How to help protect your business if an associate passes away

It’s terrible to contemplate losing your business associate, but it’s a risk all business co-owners face, making it important to plan for. Many individuals are starting to prepare for critical illness, with employee ownership of critical illness insurance rising 100% since 2014.¹ As a business owner, you should consider doing the same. Failure to plan can affect the ongoing viability of your business: It can also take a toll on the family of the deceased owner, as well as your own family.

To prepare for such unexpected events, you should start strategizing a business succession or transition plan early. But before you begin, you need to understand the potential business implications of a co-owner’s death. Can the business continue without the talents of any one co-owner? Does this change how suppliers, creditors, and customers view the business? Is there any impact on employee retention? Only after you and your business associate have come to a consensus on these important questions can you begin developing an agreement to lay out an action plan in the event of a co-owner’s death. Making sure that your plan is properly documented can help your business continue without significant interruptions.

It may be a good idea to engage a financial professional to help you develop the appropriate plan. In the meantime, here are three basic choices you can start to think about on your own.

Liquidate the business and move on to a new chapter 

Losing someone is a significant change in life, and it can take a while for you and your business to grieve. If that person was the key brains behind the business, it may not even be possible to continue the work without them. One option in these scenarios is to liquidate the business and distribute the remaining assets among the owners and the family of the deceased owner. However, this, of course, may mean a loss of steady income and forfeiting any sale value that a competitor may find in buying the business.

Welcome the heirs to the team 

A second option is to have the surviving owners take on the heirs as new business associates. This could be anyone, including the surviving spouse or children. Keep in mind that there is a possibility that the heirs may have less experience or knowledge about the business, or may not share a passion for the business.

Consider a buy-sell agreement

On the other hand, a more practical course of action may be to form an agreement to buy out the deceased owner’s share of the business. Known as a buy-sell agreement, this agreement should set a purchase price or a methodology for determining a fair and reasonable price to ensure heirs receive what they’re owed. The challenge with setting a price is that the value of the business may change over time. Recognizing this, the agreement can either:

1. Call for a price to be negotiated should an owner pass away, though this may leave owners wondering how fair of a price the surviving spouse may get.

2. Update the price annually.

3. Or indicate a formula in the agreement for determining the buyout price. 

Annual updates or a formula often work well, particularly when established by a professional business valuation firm.

Fund the buy-sell agreement with life insurance

One of the biggest obstacles to buying out the deceased owner’s interest in the business is finding the cash for the purchase. If you find yourself in this position, you could request a bank loan or pay the buyout in installments. However, loans can be difficult to obtain in view of the uncertainty of the business following the loss of an owner, and paying with after-tax profits could put pressure on the business and the other owners.

Alternatively, you and your partners could agree to buy life insurance on the life of each owner in an amount equal to the purchase price of each of their interests.  

If premiums are paid on time, the cash value of a whole life insurance policy grows at a pre-determined rate and a death benefit is guaranteed.^2,3 The death benefit provides income tax-free funds to finance a buyout, and also can help avoid the cost of interest associated with the loan option. Cash value may also be accessed tax efficiently.

You should periodically review the value of your business and the buy-sell agreement, this can help ensure that the life insurance coverage is equal to the growing value of the business. And don’t forget to include other events that could impact your business in the agreement, e.g., an owner’s prolonged illness, injury, or disability, bankruptcy, divorce, and other life events.

Engage with a team of professionals

Transitioning a business after the passing of an associate can be difficult, but a team of qualified professionals can help guide you. Collaborating with a financial professional is a typical place to start, as they can work with you individually and introduce you to other professionals who specialize in working with small business owners, such as a certified public accountant (CPA), certified financial consultant (CFC), or business attorney.