If you run a small business in partnership with others, often you and the other owners are a key asset of the business. Are you prepared if one of the other owners suddenly dies or has to retire due to illness or an accident? How will you ensure that they or their family are paid out for their interest in the business without causing financial hardship to you and the remaining owners? This article explains how a Buy/Sell Agreement can help.
A Buy/Sell Agreement is an agreement between the owners of a business as to what will happen to the shares or partnership interest of one of the owners if they die, have a terminal or critical illness, or become totally and permanently disabled. It requires the remaining owners to buy the former owner’s shares or partnership interest at a price set in advance or through a formula. The purchase price for the shares or partnership interest is likely to be met by the proceeds of an insurance policy taken out to cover the risk of death, illness or disability.
Why do this?
Buy/Sell Agreements are intended mainly for companies with a small number of owners who are both directors and shareholders. They can also be used for partnerships. In these situations the death, illness or disablement of a director or partner are major events for the business.
If one of the above events occurs to one of your colleagues, having a Buy/Sell Agreement and the necessary insurance policies in place will be reassuring for you and the other business owners. It will enable you to concentrate on dealing with the impact on your business of the absence of your former colleague without having to worry about how you are to buy their share of the business or prevent a third party from buying those shares. It will also provide comfort to your former colleague’s family to know that they will receive money for their shareholding or partnership interest relatively quickly without having to search for a buyer.
You should consider how you or your family would cope with the loss of income from your business and not knowing when or if your interest in the business will be paid out.
What about the constitution or shareholders’ agreement?
Most company constitutions state that if you wish to sell your shares you must first offer them to the other shareholders before selling them to a third party. Sometimes, a formula will be set for determining a fair value for those shares. However, these pre-emptive rights provisions won’t be sufficient to ensure that a business owner, or their family, is paid out if the business owner exits involuntarily. The other owners may be unwilling, or unable, to buy the shares and it may not be possible or desirable for the shares to be sold to a third party.
If the owners of your company aren’t within the same family you should have a shareholders’ agreement in place. A well-drafted shareholders’ agreement should provide for situations where the owners are in a deadlock situation or one owner wishes to leave the company voluntarily. However, even if you have a shareholders’ agreement, it may not provide for situations where the event causing an owner to leave the company is insurable with the purchase price paid through insurance, so a Buy/Sell Agreement will still be necessary.
Putting an Agreement in place
There are three main actions you need to take:
First, you and the other owners should arrange to see one of our lawyers. Each business situation is different and we’ll need to discuss how best to tailor a Buy/Sell Agreement to your situation.
Second, you and the other owners will need to agree upon a share price or a formula for determining the value of the shares in the event that one of you needs to be paid out. There are several ways to do this; your accountant can help you to decide the best option. The share price should be reviewed annually.
Third, you and the other owners will need to put in place insurance policies to cover the risk of an event which prevents any of you from being able to work in the business. An insurance broker can help to ensure the policies suit your situation and that the insured amount will be sufficient to meet the agreed share purchase price. The insurance policies should be held by an independent trustee on behalf of you all, but the premiums will be payable by the owners. Usually the premiums are pooled and the cost is shared equally between the business owners, but sometimes it may be appropriate to divide the cost unequally if the premium for one owner is significantly more due to their age or pre-existing health conditions. You should review these policies annually to ensure that the cover is still sufficient.
How does the Agreement work?
A Buy/Sell Agreement will impose obligations on you and the other owners to pay your share of the insurance premiums when due. It will also require you to disclose any information which may affect the insurance to the insurer.
If an insured event occurs, the independent trustee will make a claim under the relevant insurance policy and will hold the proceeds on trust until the settlement date. The Buy/Sell Agreement will stipulate when settlement must occur. The settlement date will need to be close enough to the insured event to ensure that the former business owner or their family receives prompt payment but should also allow enough time for the proceeds to be received, any top-up amount collected, and dividends paid out if the change of ownership is likely to affect imputation credits.
On the settlement date the former owner, or the executor and trustee under their Will, must sell their shares to the remaining owners at the price set in the Buy/Sell Agreement; the independent trustee will pay to them that part of the insurance proceeds which is required to meet the purchase price less any amount owed by the former owner on their business current account. If the insurance proceeds exceed the purchase price then the surplus will be used to repay the former owner’s current account and usually any balance will belong to the remaining owners. If the insurance proceeds are not enough to cover the purchase price then the remaining owners will need to pay the balance. The Buy/Sell Agreement may allow for the balance to be paid in instalments over a period of time and potentially be subject to interest. The former owner’s current account will also need to be paid out.
What if the ownership changes?
If the ownership of your business changes before the buy/sell is triggered you’ll usually need to enter into a new Buy/Sell Agreement. The Agreement will generally require that if an owner sells their shares to a third party, the person buying the shares must enter into a Buy/Sell Agreement with the other owners of the business in a similar form.
If you think that your company or partnership needs a Buy/Sell Agreement we can give you advice on this and help you put one in place. We recommend that you don’t delay as you never know when the unexpected may happen to your business.
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Copyright, NZ LAW Limited. Editor: Adrienne Olsen. E-mail: email@example.com. Ph: 029 286 3650.