By David Richards  – Financial Advisor with Park Avenue Securities, LLC and Field Representative with The Guardian Life Insurance Company of America, New York, NY.

One of the most significant business decisions that any professional can make is to begin a business venture with a partner. Many dentists and dental specialists start up or buy into existing practices with a friend or colleague. With dreams of success and an entrepreneurial spirit, they borrow several hundred thousand dollars together and realize their dreams of business ownership.

Hard work and dedication can pay off in a big way for people willing to take the risk. Making sure proper partnership agreements have been drawn up by an attorney is an essential step in protecting each individual partner’s interests in the business. Even when business partners are best friends, written agreements are necessary.

One of the most overlooked areas of a business partnership agreement is the funding provision of the buy-sell agreement or buy-sell clause within the partnership agreement. Most attorneys who draft these agreements include the buy-sell provision, but often neglect to counsel their clients on the most important consideration: how will the partner who is buying out a deceased or disabled partner’s share of the business pay for it? This article will detail the methods used to fund Buy-Sell agreements.

A Buy-Sell agreement is a separate agreement or clause within the larger partnership agreement that details how the individual partners will deal with the death or disability of the other partner. Many buy-sell agreements also deal with retirement and lifetime sale of a partnership interest. Generally speaking, the agreements will stipulate that the surviving or non-disabled partner has the obligation or guaranteed right to purchase the deceased or disabled partner’s interest in the business. This is often referred to as a mandatory buy-out provision or a "right of first refusal." This allows the surviving or non-disabled partner to wholly own the business without the interference of the deceased partner’s estate or without the drain of a disabled and non-productive partner. A mandatory buy-out provision also assures the business interest of the disabled or deceased partner will be purchased.

There are several ways of funding a Buy-Sell agreement. These methods include personal funds of buyers, a sinking fund within the business, borrowing funds, installment payments to the disabled partner or his/her heirs, or special insurance policies.

Personal funds of buyers: Most successful business owners do not keep large sums of liquid assets on hand. They have their money working in their businesses and other investments. This method is simply not feasible for most business owners because such a significant amount of cash is not available.

Sinking fund: Such a fund will be inadequate if death or disability is premature and the time of need is uncertain. For corporations, an accumulated earnings tax problem may develop over time.

Borrowed funds: Loss of a key person (owner) may impair the credit worthiness of the business and other partners or shareholders. Interest costs may be excessive, and interest expense of shareholders or partners may not be deductible. This is by far the most expensive method for funding a Buy-Sell agreement.

Installment payments to heirs by buyer: The business may fail due to the loss of the other partner and the payments may stop as a result. As with borrowed funds, the principal and interest payments may be too burdensome.

Life and Disability Buy-out policies: A specified amount of financing is guaranteed from the beginning of the agreement with insurance coverage. This method is generally the most economical method of funding because proceeds from the policies are generally income tax-free and benefits can be purchased for a modest annual outlay. In addition, if permanent (cash-value) life coverage is used, then the cash values can also be used for a buyout due to retirement of a partner. Where the policies are owned by the partnership, the credit position of the partnership is strengthened because the cash value in the policies is an asset to the business and the proceeds of the policy can help guarantee that the business will survive.

The most common and most affordable method that business partners use to fund their buy-sell agreement is disability and life buy-out coverage. It can be the most affordable and fail-safe method. In addition to the methods for funding the buy-sell agreement listed above, there are also two different types of agreements. These include the Stock Redemption Plan and the Cross-Purchase Buy-Sell Agreement. Our next article on the subject will detail these agreements as well as discuss the advantages and disadvantages of each.

As the name of this article implies, the un-funded buy–sell agreement is a ticking time bomb. Think about it for a minute: if your business partner died or became disabled, how would you handle it? Your partner is of no economic value to your business if he or she is gone or can’t work. Yet your business partner or their estate still owns 50% of the business. Think of it from the disabled partner or his estates’ (if deceased) point of view as well. He or she or their family deserves the fair value of the business that the partner helped build if he or she dies or becomes disabled.

If you do not have a separate buy-sell agreement, the first thing we suggest you do is review your partnership agreement to make sure there are buy-sell provisions related to death and disability. If the provisions aren’t there, enter into a separate buy-sell agreement. If the agreement is there, then make sure it is funded. After all, what good is the agreement if there’s no money to back it up. Specially designed life and disability policies are the easiest and most efficient means of funding these all important agreements. Don’t wait until its too late and the bomb blows up. Defuse it now and you’ll sleep better at night knowing that should the unforeseen happen, you’re covered.