Funding buy-sell obligations — how the agreement actually gets paid.

Funding is the link between the buy-sell's design and its execution. The agreement can specify a fair valuation, name the right successor, and document an elegant triggering event — but if there is no cash to complete the transaction, the agreement is a wish list. Sellers planning for exit should treat funding as the load-bearing element it is.

§ 01 · Life insurance for death triggersThe gold standard, sized correctly.

Mechanics: upon a partner's death, the policy provides immediate, typically tax-free cash to the specified beneficiary (surviving partners in Cross-Purchase, the agency in Redemption, the Trust in Trusteed Cross-Purchase). Proceeds fund the buyout.

The critical sizing rule: the policy should cover 100% of the deceased partner's ownership stake value. As the agency grows, coverage becomes outdated. The Milly standard requires reviewing coverage every 2 years minimum — annually for growing agencies. A policy purchased when the agency was worth $2M cannot fund a buyout when the agency is worth $5M.

Structural choice: Cross-Purchase (each partner owns policies on the others) provides superior tax benefits via stepped-up basis. Redemption (agency owns policies on all partners) is simpler administratively but post-Connelly creates estate-tax exposure. Trusteed Cross-Purchase captures the tax benefits without the policy-matrix chaos.

§ 02 · DBO insurance and the elimination-period trapThe most common funding-gap source.

Disability Buy-Out insurance pays a lump sum after a specified elimination period when the insured becomes totally disabled and unable to perform occupational duties.

The elimination-period alignment trap is a hidden deal-killer. The DBO policy's elimination period must match the buy-sell's disability trigger definition exactly. If the buy-sell says "disabled for 12 months of continuous disability" but the DBO policy has a 24-month waiting period, a 12-month funding gap opens. During that gap, the agency must fund the buyout from cash flow — creating immediate liquidity pressure and potentially forcing fire-sale decisions.

The Milly standard: exact elimination-period alignment is mandatory. Typical alignment is 12 months in both documents. Some agencies use 24 months in both. The numbers do not matter as much as the fact that they must match.

§ 03 · Installment notes for retirement and gap fundingThe mechanics that secure the seller.

Installment sales using promissory notes are the standard for retirement, voluntary departure, and unfunded portions of death/disability buyouts. The selling partner accepts a promissory note from the buying partners (or agency) in place of immediate cash. The agency pays the departing partner from future profits over a defined period.

Essential terms. Principal: total purchase price or gap amount. Interest Rate: must meet or exceed the IRS Applicable Federal Rate (AFR) minimum. Below-AFR rates trigger imputed-interest treatment and tax penalties. Most agencies negotiate between AFR and Prime Rate. Payment Schedule: typical 5–10 year terms with monthly or quarterly installments. Maturity Date: clear date when the final payment is due.

The critical collateral requirement: without collateral, the selling partner is an unsecured creditor. If the remaining partners run the agency into the ground, they may stop paying, and the seller has no remedy beyond slow litigation. The fix is a Stock Pledge Agreement.

§ 04 · Stock Pledge Agreement + UCC-1The collateral architecture.

The selling partner formally pledges the shares purchased back to the seller as security for the promissory note. If the buyer defaults on payments, the seller can foreclose on the pledged stock and reclaim ownership.

The UCC-1 filing is non-negotiable. A UCC-1 Financing Statement filed with the state Secretary of State perfects the security interest. Without the filing, the stock pledge may be unenforceable against third-party creditors — and a bank that lends against the same stock (with its own UCC-1) takes priority. Filing cost: $25–$75 plus modest attorney time ($200–$500 for preparation). UCC-1 filings last 5 years; before expiration, the seller must file a continuation statement.

§ 05 · The mechanisms that mostly don't workSinking funds, lines of credit, and when to use ESOPs.

Sinking funds — annual cash set-asides — are generally inefficient as a primary funding mechanism. Three problems. Opportunity cost: capital in a low-yield account earns 4–5%; deployed in agency growth, it would earn 15–25%+ EBITDA returns. Tax inefficiency: accumulated cash creates potential Accumulated Earnings Tax (AET) liability under IRC §531. Illiquidity during crisis: management often dips into the fund for operational needs, defeating the purpose. Sinking funds are appropriate only for very small agencies with limited access to insurance or credit, where owners are willing to trade growth opportunity for buyout security.

Lines of credit are not appropriate primary funding. Most bank covenants prohibit using LOC proceeds for shareholder buyouts. Lines can be revoked when financial performance weakens — precisely when a buyout is triggered. Bridge use only.

ESOPs (Employee Stock Ownership Plans) are appropriate only for agencies with 20+ employees where the tax benefits — Section 1042 rollover, potential entity-level tax exemption for S-Corps with 30%+ ESOP ownership — justify the costs. Setup $50K–$150K; annual administration $15K–$50K. ESOPs are succession tools more than funding mechanisms; they solve the internal-successor problem rather than the trigger-event funding problem.

◆