What is a Buy Sell Agreement?
A Buy Sell Agreement is a contract that allows transfer of a business to the remaining owners, if one owner is unable to stay in the business.
The need for a transfer may be due to unforeseen factors such as death or permanent illness or disability. The agreement is usually coupled with insurance policies to provide the funding to buy out the departing owner’s equity interests.
The agreement can allow the remaining owner(s) to continue the business and provide an exit compensation to the departing owner, or their estate, for their ownership.
There are many options for policy ownership that include via the individual or business or a separate structure. Seek advice to the best structure for your situation.
What should a buy sell agreement include?
A Buy Sell Agreement should include the requirement of the individual owners or the business to take out and maintain life, trauma and/or permanent disability insurance.
The agreement should also stipulate how the insurance premiums are to be paid.
Why is it Important?
There are a number of reasons why it is important to be prepared. Scenarios from our experience include:
- The remaining owners having to sell part of the business to pay out the exiting owner's interests.
- A departing owner’s spouse becoming an active partner in the ongoing operation of the business, where they do not have the optimal skills to do so.
- The departing owner’s interests retaining a right to claim a share of the business profits, without having to make any material contribution to the business.
Case Study - A true story to avoid
Nick, Tom, David and Karen are co-directors of a real estate sales and property management business. It has 45 staff and an annual turnover of $12 million.
The four directors are unconvinced of the benefits of personal insurance to protect their equity in the business. They have a handshake agreement in place and believe that the business can draw on its capital should the requirement to ‘buy out’ one another arises in the future.
And then:
Nick unexpectedly passes away. Nick’s family trust owns his shares in the business, which is now represented by his wife Jenny.
Jenny decides that she wants to sell the shares. The remaining three directors offer to pay $2 million for Nick’s shares. Jenny requests an independent valuation and it reveals that the shares are worth $3 million.
The remaining directors cannot fund the purchase. Twelve months on, Jenny and the three remaining directors are still gridlocked without a satisfactory resolution. Business growth planning is disrupted as are attempts to gain additional commercial financing.
The learning:
Directors need supporting insurance policies to fund the exchange in shares in a business, as its true value is often underestimated.
An agreement could have provided for a transfer of Nick’s ownership interest to the remaining directors, while ensuring Jenny received adequate consideration for relinquishing the equity she inherited from Nick.
We have a team of advisers in insurance, legal and financial experience to guide you in these matters. Please contact us to learn more.