A buy-sell agreement allows you to buy out a co-owner of your business if they die or become permanently incapacitated.
Why have a buy-sell agreement?
The purpose of a buy-sell agreement is to ensure that you retain control over who owns your business.
The most common situation where a buy-sell agreement operates is where one owner of a business dies. Without a buy-sell agreement, the deceased owner’s interest in the business would pass to their estate. If this happened to you, you could end up in business with the beneficiaries of the deceased owner’s will (usually their immediate family).
It is surprising how frequently disputes arise in this scenario.
A buy-sell agreement would allow you to buy the deceased owner’s interest, usually at market value.
How is the sale funded?
The purchase price for a deceased owner’s shares under a buy-sell agreement is funded in three ways:
- from the continuing shareholder’s own resources (which may involve loans);
- buy-sell insurance, whose sole purpose is help fund the purchase of shares in this scenario; or
- a combination of the above.
The cost of buy-sell insurance will depend on a range of factors, including the nature and value of the business and the ages of its shareholders. (There is usually no cost to obtain a quote for this insurance.)
How do buy-sell agreements work?
Buy-sell agreements can work in various ways. They are usually structured having regard to the size (and value) of the business, the financial position of the owners, and taking into account tax considerations.
It is common for buy-sell agreements to provide for the shares to be:
- sold to the other shareholders, usually in proportion to their existing stakes (although this does not have to be the case); or
- bought back by the company.
There may be other ways to structure the arrangement, depending on your circumstances.
The agreement typically provides a mechanism for determining the sale price. Sometimes this may require an independent valuation. Other times the price may simply be expressed as a multiple of EBITDA or contain some other formula that attempts to approximate value.
For private companies, there would normally be a discount to reflect that the shares are not readily saleable (compared with shares in public companies). There would also normally be a discount for minority interests.
Sometimes payment can be made over time (with vendor finance and appropriate security put in place), and sometimes the price will be paid upfront. Again, the mechanism is usually a function of the parties involved and the availability and extent of buy-sell insurance.
Tax consequences are frequently overlooked in the context of buy-sell agreements. Care needs to be taken in relation to who pays the premiums and whether they are treated as deductible expenses. You also need to take into account the potential consequences of a payment under the policy and the impact of the shares being sold.
To ensure the arrangement is as efficient as it can be, you should speak with your tax advisor before setting up a buy-sell arrangement.
How are buy-sell agreements documented?
Sometimes buy-sell agreements are prepared as stand-alone documents. However it is equally common for them to be incorporated into the shareholders agreement.
One reason for this is to ensure consistency between the terms of the buy-sell arrangement and the exit provisions of the shareholders agreement, such as the pre-emptive rights and drag along clauses. Having the arrangements all in the same document also ensures transparency between shareholders.
Because of the various considerations that need to be taken into account (as described above) buy-sell agreements are usually prepared by commercial lawyers with the input of specialist tax advisors.