Running a business can be fraught with uncertainty. And although you can’t prepare for every eventuality, there are steps you can take to prepare for the future. Shareholder buy/sell agreements are the perfect way to ensure your business continues to run smoothly, even when the unexpected occurs.
Here’s how they work and why you should consider instituting one for your business.
What is a buy/sell agreement?
A buy/sell agreement outlines how your business will continue to operate in the event of an unexpected or worst case scenario.
Used by private companies and partnerships, they include mechanisms allowing a nominated purchaser to buy out the interest of a partner or shareholder on the occurrence of a ‘trigger event’. They can be put into place at any time and usually operate in conjunction with, or are incorporated into the company or partnership’s shareholder or partnership agreements.
You can institute a buy/sell agreement regardless of how your business is structured – eg. partnership, family trust, unit trust or proprietary company.
Why might my business need a buy/sell agreement?
A buy/sell agreement helps you plan for the unexpected. By outlining what happens after a trigger event, they:
- Ensure your ability to fund a buyout you may not otherwise be able to afford
- Keep the business out of the hands of third parties – like estate beneficiaries
- Give you and your partners and/or shareholders control in an uncertain time
What is a ‘trigger event’?
Trigger events are usually defined as the death, serious illness or total and permanent disablement of a shareholder or other key company personnel.
How does a buy/sell agreement work?
Buy/sell agreements operate alongside an insurance policy. When a trigger event occurs, the policy kicks into action, providing the remaining partners/shareholders with the funds needed to purchase the deceased/ill/disabled partner/shareholder’s share in the business.
Because they operate alongside an insurance policy, each shareholder or partner must take out a policy to cover the trigger events nominated in the buy/sell agreement. Policies can be held under any of these arrangements:
- Cross ownership – where the owners of the business hold policies on each other
- Principal ownership – where the owner holds a policy on him/herself
- Discretionary trust – where the trustee holds the policies on behalf of all the owners
- Company ownership – where the business holds the policies on behalf of all the owners
Which option is appropriate for your business depends on your company’s circumstances and how it’s structured.
The beneficiary of the policy may be one or more of the remaining partners/shareholders, or any other person appointed the right to buy out the affected person’s shares if the trigger event occurs.
What to include in your buy/sell agreement
There’s quite a lot to think about when putting a buy/sell agreement into place. Some of the most important things you need to consider are:
Which parties must take out insurance?
This is dependent on how your business has been set up. You may need to seek legal advice as to which parties should take out policies.
What will your trigger events be?
What constitutes a trigger event is defined by you and your partners/fellow shareholders. Death, serious illness and serious or permanent disablement are standard trigger events. However you may choose to include options (Put Option) that grant interested parties the right to buy out the affected person’s shares if an uninsurable trigger event occurs, such as bankruptcy, divorce or retirement.
How will the buyout occur?
Your buy/sell agreement must outline how the buyout is to occur. It must specify the buyout price or sale price of affected shares, as well as the timeframe in which sale or purchase must occur.
Your agreement must also clearly identify:
- The owner of the interest being disposed of
- The type of interest being disposed of – shares, units or partnership
- The beneficiary – i.e. who will acquire the interest
What is the value of the business, or how will the value of the business be determined?
The value of your business may be determined by one of four methods:
- Book value
- Agreed value
- Appraised value at the time of the trigger event
- Capitalisation of earnings at the time of the trigger event
Again, you may require legal advice to determine which is most suitable for your business.
Are there any tax implications to be considered – eg. capital gains tax?
Capital gains tax can have serious financial implications for your business. Guard against it by considering any possible implications and according for them in the agreement.
Regular reviews
Your buy/sell agreement should be reviewed regularly – at least once a year. This ensures the arrangements you’ve put into place (including the buyout value) are still appropriate.
Buy/sell agreement versus a will
If a shareholder or company owner dies, their share in the business may be transferred via their will or the buy/sell agreement. In the event of a conflict between the two, the buy/sell agreement takes precedence over the will.
This means the business cannot become the subject of any claims made against the estate. It also can’t be delayed by Probate or other estate administration issues.
Future planning for your business
As you can see, a buy/sell agreement helps you plan for the expected, as well as the unexpected. Ensuring your business continues to operate smoothly in times of change, it should be part of every business’s future planning strategy.
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About the Author:
Ian Macleod is the CEO of the legal publisher RP Emery and Associates. They provide cost effective legal contract kits for Individuals, SME’s and the legal fraternity.
