Hey Partner, we need a Buy-Sell Agreement

If you have business partners, you need to consider what will occur when a partner wants to retire or suffers death or disability. One way to minimise the chaos, and control the order of events, is to design and execute a Buy-Sell Agreement.

Life happens and business owners are not immune to that. If you are a business owner, you will probably experience one of the ‘Seven Ds‘ during your time at the helm: Death, Disability, Divorce, Default, Departure, Disagreement and Deadlock.

So how do you navigate running the business, maintaining harmony among your employees and keeping a cool head, whilst one of the ‘Seven Ds’ is rearing its ugly head?

Read on to find out how you can give your business security and certainty in these otherwise turbulent times.

What’s the point of a Buy-Sell Agreement?

A buy-sell agreement is a contract between two or more business partners that governs how their valuable interests in the business will be dealt with in a range of foreseeable scenarios.

Having a buy-sell agreement in place will help you:

  • Preserve control by restricting transfers or sales of company shares to persons outside the company or owner’s immediate family.
  • Protect business assets and ongoing operations.
  • Provide cash or other assets (e.g., life insurance proceeds or promissory notes) to the retiring or disabled owner or family of the deceased.
  • Establish a method for determining the value of the business for estate tax purposes and transfer or sale of company shares.
  • Assure sufficient liquid assets are available to fund a buyout, pay taxes, and meet financial needs of surviving family members.
  • Reduce some of the risks inherent in grants of incentive equity awards to key employees.

When one of the ‘Seven Ds’ events occurs, often one business owner will want to take ownership and control of the business, and the other owner (or their family) will want funds to maintain their lifestyle. A lot of questions then arise, primarily: At what price can one owner buy-out the other owner? How will the buy-out be funded?

A buy-sell agreement provides a clear and fair way forward because you and your business partners will have already sat down and arrived at answers to these key questions. Trust us – when you are dealing with the loss of a key person in your business, the last thing you want to be doing is scrambling around for urgent advice about how to manage their exit, whilst simultaneously trying to keep the doors open and the lights on.

If you want help putting in place a Buy-Sell Agreement for your business, call us on 1300 654 590. 

Structuring a Buy-Sell Agreement

A buy-sell agreement can protect business value, reduce the likelihood and severity of shareholder disputes and provide for continuation of the business beyond its current ownership. A buy-sell agreement can also be designed to provide income to the retiring or disabled partner or to the family of a deceased partner.

Initial questions that need to be considered are:

  • Should the buy-sell be cross-purchase or share redemption? In a cross-purchase, share buyouts are affected by one or more partners buying the shares of another. In a share redemption, the company does the purchasing.
  • Should the buy-sell be funded with proceeds from life insurance on each owner’s life, and what cautions should the surviving owners take to assure payment?
  • How will the business, or partial ownership interests in the business, be valued under the buy-sell agreement and will it conform to Tax Office valuation guidelines?
  • Is the valuation method dynamic so that the valuation of the business changes as the business changes?
  • Will changes in the business value trigger adjustments to mechanisms that will provide buyout funds?
  • If insurance is the financing vehicle, should the premiums be paid by the company or the individuals?
  • How can you structure the insurance policies to reduce or eliminate taxes?

If you are not sure how to answer these questions, call us for straightforward and honest advice on 1300 654 590. 

Buy-Sell Agreement Checklist

These are the major items to include in a buy-sell agreement:

  • Names of individuals, number of shares (ownership percentage), purchase price, and the corporate or partnership entity involved in the buy-sell arrangement.
  • When the agreement will become effective: death, termination of employment, retirement or disability.
  • Method of share purchase: share redemption, cross-purchase, combination of both, or survivor’s option plan, where the decision is not made until death or retirement of the owner.
  • Buy-sell value (price) and method for updating the value over time, preferably every year or two. Keep in mind that the value of many closely held businesses can increase (or decrease) substantially from year to year.
  • How the owner(s) will be paid for the shares: life insurance proceeds, promissory notes, other owners’ personal assets, company cash or a combination.
  • Circumstances in which the ownership position (i.e, actual shares of equity) can be hypothecated or otherwise encumbered for loans or other purposes.
  • Whether the buy-sell is a legal obligation or only an option to buy or sell.
  • Conditions in which the buy-sell is to be amended or terminated, whether by written approval of all parties or just a majority of shareholders or shares outstanding.
  • State law governing the agreement and any alternative dispute resolution provisions.
  • “First-offer” or “right of first refusal” clause stating that before a shareholder can sell their shares, they must first be offered to the corporation and/or other members.
  • Clause binding future owners to the buy-sell agreement (i.e. covering options issued to key executives and other employees).
  • Provision for an independent trustee if the purchase price of shares is substantial and funded by life insurance. Recommendation: Use a law firm or financial institution to make sure insurance proceeds are disbursed directly to your designated heirs/beneficiaries.

And those are just the main points! If you are feeling overwhelmed, don’t fret. We’ve successfully helped many businesses put in place a Buy-Sell Agreement that works for them and their circumstances. We can explain the jargon and help you confidently move forward. To get started, call us on 1300 654 590. 

