speaker 1: 14:32
It’s three policies. It’s three policies instead of six.

Speaker 2: 14:34
So if you end up having a situation where there’s eight shareholders, you could have all. I mean, it can get really. The only thing I want to say, Matt, when you talked about Jamison and I agree to buy you out at your death, it’s really, really important. That’s in the agreement. So that’s stipulated before. Jamison and I are not coming to that agreement after you die.

Speaker 1: 14:59
Right.

Speaker 2: 14:59
It is something that the three of us have agreed upon and is in the agreement that we all collectively agree. We want our spouses bought out at a fair price for what we think our shares are worth. But we do not want them replacing me in the business and running the business with you. So that is in the agreement before there is a death.

Speaker 1: 15:20
No question.

Speaker 3: 15:21
Ideally at some point you have evaluation or at least you know, within the industry what the metrics are that you’re getting.

Speaker 2: 15:26
And that should be updated, I would say every couple years, two to three years, just to make sure it’s, you know, it’s fair.

Speaker 3: 15:31
And I was going to say too, like we may put the each have $10 million. Five years from now the business could 3x correct. And now Matt dies, his value’s worth 30 million instead of 10. And we only have $10 million to pay out in life insurance.

Speaker 2: 15:46
I’ve seen that before and that’s okay. You can cash flow to some extent, some of the obligation. You may not be in a situation where you can insure everything, but boy, it’s a whole lot better to be able to make a nice down payment and then maybe finance the rest. If you’re in a position where you’ve got to finance everything right from the get go. That’s where it can become stressful on the business.

Speaker 1: 16:11
No question. I think the most common. So you can have the buy sell baked into a really good operating agreement or you can have a separate buy sell agreement on the books of the company. So in that example, I think it would be important to outline. It’s basically okay, we agree we’re taking these life insurance policies in place. We need, I’m just making this up. 80% of whatever proceeds come in got paid to the surviving spouse and then the remaining balance on that 30 million example has to get paid over a five year period. And then the business maybe takes a little bit of the life insurance proceeds to replace the partner that died.

Speaker 2: 16:47
Yeah, that’s a really good point, Matt, that you bring up. There’s a key person component to really any of these discussions as well. So that’s really important that you mentioned that.

Speaker 1: 16:58
I think it’s really important though as partners to agree, okay, we’re going to have a down payment of either the amount of the life insurance or 80% of the life insurance and the rest has to be paid over five years. So that way you can go home individually and explain that to spouses. Hey, just so you know, if I die, here’s what it’s worth. Now I trust my, it’s all in a written document. Here’s what to expect and this is done. So there’s, there’s not a negotiation here. You’re going to just ask for, you know, in our operating room it’s two independent appraisals get done. You take the average of those two and then it’s a, it’s a five year period that gets paid out after.

Speaker 3: 17:33
But if you don’t have those terms in, you could get, I mean you could be fighting over appraisal value too.

Speaker 2: 17:37
Yeah, absolutely.

Speaker 3: 17:39
I may go get it appraised and it’s, they’re going to be, you know, working for me, you’re getting appraised or working for you. And if you don’t have that in there to meet in the middle somewhere that could just be, that could take years to figure out what’s what paid out.

Speaker 1: 17:50
We just did one for a company that’s evolved into a tech company, it’s like they’ve just gone crazy growth. And so when we originally did this, the company was worth 20 million. It was like a 60, 40 split. So it was 12 million. The one, the two partners was 12 million and $8 million policy. And then fast forward even a year and now the company’s, you know, hypothetically, if we use the same multiple, it’s worth 50 million. So I went back to them and said, you know, you have two options. I’m like what’s likely? And they think the industry is going to change and they’re just cash flowing like their own financial independence. Right. Like they may be sell, they may not, but they don’t want to count on it. So instead of going back and getting 50 million total of life insurance, 30 million and 20, we kept it at 12 and 8. And then we updated the buy sell agreement to say whatever the life insurance proceeds, buy out of the value. That’s it. And then the remaining spouse will be a passive partner of profits. But they felt like that would be enough to make their spouses financially independent and then fair because if the, you know, in this kind of cyclical industry they’re in, if they’re committing to like a 50 million buyout and then suddenly the industry stops. Now the one spouse has a note with no value there. So this was, this was, you can be very flexible and think and match this to your industry and your the risks and ups and downs. But they decided to do that. So not opposite of what we’re saying. We wrote it as a passive partner so the surviving spouse, whatever doesn’t get bought out. Let’s say they buy out 30% and that the 40% partner, that spouse would still own 10. They would get 10% of the profits or they could agree to a buyout over that five year period. But they basically, that partner has the flexibility where it’s like, I don’t want to take the risk of buying this person out because the business could end in a couple of years. I’m just going to keep them on as a passive. And if the business explodes, that spouse gets 10%. If the business goes under, it doesn’t, I’m not taking any additional risk. But you can be very flexible with.

