Published in CREDIT TODAY, Authored by Mel Kaye
There are unique inherent credit risks when you sell to a small business or partnership. If one of the partners or a key individual suddenly leaves due to an illness or dies, it can have a severe impact on the financial viability of a small business. A buy-sell agreement can mitigate the crfedit risk by addressing both a Credit Manager’s concerns, as well as the owner’s. As a credit professional, you are looking for some assurance that the business will continue to buy from your company and be able to meet its obligations.
Of primary concern is what will happen upon the incapacity or death of one of the owners or someone critical to the company’s operation. These types of events affect the continued creditworthiness of the business, other owners, and in the case of a death, the heirs of the deceased owner.
If you are looking for a mechanism to mitigate the risk of unsecured credit terms with a small to medium size company or partnership. Suggesting or even requiring “Buy Sell Insurance” and “Key Person Insurance” are options you should consider.
It Starts with a Buy-Sell Agreement
A buy-sell agreement is a contract among business owners. Upon the death of one of the owners, the remaining owners, or the company itself, will purchase the deceased’s interest in the company according to the agreed-upon terms of the contract. In addition, the deceased’s heirs are required to comply by selling their inherited interest at the previously agreed-upon price, or at market. This helps mitigate the credit risk.
There are various options for funding a buy-sell agreement, though some carry more risks than others. Here are the options:
- Personal or Business Loan: Some owners choose to take out a loan to buy out a deceased owner’s share in the company.
- Life Insurance Options: These provide the type of coverage needed, and funds are immediately available when a death occurs. Furthermore, death benefit proceeds are generally income-tax-free.
- Cross-Purchase Plans: Under this type of plan, the owners enter into an agreement with each other. Each owner purchases a life insurance policy on the other owners and will be named the beneficiary of the policy. Upon the death of an owner, each surviving owner receives life insurance proceeds income-tax-free and uses said proceeds to purchase the deceased’s business interests, while the heirs receive an agreed-upon payment for their business interest.
- Entity Plans: In this type of agreement, also known as a stock redemption plan, the company purchases life insurance policies for each owner, with the company itself as the beneficiary. When an owner dies, the company receives the life insurance proceeds and uses said proceeds to purchase the deceased’s business interest, providing the heirs with an agreed-upon payment for their business interest.
The Benefits from a Credit Manager’s Perspective
As a credit professional, you want the company to remain financially viable, as do the owners. Another key objective involves ensuring continuity of ownership to avoid the possibility that a large share of ownership will fall into the hands of potentially inexperienced heirs of the deceased.
Advantages to a Small Business Owner
The owner(s) want to protect themselves and the company financially. They want their family to be financially secure and compensated fairly in case something happens to them. This tax-free option ensures the continuity of business ownership and stability and thereby opens the opportunity for trade credit and borrowing capacity that would not otherwise exist.
What Happens to the Policies if the Owners Continue to Live?
These policies have an agreed-upon date at which time the premiums stop, but the policies continue. If the policy owners and insured make it to this date, the people that the policies insure become the policy owners, thus enabling them to realize the retirement benefits of these unique policies, which could be substantial and tax-free. This will be arranged in advance via a written agreement.
Key Person Life Insurance
Losing a “key person,” such as a partner, top executive, or any other critical individual, can be catastrophic to the business. A “key person” is someone who is considered essential to running the business, whether it’s an owner/partner, top executive, or somebody else with specialized knowledge and skills. Losing this person would cause the business to suffer financially, because of the difficulty and expense of replacing them, or because this person brings in a significant amount of revenue.
Key person insurance is designed to pay a life insurance death benefit to a business should the insured person pass away. The policy may also be structured to pay multiple beneficiaries in addition to the business, such as the insured’s family. This type of insurance offers small companies a contingency plan for worst-case scenarios. The business typically pays the premiums on this type of life insurance policy as the primary beneficiary.
There are no restrictions on how the death benefit is spent, and it is tax-free. The funds can be used for any expense, including daily operational costs, training a new hire, or paying off debt. “Accelerated Death Benefits” cover an insured individual that becomes critically ill and unable to perform his or her duties.
What Happens to the Policy if the Key Person Remains Healthy and Stays with the Company?
These policies have an agreed-upon date at which time the premiums stop, but the policies continue. If the policy owners and the Key Person make it to this date, the Key Person becomes the policy owner, thus enabling him/her to realize the retirement benefits of these unique policies, which can be substantial and tax-free. This also provides a major incentive for that person to stay with the company.
The Credit Department Perspective
Keeping all this in mind, credit managers should ask all prospective sole proprietors, partnerships, LLCs, and any other small corporations if a Buy-Sell Agreement or Key Person Coverage is in place. If this question has not been part of your credit application, you should add it, and in your periodic review of existing customers, request this information. Knowing your customer contingency planning provides an extra cushion of assurance when setting credit limits.
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