Most business owners think about funding a buy/sell agreement with life insurance. This would protect all parties involved with a smooth, funded transfer of business interests in the event of an untimely death of one of the owners. However, many businesses fail to address a more likely scenario - the disability of one of the principals and how to fund the transfer of ownership.
There are many business and financial considerations that need to be addressed upon the disability of a principal. Since that person is still alive and not eligible to begin collecting retirement funds, he certainly would need some money to live on. He has an equity interest in the business and would need access to that. A disabled individual that can no longer contribute to the business can be quite a burden on the remaining partners. Both parties need to affect a transfer of ownership whereby the disabled individual can receive compensation for his equity interest and remaining owners would have full control of ownership rights.
Disability buy-out insurance is designed specifically to provide the company's owners with the money they would need to reimburse a disabled owner for his or her financial interest in the company. This money is, of course, available over and above any replacement income the owner or partner is receiving under a traditional disability income insurance contract.
Disability Buy-Out Options
The Do-Nothing Approach - Highly Risky
A long-term disability doesn't necessarily lead to death. A disabled person could live for many years. Without a business continuation plan funded by disability insurance, he may find it difficult to receive compensation for his ownership interest. Remaining partners would be burdened with paying or sharing profits with a non-participating partner.
Readjustment of Ownership Rights
The disabled owner's position is modified-usually to limited partner status-or issued preferred or non-voting stock. This gives the disabled party a fixed return on any initial investment, but does not allow access to that capital.
Mandatory Purchase - A Better Way
This alternative calls for the firm (entity purchase) or the other owners (cross purchase) to purchase the entire interest of the disabled owner for a price agreed upon in advance-and Funded by the company's Disability Buy-Out insurance. Ownership is then transferred at once, with the money paid either in a lump sum, in installments or a combination of these two methods.