Speaker 2: 19:45
These things as long as everybody agrees. As long as the partners agree. Another very good point. Yeah, every industry is different and so there can be significant Risks to having ownership down the road along with significant reward. So you have to plan for all of that in an agreement.

Speaker 3: 20:04
Yeah. And I’d say one thing I thought of, that’s a good solution. What I’ve seen happen too. Let’s say Matt dies, me and Jimmy take the business over. Spouse is paid out, let’s say a year, two years, we 2x the business and then sell it to an outside party. The spouse that got paid out could come back and say, whoa, they paid me half of what I should have. Now there’s a lawsuit going on while you’re trying to sell your business to, you know, make that, make that spouse whole. So all of these things are. You just have to have these conversations to avoid all that.

Speaker 1: 20:34
Yeah. And I think in today’s landscape, how quickly things are changing with technology, you need to have an agreement that is tailor made to your business and can anticipate the risk, the unknowns, the changes and make sure it’s fair and accountable for everybody. Let’s talk about funding. So the first option is you could just have the agreement and have no funding and then hope and pray that the business has the cash flow, cash.

Speaker 2: 21:00
Flow in the agreement.

Speaker 1: 21:01
Some people do. That would be most appropriate. If you have an installment agreement like a five year period where you can or a ten year period where you can pay out the. That can be dangerous because if your business valuation goes up and then suddenly that that valuation is locked in and cash flows go down, that’s where we’re talking about the lawsuit or risk can happen. So we highly recommend to pre fund this and that. Basically the option would be you could start setting aside an investment account.

Speaker 2: 21:25
Which.

Speaker 1: 21:25
Would take a long time probably to ever reach and you know your money temperature personally in the money temperature of the business which does exist, whatever doesn’t get saved in the business is probably going to get spent or you can buy insurance. So Jim, talk about the difference between term insurance and permanent insurance and then also how the permanent insurance, you know, if we’re talking about three 40 year olds that are doing a buy sell agreement, let’s say they do a mix of it, but that permanent insurance could turn into a proactive living buyout at the end. So walk us through that.

Speaker 2: 21:59
So this is where some of the honest conversations with the partners have to come into play. Especially if you’re going to do the first route, which is just cash flowing. There needs to be a real understanding of what each partner’s role is in the business. So that if cash flow is going to be impacted by the loss of one of the partners. That really needs to be in consideration if you’re going to cash flow. So we always try and be really cognizant of that. And not to say that we don’t recommend that, but we want to make sure that we point out all of the difficulties that could come with cash flowing, that your second option is you can borrow it if you need to. But now you’re a partner with the bank and interest rates, as we have all seen over the last few years, that can change. So, you know, 10 years ago, getting a loan from a bank would be cost effective. I don’t know if any business owner would want to do that today. So we come to insurance and we think it’s a reasonable expense for, you know, bringing a lot of peace of mind to these situations that we’ve been talking about. As you mentioned, term insurance, that is going to be the least expensive way to address this. So we, we recommend that a lot for a lot of different reasons. Especially if it’s a business that’s just starting. Cash flow’s tough and you’re just trying to get on your feet. But you really believe this is a value that we want to protect for our families. Obviously we’re going to use term insurance. If we think there’s going to be an exit strategy within a five or ten year period, we’re going to use term insurance. If this is a business that is multi generational, or even if it’s a business that you’re starting where you really feel that you want your kids to come into the business. Meaning if we ask how long are you going to be an owner here or how long do you want ownership in your family to be, then if there is not a timeframe where they can really tell us no, it’s this amount of time and that’s it. Well, you can kick the can with term insurance. I mean, we can put in place 10 and 20 year term policies. We just need to make sure everybody understands if you still own the business in the 21st year of a 20 year term policy, we got to go back into the market and we got to purchase it again. You’re 20 years older, health may change. As long as everybody understands what all of the outcomes would be in that scenario, great. If we use permanent insurance, we don’t need to worry about outliving our coverage. And it’s also, as you mentioned, cash that we can carry on the books that can be used for a multitude of different things. So it really comes down to how long is ownership going to be in this business that oftentimes dictates exactly what we’re going to recommend.

