Life Insurance and Critical Illness Insurance Funding of Buy Sell Agreements
When multiple shareholders are involved in a business venture, there often is a Buy Sell Agreement put in place that lays out how a shareholder’s ownership stake is re-distributed in the event of a death or critical illness.
The reason the re-distribution of the ownership stake is so important is because the remaining shareholders don’t want to be stuck sharing control with a disinterested outside party such as the spouse, child or relative of the shareholder who has died or has suffered a critical illness.
On the other hand, a shareholder who has suffered a critical illness has the liquidity to cash out their shares so that they can spend their time recovering rather than worrying about the business. Similarly, the spouse, child or beneficiary of a shareholder who has inherited the shares due to death typically would rather have the value of the shares instead of an ownership stake in the company.
While the Buy Sell Agreement may have been put in place in good faith, the company may not have the liquidity at the time of death or critical illness to buy out the shareholder. This is the problem that is solved by Life Insurance and Critical Illness Insurance.
A typical arrangement for a Buy Sell contract would be to use Life Insurance proceeds on the death of a shareholder to buy out the shares of the shareholder’s beneficiaries. In this manner, the shareholder’s beneficiaries receive cash and the company’s remaining shareholders retain control of the company. Similarly, in the instance of a shareholder suffering a critical illness, the company would use the proceeds to buy out the shareholder. The shareholder receives funds for an early retirement and the remaining shareholders retain full control of the company. In this arrangement, the company would own the policy, pay the premiums for the policy, and would also be the beneficiary of the policy. The amount of the payout is usually determined by the Buy Sell Agreement, usually a fixed amount or the fair market value of the shareholder’s shares.