You have worked hard to build a sustainable business, but there are events outside your control, like death or disability, that can negatively impact it.
Thankfully, you can plan for these contingencies using a buy-sell agreement.
A buy-sell agreement is a practical approach for protecting the people who rely on your business, its owners and their families, employees, customers, and other stakeholders.
Generally, a buy-sell agreement involves purchasing life insurance, with each business partner getting a life insurance policy equal to their stake in the company. When a partner leaves, the remaining business partners or the business itself can use the insurance proceeds to buy out the partner’s shares and ensure business continuity.
What is a buy-sell agreement?
A buy-sell agreement is a legal document that outlines the process for the entry or exit of a company shareholder. It outlines how an owner’s interest in the company may be transferred, purchased, and sold in the event of certain predefined events. These events can include death or termination of employment with the company due to a disability or other reason.
A buy-sell agreement usually requires that if one business owner dies or wishes to give up their shares, their share can only be sold to the remaining partners. This ensures that the surviving co-owners retain full control over the business. In other words, buy sell agreements prevent beneficiaries of the deceased owner’s estate and others from buying into the business and having a say in how it's running.
A Business Example: Maverick Cleaners Co
For instance, let's say Maverick Cleaners Co has four business owners — Robert, Susan, Michael, and Debby — with each having a 25% stake in the business. If Robert dies and there is no buy-sell agreement, his share would be passed on to his estate. That would allow his heirs to have an ownership interest in Maverick Cleaners Co — something which might not go well with the other co-owners. A buy-sell agreement could prevent this by only allowing Susan, Michael, and Debby to buy Robert’s shares in the business upon his death.
A buy-sell agreement can also come in handy in other situations Suppose Robert is diagnosed with a life-changing condition and wants to relinquish his stake in the business. With a buy-sell agreement in place, Robert can easily monetize his stake in the business. The agreement not only defines the valuation method for the shares, but also the manner in which they can be sold to other co-owners.
Buy sell agreements minimize the impact of death or other unfavorable circumstances a co-owner may have on your business. It also helps avoid complicated and lengthy legal disputes by clearly spelling out the scenarios in which remaining partners can buy a co-owner’s share in the business, how the business interests will be valued, and how the buyout agreement will be funded.
Well-thought-out buy sell agreement offer the following benefits:
- Known buyers for your share in the company: You know in advance who will buy your shares in the business upon your death or termination of employment.
- The purchase price: You know beforehand how the business will be priced at fair market value, allowing you and your family to plan for the future with confidence.
- Business stability: Employees, suppliers, and customers know in advance who will lead the business following your planned or unplanned departure from the company. This knowledge will help them feel more secure and increase their likelihood of remaining with the company after your departure.
- Minimize potential disputes among shareholders: A buy-sell agreement comes into effect when all the concerned parties agree to its terms and sign the document.
- Better access to credit: Buy sell agreements ensures business continuity after a potentially disrupting event. With it in place, lenders will likely feel more comfortable about the company’s future and be more open to extending credit.
- Greater financial security at retirement: Since owners know how much money they will receive at retirement and from whom, they can plan for their life post-retirement with greater confidence.
How do buy-sell agreements work?
Buy-sell agreements define how a business will proceed if a business partner dies or leaves the company.
Typically, buy sell agreements involve the following steps:
- Step 1 – Determine the events that will trigger a buyout.
- Step 2 – Determine all the parties that have rights and purchase obligations.
- Step 3 – Declare the purchase price or define the formula or process for valuing the business.
- Step 4 – Establish how the buyout will be funded. (For example, will the agreement leverage any other life insurance policies?)
- Step 5 – Define what will happen if one or more involved parties do not use their purchase rights.
- Step 6 – Declare whether the business will be restructured after the buyout. If so, how it will be restructured.
Types of buy-sell agreements
Each company is different. There is no such thing as a one-size-fits-all buy-sell agreement. To assure business continuity in the case of a stakeholder's death, incapacity, or retirement, thoroughly assess your company's particular circumstances. Consult with a trusted buy-sell agreement broker at Dundas Life. Next, determine which sort of buy-sell agreement will best suit your requirements.
The four most common types of buy-sell agreements include:
A cross-purchase agreement allows company shareholders to buy the shares of a co-owner when a triggering event occurs. As part of the agreement, each business owner purchases a life insurance policy on the other business partner(s).
For example, Mike and Arnold co-own a bakery business, called SmoothDough. To ensure business continuity and smooth transition of ownership from the departing partner, they enter any cross purchase agreements. As a result, each buys a life insurance on the life of the other and pays the premiums out of their own pockets. The beneficiary of Mike’s policy will be Arnold and vice-versa.
The face value of any life insurance policies depend on the value of a co-owner’s stocks. For instance, if Mike’s shares are worth $10 million, Arnold will purchase a $10 million policy on his life. Upon Mike’s death, Arnold will use the life insurance payout to pay for his share of the company.
In a redemption agreement, the company itself purchases the shares when a triggering event occurs. A company will usually use life or disability insurance to help with the funding of a repurchase if a shareholder passes away or becomes disabled. The premiums are paid by the company, which is also the beneficiary. Typically only one policy is purchased per shareholder.