Valuation Methods to Use in Buy-Sell Agreements

Be aware that the Tax Office can challenge the price at which an interest in your business changes hands. This occurs most often when no documentation exists to support the business’ value and price per share prior to the trigger event. Documentation is particularly important if the buy-out is substantial. You can support your valuation and buy-sell price by using one or more of the following accepted valuation methods:

  • Book Value: Simply the company’s total assets less total liabilities as presented on your financial statements. Tangible net book value also could be used. It excludes all intangible assets such as capitalised financing costs and goodwill.
  • Adjusted Book Value: Amends the company’s book value to reflect any difference between book value and fair market value of certain assets and liabilities. For example, book value of depreciable assets such as buildings or equipment are often understated. The adjusted book value method usually renders a value higher than reported book value.
  • Replacement Cost: Adjustment of all assets to their replacement value and then subtraction of all liabilities. Usually leads to a valuation that exceeds that of book value and adjusted book value.
  • Price-Earnings Multiple (P/E): Value of the business is determined by applying a multiple to earnings of the business. The multiple, and how to apply it, is described in the buy-sell agreement. Important elements should be stipulated, such as type of earnings (pretax, after-tax, EBIT, EBITDA); earnings period (most recent 12 months, most recent fiscal year, average of the past four fiscal years); how debt of the business will factor into the valuation; and what to do if earnings are zero, near zero or negative. Earnings-based methods typically yield valuations far greater than balance sheet methods during periods of high profits. The reverse is true, of course, during periods of low or no earnings.

Your accountant can help you design and apply your valuation method. You might also use two or three of the methods and take the highest average or weighted average. We can work with your accountant to help you determine the most suitable valuation method to use for your business. To get started, give us a call on 1300 654 590. 

Financing the Buy-Out of Your Stock

Establishing the procedure by which stock is bought and sold on the departure or death of a shareholder is the first step in protecting your company. Providing money to carry out the procedure is the second.

You can’t assume that surviving owners will have enough personal liquidity to finance the purchase on their own or that they will be eligible to borrow the required amount. The price tag on shares in a profitable, growing company can be substantial. Nor can you assume the company will have sufficient liquidity or access to capital to fund the purchase on its own. You might want to consider another approach for providing the needed money.

Some key issues you should consider here are:

  • Life insurance. Life insurance on the life of each owner can supply all or part of the needed cash. In the case of a share redemption plan, the company buys the insurance and names itself beneficiary. A self-owned or cross-purchase agreement could incorporate life insurance by each shareholder. Any insurance payout is then used to purchase the deceased owner’s interest.
  • How much insurance? Shares to be covered by insurance on each owner’s life represent a certain percentage of the company’s value at the time the insurance purchase is made. For example, if each of four shareholders owns 25 percent of a company valued at $1.2 million, then $300,000 in life insurance must be purchased on each owner’s life. To reflect future increases in the value of the company, the dollar amount needed to purchase the shares should be adjusted periodically along with the amount of life insurance relied on to finance the purchase.
  • Joint life or first death. Another possibility, where several owners have roughly equal shares of the company, is joint life or first death insurance. The policy covers all of the owners but pays the life insurance proceeds when any one of the parties dies. The insurance proceeds can be paid to the company or to the others in the group, depending on how the agreement was set up. Of course, if this type of insurance is used, it will be necessary to work out a new arrangement and take out a new policy after the death of any one of the owners.
  • Covering a shortfall. If life insurance is used, consider including a provision that addresses how a shortfall will be bridged. For example, if the policy pays $200,000 but the buyout is $300,000, should the surviving partner be allowed to pay off the shortfall over a period of years? Will an interest rate apply?

Not sure where to start? Give us a call on 1300 654 590. We can guide you through these issues and get you moving forward with confidence.

Buy-Sell Taxation

If a buy-sell agreement is funded with insurance, it is critical it be structured in a way that minimises taxes. Generally, life insurance premiums are not tax deductible and life insurance proceeds are not taxable income when received by the beneficiary.

If the company is the owner and beneficiary of the life insurance policy underlying a share redemption plan, there is usually no taxation. It’s straightforward — the premiums are not tax deductible by the company, so the proceeds received are not taxed. This position will change, depending on how the life insurance policy is owned.

Aside from the ‘Seven Ds’ above, the other thing you can’t avoid as a business owner is tax.  We can provide you with straightforward advice about how to structure your Buy-Sell Agreement in a tax-effective manner. Let us help. Call us on 1300 654 590. 

Additional Considerations

If we haven’t already overloaded you with good reasons to get a Buy-Sell Agreement in place, here are some additional things you should consider:

  • You should take other precautions to assure the buy-sell agreement’s validity and effectiveness. These ideas apply to both existing and new buy-sell agreements.
  • Each share certificate subject to a buy-sell agreement should have a written legend stating such on the face of the certificate. Example: “These shares are subject to a buy-sell agreement dated ______________.”
  • If the company is to purchase shares, you will have to provide for it in the corporate minutes and possibly obtain approval, in advance, from any minority shareholders. You should obtain advice about the company’s governance documents to clarify what approval (if any) is required.
  • The signed buy-sell agreement must be bona fide (meaning it was entered into in good faith and effected on an arm’s-length basis), particularly when transacting with family members. For example, you can’t set a low value on a small portion of your company shares and expect the value to apply to the remaining holdings for tax purposes.
  • The buy-sell price per share must be reasonable and legally binding. It cannot be a device to transfer ownership to family members at less than its full fair market value.
  • Include provisions that will aid if an active partner becomes disabled.
  • You might want to consider building in an instalment sale provision. Keep in mind, though, that delaying payments could increase risk of non-payment.
  • In crafting an effective buy-sell agreement, consider also seeking advice from a mergers and acquisition expert and/or business valuation expert.

We’d be lying if we said there wasn’t a lot to think about when it comes to Buy-Sell Agreements. In our experience, if you do the hard work up-front and get the documentation in place, your efforts will pay dividends when an inevitable life event happens to one of your business partners.

Don’t put it off any longer. Let us help. Call us on 1300 654 590. We will guide you through the process so you can move forward with confidence.

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If we sound like people you can work with, call us now on 1300 654 590 and speak directly with a great lawyer.

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