When a business with several partners experiences the loss of one, determining the distribution of the deceased partner’s shares can be challenging. This is where a “buy-sell agreement” comes into play, serving as a critical tool for business owners to ensure the smooth transition of ownership and management in unforeseen circumstances. This article delves into the essence of buy-sell agreements, their workings, their significance in the business landscape, and how getting life insurance benefits them.
Canadian Small Business Landscape
As of January 2024, Canada has 1.3 million businesses with employees. However, in the next ten years, more than $2 trillion in business assets might be transferred as over three-quarters (76%) of small business owners intend to exit their businesses. The primary reason for leaving, cited by 75% of these owners, is retirement, followed by 22% feeling burned out and 21% desiring to reduce their ownership responsibilities. However, only 9% of business owners have established a formal business succession plan. Business owners might want to think about a buy-sell agreement, also referred to as a buyout agreement, as a viable option.
What is a Buy-sell Agreement?
Buy-sell agreement is a legally binding contract between business partners or shareholders. It outlines the procedure for the transfer of business ownership in the event of a partner’s death, disability, retirement, or other triggering events. Essentially, it’s a contingency plan that safeguards the business’s continuity and the interests of its stakeholders.
Do I Need a Buy-sell Agreement?
Buy-sell agreements benefit businesses with multiple owners, including limited corporations and sole proprietors. They are particularly beneficial for:
- Medical and dental offices
- Law firms
- Auto repair shops
- Physical therapy centers
- Family businesses
- Landscaping companies
- Local retail stores
The Key Elements of Buy-sell Agreements
The operation of a buy-sell agreement is straightforward yet intricate. It involves several key steps:
- Triggering Events: The agreement specifies certain events that trigger the buyout process. Buy-sell agreements typically contain precise definitions of triggering events, but while death is self-explanatory, critical illness or disability triggers require detailed and verifiable criteria aligned with insurance policy definitions. These events can include:
- Shareholder’s death
- Long-term disability
- Critical illness diagnosis
- Business retirement
- Marital dissolution
- Shareholder’s resignation or employment termination
- Filing for bankruptcy
- The decision to leave the business
- Valuation: It outlines how the business will be valued during the buyout. This could be a pre-agreed amount, a formula-based approach, or an independent valuation.
- Funding: The agreement details how the buyout will be financed. Coverages like life insurance, critical illness insurance, and disability insurance fund the buyout, providing the necessary financial resources to facilitate the agreement’s transactions without straining the business’s finances.
How Do Buy-sell Agreements Work?
Buy-sell agreements typically involve these steps:
- Identifying Trigger Events: Determining what events will initiate a buyout.
- Rights and Obligations: Establishing all parties’ rights and purchase obligations.
- Valuation: Setting the purchase price or defining a valuation method for the business.
- Funding the Buyout: Deciding how the buyout will be financed, such as using life insurance policies.
- Insurance Purchase: Every owner secures a policy matching the value of their share in the business. While not essential, an insurance policy in a buy-sell agreement enables partners or the corporation to buy shares without personal funds. This is particularly useful if the business’s high valuation makes it difficult for survivors to afford shares without loans or affecting cash flow. The insurance payout helps cover the cost of shares in case of an owner’s death or exit.
- Non-exercise of Purchase Rights: Outlining actions if parties don’t exercise their purchase rights.
- Post-Buyout Restructuring: Detailing any business restructuring following the buyout.
Types of Buy-sell Agreements
A one-size-fits-all approach doesn’t work for buy-sell agreements. To ensure your business remains stable in events like a stakeholder’s death, carefully evaluate your situation and choose the type of buy-sell agreement that best fits your needs. There are four main types to consider:
- Cross-Purchase Agreement: Each business owner buys a life insurance policy for the other partners. In the event of a partner’s death, the surviving owners use the insurance payout to buy the deceased partner’s share.
- Redemption Agreement: The business entity purchases each partner’s life insurance policies. Upon a partner’s death, the business uses the policy’s proceeds to buy the deceased’s share.
- Hybrid Agreement: This combines elements of both cross-purchase and redemption agreements, offering flexibility based on the specific event that triggers the buyout.
- Entity Purchase Agreement: The company acquires a departing stockholder’s shares in an entity purchase agreement. Subsequently, the remaining owners adjust their shares to maintain equal partnership in the business.
Who Is The Beneficiary of a Buy-sell Agreement?
In a buy-sell agreement, the life insurance policy’s beneficiaries, who can be revocable or irrevocable, are the company or the surviving partners. The business is often the policy’s owner and beneficiary for multi-partner corporations. Upon one of the partner’s death, the insurance payout is used to buy the deceased partner’s shares.
Benefits of a Buy-sell Agreement
- Stability and Continuity: It ensures clarity for employees, suppliers, and customers on leadership succession, enhancing stability and providing a clear succession plan.
- Financial Security: Offers financial security to the departing shareholder or their family.
- Prevents Disputes: Minimizes potential disputes among shareholders or family members.
- Pre-identified Share Buyers: Assurance who will purchase your shares upon death or job termination.
- Predetermined Purchase Price: Advance knowledge of fair market valuation for future financial planning.
- Enhanced Credit Access: Lenders’ confidence in business continuity post-disruption.
- Secured Retirement Finances: Owners can confidently plan post-retirement life with known retirement payouts.
Common Mistakes in Buy-sell Agreements:
- Generic Templates: Avoid using one-size-fits-all templates. Tailor the agreement to fit the unique aspects of your business and its owners.
- Inadequate Valuation Process: Select a valuation method suitable for your business. Regularly review set prices to ensure fairness for both selling and remaining owners.
- Neglecting Funding for Buyout: Properly plan for funding the buyout. The agreement should clearly state how funds will be sourced when a partner exits the business.
- Not Using a Lawyer’s Services: Only 24% of business owners collaborate with lawyers for succession planning, whereas approximately 39% depend entirely on their own efforts to create a succession plan. Working with a lawyer ensures an effective buy-sell agreement that executes the way everyone intends.
The Bottom Line
A buy-sell agreement is an indispensable tool for any business with multiple owners. It provides a roadmap for handling unexpected events and ensures the company’s and its stakeholders’ stability and financial security. By understanding its workings and importance, business owners can make informed decisions to protect their life’s work and legacy.