Continuing with the above example, instead of Mike and Arnold buying a policy on each other, their company, Smooth Dough, purchases a policy on both of them and pays the premiums. If an owner dies, retires, or becomes disabled, Smooth Dough will use the proceeds of their life insurance policy to repurchase their stocks for a preset price.
A hybrid agreement, sometimes referred to as a wait-and-see agreement, can create certain obligations and rights for both the shareholders and the company. For instance, a hybrid agreement can require cross purchase agreements obligations under certain circumstances, like the death of a stakeholder, and redemption obligation for specific events, like the retirement of most business partners.
For example, under a hybrid agreement, Mike and Arnold take out life insurance policies on each other. If one of them dies, the other will buy the deceased partner’s stocks at a pre-determined price. However, since not all disrupting events are insurable, Mike and Arnold decide to go with the redemption option for other situations. So, when either of them retires, SmoothDough will repurchase their stake in the company at a fixed price.
Entity Purchase Agreement
In an entity purchase agreement, the business purchases the shares of a stockholder when she leaves the company. The remaining business owners then rearrange their stake in the business so that they are equal partners.
Who needs a buy-sell agreement?
Any business with more than one owner benefits from having a buy-sell agreement. However, a limited corporation and a sole proprietor may also benefit from setting up an effective buy sell agreements.
The following types of business are likely to need a buy-sell agreement:
- doctor’s offices
- dental offices
- law firms
- auto mechanics
- physical therapists
- family-owned businesses
- local retailers.
What should be included in a buy-sell agreement?
A buy-sell agreement should clearly outline three things: the triggering events, the process that will be followed for valuing the business, and how the sale of ownership will be funded.
Events that usually trigger a buy-sell agreement include, but are not limited to, the following:
- the death of a shareholder
- a critical illness
- a long-term disability
- termination or resignation of the shareholder as an employee
- bankruptcy declaration
A buy-sell agreement must clearly define what constitutes a trigger event. While certain trigger events, such as death, may not require explanation, others must involve precise and specific descriptions. For example, if disability is mentioned in the contract, it must specify how total disability will be determined. Similarly, the agreement should clearly state which medical conditions will be designated critical illnesses.
If the buy-sell agreement is backed by life insurance, the various triggering events should be defined in the same way as the insurance contract.
A buy-sell agreement should define how the business will be valued. Some small business owners choose a pre-determined amount (e.g. $2 or $5 million), while others prefer using a specific formula (e.g. six times pre-tax earnings) or hire a business valuation expert. If you and your business partners agree to a pre-determined amount, do not forget to review this figure annually, since a company’s value can change over time.
A buy-sell agreement must outline how any sale of ownership will be funded. Would the company or the business owners use the insurance proceeds to buy the business interest of a deceased partner? Or would they use cash, or take out a loan to fund the buy-sell agreement? Over how many years do they want to fund the insurance policy (5 years, 10 years, or more)?
Who is the beneficiary of a buy-sell agreement?
The company itself or the surviving business partners are the beneficiaries of the life insurance policy used for funding a buy-sell agreement. Generally, when a corporation has multiple business partners, it is better to name the business as the owner and the beneficiary of the life insurance policy. When the insured passes away, the beneficiary (either the corporation or the remaining partners) uses the payout to buy the deceased partner’s shares.
Common buy-sell agreement mistakes
When implemented correctly, a buy-sell agreement paves the way for a smooth transition of ownership in the event of a owner leaving the company. Done wrong, if not implemented correctly, it could lead to major legal issues.
Here are some of the common mistakes to avoid when creating a buy-sell agreement:
Using a generic buy-sell agreement template
A generic buy-sell agreement does not work for all businesses. Unless the agreement is tailored to your business and all of its owners, it is likely to fail when needed the most. Make sure the terms of your buy-sell agreement take into account all the unique aspects of your business.
Vague or improper valuation process
Choose the valuation method that will work best for your business. Stating a fixed price in the buy-sell agreement for transferring ownership might not be the best strategy, unless the involved parties agree to review it from time to time. If the set price is too low, the selling owner or their heirs will suffer. If it is too high, the surviving business owners or the corporation will suffer.
For these reasons, getting the business appraised by an independent party at the time of ownership transfer or using a fixed formula may be a better option.
Overlooking trigger events
It is important that your buy-sell agreement cover all possible trigger events; including death, critical illness/disability, termination/retirement, divorce, and bankruptcy, among others.
Failing to fund the buy-out price
Even if your buy-sell agreement covers all possible trigger events and appropriately determines the buy-out price, it could fail if it does not make proper arrangements for funding it. Therefore, make sure the agreement clearly outlines how cash will be procured when a partner leaves the business.
When a partner passes away or leaves the company, buy sell agreements enable a straightforward transfer of ownership. Typically, life insurance is used as a funding mechanism in these arrangements. Speak with a Dundas Life specialist if you wish to set up such an agreement and fund it with a life insurance policy. We can assist you in obtaining the appropriate level of insurance coverage to protect your company from serious financial and legal problems.