How RISR estimates risk to equity owned
RISR measures risk to equity owned based on whether a buy-sell agreement is in place, if it is funded, and when the last time it reviewed by a professional was.
To measure this, RISR asks business owner clients two questions:
- Do you have a buy-sell agreement and funding in place?
- If so, when was it last reviewed?
The following table shows how answers to this question inform risk to equity owned.
Estimating risk to equity owned
| Risk Level | Contributing factors |
|---|---|
| High | Buy-sell agreement and funding are not in place or have not been professionally reviewed for more than 3 years. |
| Moderate | Buy-sell agreement and funding are in place and have not been reviewed for 1 to 3 years. |
| Low | Buy-sell agreement and funding are in place and have been professionally reviewed within the last year. |
This approach assumes that regular professional reviews of the buy-sell agreement and funding will help ensure they are viable and effective.
Owners need a comprehensive approach to risk management
Clients that own businesses have a unique set of risks that are important for advisors to consider and help mitigate during financial planning.
Risks that business owners and their advisors need to keep in mind:
- Wealth concentration risks. Most owners have a high concentration of wealth in the business. Advisors can work with owners to find ways to diversify their portfolio by allocating compensation from the business to savings and other investments assets.
- Business risks: The likelihood of disruptions to operations or negative impacts to revenue or profitability based on the characteristics of the business. The risk profile of the business is a key driver of the value of the business today, the potential value in the future, and the stability of the owner's income.
- Risk to equity owned: In addition to risks within the business itself, the current value of the owner's equity may be at risk in the event of death, disability, or dispute if they do not have a proper buy-sell agreement and funding mechanism in place.
The importance of a buy-sell agreement and funding
Owner's dedicate their lives to building their business. An updated buy-sell agreement and funding mechanism protects this value.
Showing clients the benefits of a buy-sell arrangement:
- Protects the value the client has built
- Protects the longevity and continuity of the business
- May open opportunities to optimize estate taxes
Show clients how buy-sell arrangements work in simple terms
Before diving into the detail of comparing buy-sell structures or discussing funding mechanisms, advisors should start by explaining the importance of buy-sell arrangements and explaining how they work in simple terms.
Buy-sell arrangements consist of the following two components.
- A legal agreement. A legally binding contract among business owners is required to govern how equity is valued and what happens to your equity in the event of death, disability, retirement, or voluntary exit.
- A funding mechanism or insurance policy. In order to be viable when triggered, buy-sell agreements must be backed by funding. Common vehicles include life insurance, disability insurance, or cash reserves.
Reviewing and updating buy-sell arrangements
Measuring risk to equity owned based on how recent the buy-sell arrangement was reviewed assumes that professional reviews will help ensure the agreement and funding are viable and effective.
These reviews should be done at least annually to confirm that:
- Valuation methodology is clearly listed in the agreement typically via an attached Schedule A
- Funding levels are reflect recent business valuation estimates
- Insurance policies cover unforeseen events