These agreements are usually obtained through a lawyer who specializes in corporate law. It should form part of a shareholders agreement, and the buy-sell component is used to facilitate the transition or succession of the share ownership should certain events like those listed above occur.
In a March/April column, we outlined the importance of establishing and reviewing wills for the smooth transition of a person’s individual possessions and assets and highlighted the problems with dying without a will. For business owners, the buy-sell agreement is the document needed to provide for the smooth transition of its assets, key personnel, and ownership structure.
Not having such an agreement, in the absence of a key shareholder who is instrumental to the success of the business, could place the company’s financial well-being at risk. A buy-sell agreement provides for a smooth and orderly transition of remaining shareholders and departing shareholder/equity positions and reassures company employees, suppliers, creditors, and customers.
Buy-sell agreements are not difficult to obtain, but they will require the services of an accountant or qualified business evaluator who will help to assess not only the value of the assets of the business but also the level of contribution from each individual shareholder. You will also need the services of a lawyer to structure the agreement and the services of a financial planner or insurance specialist who will provide financial solutions to implement the contents of the agreement.
Buy-sell agreements are needed for simple partnerships as well as corporately structured ownerships, but the contents of the agreement will differ depending on the type of business. For this article, we are going to focus on the issue of a death of a shareholder. The key issues are:
- The beneficiaries of a deceased shareholder may not want to become actively involved in the business nor might the remaining shareholders want the beneficiary to be their new business partner. To avoid this situation, the buy-sell agreement outlines the necessary steps to properly transfer the entitled share equity at fair market value from the beneficiaries to the remaining shareholders.
- The remaining shareholders may need a source of liquidity in order to buy out the value of the deceased’s estate, which may be tied up in the business operations or hard assets of the company. This, of course, could force liquidation of assets or a drain on the company’s operating capital and may put the business at risk of surviving.
- The sale of the business interest could trigger a taxable event, such as a capital gain or other expenses, that the deceased shareholder’s estate may incur and could place undue hardship on the surviving family members.
- With the death of a key shareholder, the business may need to replace capital that is lost from declining revenues brought on by the loss of that individual. For example, a technology company may have one or two key shareholders that possess the intellectual capital to drive a company’s entrepreneurial innovation in product advancement. Replacement costs could be high in order to hire and train a new key partner to the business not to mention the loss of existing revenue.
In order to avoid the above problems, a legally drafted and funded buy-sell agreement will be necessary. While the agreement itself lays out the legal transition of the shareholders’ equity positions, a funded agreement is most certainly critical to its success. There are several funding options available:
- Borrow the funds to buy out the deceased partner’s shares. This may or may not be possible given the current financial position of the company or the reluctance of a financial lender to agree to the loan. Banks are not always generous during times of uncertainty and the costs will be 100 cents on the dollar plus future interest costs. This may leave a business at risk to credit conditions that could hamper future growth.
- Create a sinking fund to provide liquidity when needed. This self-funding approach can work, but it ends up being a drag on current cash flow and capital gets diverted away from the growth of the business. However, this method may not work if a partner dies before full funding is achieved.
- Sell assets of the company to create the capital needed to buy out the deceased shareholder. Again, this approach can work but it will affect the viability of the company, its growth, and future operations. The costs will be 100 cents on the dollar plus selling costs and taxation. For example, suppose the business needs to sell a piece of property to fund the buy out. The business will forgo future revenues from that property and will incur taxes and selling fees upon disposition.
- Life Insurance: a properly funded buy-sell agreement using life insurance to fund the shareholder liability is not only the easiest to implement but is also the least costly. The premium costs will generally run around three to five cents on the dollar and is paid out as a tax-free benefit. The flexibility of this arrangement can be adapted to the various ways a business’s buy-sell agreement is structured for both partnerships and corporations. One drawback to this strategy is that shareholders must be medically approved to be insured.
We feel the fourth option is by far the best way to fund the agreement and can be set up to deal with other issues such as covering off realized capital gains taxes from the redemption of shares and/or the capital costs associated with the loss of the shareholder.
Steve Bokor is an insurance advisor and Ian David Clark is a certified financial planner and insurance advisor with PI Financial Services.