Speaker 1: 25:12
It’s interesting to me, every business owner I talked to, including myself, I don’t know if you feel this way too, like, every bit. There’s always, you’re always short on cash. You know, whether it’s a tax liability at the end of the year, whether it’s some unanticipated expense. And so, you know, if this is a multi generational approach, a lot of times it makes sense to focus on a high cash value accumulation inside of insurance because it take, it’s going to take care of the buy, sell agreement. It’s also going to take care of, you know, if it’s. If there’s a liquidity need that occurs, you can take out. So there’s obviously every solution here needs to be tailor made to the specific situation. But that’s something, you know, personally that we do depending on needs that can accomplish a lot of things. In the short term, it takes care of the what if? And then the long term, it also.

Speaker 2: 26:03
It also helps if one of the triggers just says, hey, I haven’t died, I haven’t become disabled, I’m a partner, I just want out. Now we have some cash that can help offset, you know, that. Again, coming back to the original, there are three triggers. I’m either retiring, I’ve become disabled, or I’ve passed away.

Speaker 1: 26:21
Yeah.

Speaker 2: 26:21
Those are the three components that are going to delve into a buyout agreement, no question.

Speaker 1: 26:29
Well, any. Jameson, any closing thoughts on the, on the overall discussion here?

Speaker 3: 26:35
No, I think it’s just very important conversation and plan to have in place. As, you know, business owners and things that people don’t want to talk about, they’re hard conversations. It’s not. You’re busy running a business. You know, a lot of people, if they’re young and health, they don’t want to sit down and talk about what happens if you die. Same thing. Why people don’t, you know, they drag their feet on getting an estate plan done, but, you know, important to have it done up front and you’ll avoid a lot of headache, stress time on the back end.

Speaker 1: 27:02
Absolutely. Well, how would you rank Jimmy on his first podcast? Can we name. Can we go from Jimmy Ruttenberg?

Speaker 2: 27:09
What happens now? Do I get, like, followers? Do I get. Am I an influencer?

Speaker 1: 27:12
We’re gonna start calling you Jimmy. You know Joe Rogan?

Speaker 2: 27:15
Yeah, I do know Joe Rogan.

Speaker 1: 27:16
You’re now Jimmy Rogan.

Speaker 2: 27:17
So now that’d be like companies that will call me and I’ll promote their product now and everything.

Speaker 3: 27:23
What would you want to promote?

Speaker 2: 27:24
I’ll have to think about that.

Speaker 1: 27:26
We’re gonna get some big. We’re gonna get some more revenue in the door. Some. Yeah, you think about it. But no, I think I would say 10 out of 10. We need him every week in here.

Speaker 3: 27:35
He kind of looks like Joe Rogan, too. Bald head.

Speaker 1: 27:39
He’s gonna have so much influence. You’re gonna. You’re gonna influence election results now. This is great.

Speaker 2: 27:45
Okay, Appreciate it, guys.

Speaker 1: 27:46
Thanks, everyone for joining us. Catch you next week. Thanks for tuning in to our podcast. Hopefully you found this helpful. Really hope this is as beneficial and impactful to as many people across the nation as possible. So hit the follow button. Make sure to rate the podcast and please share with any friends or family members that would also find this beneficial. Thank you very much.