Structure A Key Person Buyout That Actually Works For Your Small Business

Founder & CEO of Artisan Financial Strategies LLC. She is fascinated by the interplay between gender, money and power.

When you’re ready to exit the business you’ve nurtured through the years, who’s going to take your place at the helm? You’re probably planning a key person buyout of some variety if you’re not passing the reins to younger family members—and perhaps even if you are. It’s a great idea in theory, but will your plan hold up in the real world?

Long-planned key person buyouts often crash when it’s time to execute the transaction. Unless these arrangements are structured precisely and bolstered by well-crafted implementation supports, the odds of failure are depressingly high. Here’s a simple three-step strategy that can drastically increase the likelihood that your key person buyout goes through as planned.

Identify Common Pitfalls

Lack of liquidity is the main threat to these arrangements. You and your key person may agree on the idea of a buyout, but an all-cash offer today is probably not realistic. And that’s fine because you’re planning to keep working in the business for some time to come. You’ll make a long-term arrangement that works for everyone—unless you die.

Without the robust personal financial statement needed to satisfy potential lenders for a large business acquisition loan, will your key person be able to access the necessary funds to buy the stock from those who receive it on your passing?

The business itself represents a solid asset, but banks often won’t continue existing lines of credit or make new loans when the company is in the hands of a new owner or prospective owner. And with you gone and the key person lacking short-term liquidity, the business may suffer—creating cash flow problems that impact financial statements and make it even harder to convince lenders to provide the necessary funding.

Remove Barriers To Success

Your goal, then, is twofold:

• Make sure your key person has sufficient liquidity to buy out your family.
• Make sure your business has enough liquidity to remain strong during the transition.

Key person life insurance can help you achieve both. Depending on the nature of your business, your family and the relationship with your key person, you could approach it in two different ways—or use both in combination.

The first way is to ensure the business financials stay in good shape. You can take out a key person life insurance policy on you, as the business owner. The business owns the policy, pays the premiums and becomes the beneficiary of the policy payout. This gives the business an influx of cash upon your passing—extra operating capital that averts the risk of a crisis-driven fire sale. It also gives your key person solid business financial statements to take to the bank in search of funding to purchase the outstanding shares from your family.

Alternatively, you can choose to directly ensure that your key person has funds to buy out your family. In this case, you are the insured and policy owner, with the key person listed as the beneficiary. Then there’s no question of liquidity; your key person has tax-free funds to keep the business going smoothly and buy outstanding shares from those who receive ownership when your estate plan is executed.

Structure The Arrangement Right

Life insurance can help, but it’s not infallible. A lot of people attempt to use this strategy only to see it fail because insurance doesn’t matter if you don’t have the legal structure in place to back your buyout plan. It’s critical that you update your operating agreement so it’s clear who’s going to run the business when you are gone, how those shares are going to pass and how the prospective new owner is going to pay to purchase them.

If you want to sell shares to your key person and the insurance payout is specifically intended to fund the purchase, then the operating agreement needs to state clearly that the key person has a contractual requirement to buy those shares and that your estate has a contractual obligation to sell the shares according to the terms of the agreement. Beneficiary designations on the insurance must be aligned with ownership as defined in a properly structured operating agreement.

The operating agreement also has to state explicitly that the insurance payout must be used to fund the purchase of family-held stock in the business. If the planned buyout doesn’t happen for any reason, the money stays in the business and is controlled by the current owner(s).

The Takeaway

A key person buyout can be an effective method of passing your business to new ownership while creating financial benefit for your family. Don’t kid yourself though; these arrangements are prone to failure without the right supports in place. A well-thought-out life insurance strategy coupled with a carefully structured buy-sell agreement can help reduce the risks by making sure your plan is workable at crunch time.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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