We have been talking for several weeks with Lawrence Barrett and Thomas Craft about the importance of what is known as a Buy-Sell Agreement, typically drafted when multiple partners (or interested parties) are involved in the ownership or disposition of a pharmacy business. When 1 party needs to obtain the value of their investment due to a decision to leave or an unexpected event (such as death or disability), how will that leaving partner obtain that value while the business continues to operate under the ownership of the survivor?
It’s not a simple question, and there isn’t necessarily a simple answer. However, under the guidance of those who have extensive experience, a Buy-Sell Agreement can be put together that will ensure proper funding should such a triggering event occur. I’m so thankful that folks like the Independent Pharmacy Consulting Group are available to help owners through these issues, and I’m glad to welcome Lawrence and Thomas back to share part 4 in this series.
Six Things an Independent Pharmacist Should Consider Before Preparing a Buy-Sell Agreement
In the fourth installment of our six-part series we look at the most popular methods for funding an agreement to ensure there is not cash crunch for the business or inability to provide funds to the family of a deceased shareholder in need of paying taxes or other costs.
How to Fund Your Buy-Sell Agreement
Drafting a Buy-Sell Agreement and deciding on a fair and equitable price may appear simple compared to determining how you are going to fund the potential obligation.
Attributes of an effective method to provide funds to help meet certain contingencies should be at a relatively low cost, easy to understand and administer, not adversely affect the working capital or credit position of the pharmacy, and be paid in a reasonable time period.
Any well drafted Buy-Sell Agreement should consider a number of triggering events, although the most common include death, disability, retirement and departure before retirement. This article will focus primarily on unexpected contingencies – death and disability. The probability of a death or disability occurring to at least one pharmacy owner with partners or as a sole owner is higher than most people expect. Consider two partners age 40 to 45 have a 42% chance one partner will die before the age of 65. Disability odds are even greater.
While insurance is often the funding choice of most pharmacy Buy-Sell Agreements, let’s look at other alternatives because sometimes a combination of one or more may be an alternative option.
Cash or Sinking Fund
While cash is the simplest option, it is also the least efficient. Since there is no tax deduction for the buyer, they must earn more than one dollar to net (after taxes) the dollar to use for the purchase. Another problem is holding cash with the unknown of when or, if ever, it will be needed. Using a sinking fund requires establishing how much to deposit each year, a discipline to continue making deposits and restraint in not using these funds for your pharmacy in emergency situations. Because death and disability are rarely expected or anticipated, there is usually inadequate time to build up sufficient reserves.
Borrowing has the advantage of also being simple and requiring no outlay until a contingency occurs. The bigger question is how anxious is the bank or lending institution to lend the pharmacy or pharmacy owner cash immediately after losing a key employee and pharmacy owner. If the loan is made, what will the terms be and how will the new cash flow demands for loan repayment impact pharmacy operations?
The apparent advantage of an installment sale from the buyer’s perspective is that it’s simple with a relatively small cash outflow depending on the length of the note. The departing owner’s family prefers a lump-sum payment and may not be so patient waiting for their money. In addition, the risk of forfeiture increases because they are at the mercy of the remaining owner to operate the pharmacy profitably.
A private annuity is an agreement between the pharmacy or remaining owners and the departing owner’s family that the buyer will pay a fixed amount each year for the remainder of the departing owner and his spouse’s life. This works in situations with close family relatives or loyal employees.
A problem with a private annuity is that it cannot be secured by collateral. If secured, it loses one very important advantage – the spread of gain over the lifetime to the seller.
In essence, a private annuity can only be used when the seller has extreme trust in the personal reliability and financial management capability of remaining owners. Further, interest paid by the pharmacy is not deductible.
Leveraging Other Business Assets
Referred to as a last resort, it should be just that. If there are pharmacy assets that can be mortgaged, the debt will impact the firm’s credit rating and have an impact on day-to-day operations of the pharmacy.
Life insurance is the only option that guarantees funding of the event for which the “needed benefit” is created to satisfy the obligation. Life insurance allows the deceased owner’s family to receive the fair value of the business interest in a lump-sum payment. It allows the pharmacy and/or the remaining owners to buy the shares without impacting daily cash flow, interrupting pharmacy operations, or negatively impact their credit rating.
Disability insurance is more complex and often more costly because there may be a need for
- Disability income to protect the disabled owner and his or her family with income replacement;
- Disability buyout which provides the funds to the pharmacy or remaining owners to buy-out the disabled owner’s business interest; or
- Disability overhead which provides funds to pay normal operating expenses to keep the pharmacy open for a set time period.
A downside to insurance is the requirement that upfront dollars are needed to fund the policies long before any potential payout may be needed.
In our fifth installment, we will look at what type of life insurance should be used in funding your Buy-Sell Agreement and how to determine which product is right for your situation.
Lawrence C. Barrett and Thomas H. Craft are registered representatives of Lincoln Financial Advisors Corp.
Securities offered through Lincoln Financial Advisors Corp., a broker/dealer. Member SIPC. Investment advisory services offered through Sagemark Consulting, a division of Lincoln Financial Advisors, a registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Neither Lincoln Financial Advisors nor its representatives offer legal or tax advice. You may want to consult a legal or tax advisor regarding this information as it relates to your personal circumstances. 28601 Chagrin Boulevard, Suite 300, Cleveland, OH 44122. CRN-1036498-101414
Independent Pharmacy Consulting Group, LLC is not an affiliate of Lincoln Financial Advisors Corp.