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Top 10 things to know about buy-sell agreements

Every small company or partnership should have a buy-sell agreement. This is a document that sets out what will happen to the business if there’s a specific event – like the death or illness of one of the shareholders or partners – or if one of the business owners wants to sell their share.

Think of a buy-sell agreement like a will for your business. There are many things that can go wrong if something unexpected happens, which is why it’s a good idea to put down on paper what your intentions are. A buy-sell agreement will allow for any of the owners to force a sale, which is why it’s called a buy-sell agreement. In this article, we outline 10 things that you should know from a legal perspective about buy-sell agreements.

1. Even sole proprietors need a buy-sell agreement

If you’re the only shareholder in your business, it may still make sense to put a buy-sell agreement in place to make sure your wishes are carried out. Perhaps there’s an employee that you’re grooming to take over the business for you, a buy-sell agreement will outline how they can purchase the business from your heirs for a fair price when you’re no longer around – saving both your employee and your family unnecessary headaches.

2. It doesn’t need to be a separate agreement

A buy-sell agreement doesn’t need to be a separate document. You can include your intentions in your company’s shareholder agreement or in your partnership agreement. But don’t assume that they’re already in the document. If you already have these documents in place, it may make sense to create a new buy-sell agreement that lays out your specific intentions or amend the existing agreement.

3. Make sure your buy-sell agreement covers a wide range of events

You never know what’s going to happen in the future, so it’s a good idea to cover as many events as possible in your buy-sell agreement. Death and total permanent disability (TPD) are two of the most common events to cover, but it’s also worth extending that to critical or long-term illness. If you become ill, your business partners may not appreciate your family getting involved in the business.

Other life events like retirement, divorce or even a major disagreement between the owners can also potentially impact your business and each owner’s decisions. Another important but often overlooked situation is bankruptcy. If one of the business owners becomes bankrupt it may have significant implications for them personally and for the business legally, particularly if they’re a director. So it’s a good idea to keep everyone’s options open.

4. The sale will need to be paid for

It’s important to make sure that the buy-sell agreement outlines how the purchase will be funded. This usually involves taking out an insurance policy that covers the specific events outlined in the agreement. For example, if the agreement covers one of the business owners dying, then the agreement can also require the business owners to take out an insurance policy to cover their respective part of the business. If one owner passes away, then the insurance payout will cover the other owner’s cost to purchase the deceased owner’s share of the business.

If you don’t have an insurance policy in place or the event wasn’t able to be insured for (like if one of the shareholders breaches the shareholder or employment agreement or it’s a voluntary exit), the sale can also be purchased with cash or by taking out a loan. The agreement can take this situation into account and perhaps even outline appropriate payment terms that allow enough time to pay for the shares.

5. There’s more than one way to value a business

The value of your business will change over time, so it’s important that this is reflected in the buy-sell agreement. It’s common for an agreement to value the company at the time the specific event happens. If this is the case, then it may also be worth outlining in the agreement how the value will be calculated at that time – book value, agreed value or independent valuation, for example. This will help avoid any disputes about what the value of the business is.

6. There may be a difference between the funding and the valuation

If you have an insurance policy in place, there may be a difference between the amount the policy pays out and the amount to be paid for the owner’s share in the business. The buy-sell agreement can outline what happens in this situation, particularly if the amount of the insurance payout is less than the value of the shares. This will help avoid any potential conflict or financial stress in the future.  

7. The business structure can affect the arrangement

For many reasons, the owners may hold their interest in the business through different legal entities like a family trust or another company. It’s important that the buy-sell agreement is able to operate as intended regardless of how the business ownership is structured.

To make sure this happens, it’s also important for the agreement to outline exactly how the business will be bought or sold and who specifically can purchase it. This is particularly important if the event that triggers the agreement is the death of one of the owners as the agreement should be clear enough to override any will that the deceased owner had.

8. Everybody will need tax advice

When putting together a buy-sell agreement it’s important that the company and each owner gets tax advice of their own as well. This is because the agreement could trigger both corporate and personal tax obligations depending on each individual’s personal circumstances.

If insurance policies are also put in place, each individual and the business will need to get advice about whether the premium will be deductible to them for tax purposes. This advice can then be used to help each individual and the company get the best outcome from the agreement.

9. There are different ways to transfer the interest

The buy-sell agreement should outline how the interest in the departing owner’s shares are to be transferred. There are generally two different ways to do this – a cross-sell purchase or a buyback. A cross-sell purchase means that the other owners of the business buy the departing owners share of the business – this increases their shareholding in the business. A corporate buyback means that the company buys back the departing owners share in the business or pays for the value of the shares and then cancels them.

10. Every business really is different

There are many template buy-sell agreements available that you could potentially use. While they’re useful, it’s worth remembering that every business is different and a template is unlikely to cover your unique situation exactly. That’s why we recommend you seek legal and/or accounting clarification to make the best decisions for your company and yourself personally.

If you’re considering buying or selling a business get in touch with CCASA to make sure you protect your assets and remain compliant.