Essential Disability Buy-Out Tips for Business Succession
We've all witnessed businesses forced to sell hastily. The stories are heartbreaking, relinquishing years of hard work and dedication due to the absence of a pre-established plan.
As planners, we’re always looking to the future. Everything we do is focused on the long-term, keeping things going for generations. A significant portion of that revolves around anticipating the what-ifs — scenarios that could potentially impact your clients, whether they are individuals, families or businesses.
One aspect that often slips under the radar for businesses is the importance of disability buy-out (DBO) insurance. Business succession planning is a common topic, but too often it’s only focused on buy-sell agreements that protect a business through life insurance. However, the possibility of a partner becoming disabled is just as impactful to the success of a business.
Disability buy-out insurance helps fund the purchase of a totally disabled business owner’s interest under a buy-sell agreement.
It allows remaining owners to continue the business without:
- Using business cash flow
- Obtaining loans from financial institutions
- Selling shares of the business to get working capital
The key lies in initiating the planning process well before the unfortunate event of disability strikes. Encourage your clients to discuss these fundamental considerations about their business succession plan:
1. Understanding Business Valuation in Disability Buy-Out Planning
Do your clients know their business valuation in the context of disability?
Remember, it differs significantly from a life insurance business valuation. To get an idea of what it should be, we typically use a straightforward formula, considering all incomes from active owners, applying a multiplier of one to five based on the business type, and factoring in the book value of the business. This approach eliminates the need for goodwill or gross sales multipliers, offering a clear and practical method for disability business valuation.
2. Determining Elimination Period for Buy-Out Initiation:
Discuss the elimination period required before the disability buy-out process can commence.
While not as straightforward as valuation, it is equally crucial. Different partners may have varying perspectives on the duration of a disability. Deciding on the waiting period, or the time the disabled partner has to recover before the buy-out, in advance is pivotal for the plan's success. Typically, disability plans mandate an elimination period of at least a year, but this can be extended to 18 or 24 months.
3. Creating a Timeframe for Buy-Out:
Determine the timeframe necessary to execute and complete the disability buy-out.
If a buy-out is triggered, understanding the duration required for the business to finalize the process is vital. Additionally, consider how the partners would like the funds to be paid out. Disability plans often offer flexibility, with options including benefits a lump sum, monthly funding (available for varying durations), or a combination of both.
4. Funding Disability Buy-Out Through a Buy-Sell Agreement:
Our industry tends to use buy-out and buy-sell interchangeably, but there are a few key differences.
Specifically, a buy-sell plan is a subset of a buy-out, referring to a formal agreement among business owners or partners that details how to handle the situation if a disability occurs.
The buy-sell will include clear funding instructions, leaving no room for error in a business succession plan.
If a buy-sell isn’t necessary, discuss other methods for how to fund a disability buy-out plan for small- to medium-sized businesses.
Putting a Disability Buy-Out in Place
After you’ve talked with your client, your next conversation should be with Ash’s DI team. They can use the information you provide to determine if anything is missing or needs to be updated and then design a plan specific to your client’s situation.
Business change. So will their business succession plans. However, by encouraging foreword thinking, we increase the likelihood of a successful outcome that keeps the doors of a business open for years to come.
For more details on how to create a disability buy-out plan, check out our on-demand webinar: Protecting Business Owners with Disability Insurance.