Shareholders Agreements - The Buy/Sell Clause & What You Need To Know

What are Shareholder Agreements?

“Things are good until they’re not” -David James

Shareholder agreements are the “prenup” of the business world. They are set up as a contingency plan that describes the rights of each partner in the event of a breakdown. Each party has an interest in protecting the business in case of things going bad. But, what kind of things could go wrong?

Generally, the most common issue that is covered by a Shareholder Agreement is a buy/sell clause that describes what would happen in the event of one of the partners death or disability. In that agreement the actions or method of repurchasing the shares of the deceased or disabled party is described.

Well-drafted shareholder agreements will also include other provisions such as a shotgun clause where the business partners are no longer able to work together – this gives the partners a predetermined option to either exit themselves or exit the other partner from the business.

Other provisions can include (but are not limited to) what happens in the event of professional misconduct, a divorce, incarceration, as well as a way to wind-up the business or for a need to restructure.

How do buy/sell agreements work?

In the event a partner dies or becomes unable to work in the business due to disability, there are several issues that arise including control of the company. Additionally, these parties are also entitled to their portion of the fair market value of the business.

With these types of events, there are several questions to consider: In the event of a death, does the family even want to be part of the business? Alternatively, does the surviving business partner want to work with the family members or person who inherits the shares? What if a partner becomes disabled, how will the company or other shareholders buyback the outstanding shares?

The advantage of a buy/sell agreement is that it allows for a smooth handover of the business interest, avoiding disputes over the value of the business, providing a clear dollar value and price, a payment schedule, the calculation formula or method used (done by third-party as needed), the source of funds and clear definition of the manner in which the purchase will be financed to purchase the deceased partner’s interest and any other terms.

Where financial contracts such as life and disability insurance are to be utilized, the requirement to purchase these contracts and a reference to contract numbers or similar information should be included in the agreement. This serves to ensure that the proper funding is actually put into place and not forgotten about after the Shareholder Agreement is created. Most importantly, with a legally defined, contractual exit strategy in place, it avoids conflicts and litigation in the future which could jeopardize the financial well-being of the departing shareholder and/or their family and even the financial health and viability of the business itself.

By having a legal agreement in place, the likelihood of a confrontation between the departing partner and remaining shareholders or their spouses or families will be minimized. Where appropriate funds have been set aside in the agreement, it creates a degree of liquid cash for what would normally be illiquid shares of a private corporation. Consequently, employees, customers, suppliers, and creditors will be reassured about the continuity and financial health of the business and the remaining shareholders after the buyout.

An overview below shows how a buy/sell process works without life insurance and with a life insurance policy:

Why is life and disability insurance a preferred way to fund a buy/sell agreement?

When the buy/sell agreement is funded through life and disability insurance, upon the execution of the legal agreement, each partner has a life and disability insurance policy equal to the value of their ownership interest taken out.

Utilizing an insurance contract to fund the buyout has multiple benefits. On the life side, first and foremost, for the family of the deceased owner it provides immediate liquidity for the buyout when it is needed and assures a prompt payment. This also allows a guaranteed fair and definite price as well as a guaranteed buyer for their interest. It also ensures that they, or an executor, do not have to step in and become involved to protect their interest and frees the deceased owner’s family from the risk of future business losses.

For the surviving/healthy partner(s), it avoids the problem and costs of borrowing money and enables the business operations to continue without costly interruptions. This strengthens the companies credit position and guarantees the continuity of management which ensures the ownership and control of the business stays in the hands of the surviving owner(s). The funds used to buy the deceased’s/disabled partners share are effectively the insurance premiums purchased for pennies on the dollar and is generally a lower cost than any other alternative.

What are the potential pitfalls of a Buy/Sell agreement funded by Insurance?

Some of the pitfall are matching the life insurance product to the buyout need and timing considerations.

  • Buy/Sell Agreement with Term Life Insurance: For a business that is likely to be sold to a third party within the next decade or so, a term insurance policy is generally appropriate.

  • Buy/Sell Agreement with Permanent Life Insurance: For a business with an internal retirement buyout plan within existing partners or a family business succession, a longer term or permanent product (ex. Whole Life insurance or Universal Life insurance) option could be considered.

  • If cost is a concern for permanent insurance, there are methods called an "Immediate Financing Arrangement" that allows the business to borrow back all premiums paid to invest back into the operation of the business. This arrangement is great for businesses in growth mode and provides tax advantaged growth.

Two major mistakes when choosing an insurance solution for a buy/sell agreement are:

1. Beware of the insurance policy’s expiry: A common mistake in this situation is when partners try to save money short-term by purchasing term life insurance and the insurance expires prior to an event that triggers the buy/sell clause. This creates a similar, if not worse, situation than if there was no agreement in place.

2. Not accounting for business growth: A common pitfall is that a business in a growth and expansion phase is not accounting for the increasing future valuation and share value over time, creating a shortfall. This pitfall can be overcome in the following ways:

  • Permanent policies can have an increasing policy death benefit to compensate for increasing share values.

  • Permanent and term policies can allow for the purchase of additional insurance without any medical evidence utilizing a rider to the policy.

  • Permanent policies can also include cash values. This serves a dual purpose and can be used for a buyout due to retirement. It is therefore imperative to re-evaluate the agreement and policy type every three to five years.

Buy/Sell agreement funded by insurance: other things to look for

There are many factors to consider when setting up an insurance policy to fund the buyout including: complex structural, tax, ownership, beneficiary and even family law considerations.

Proper planning and advice are required to optimize the outcomes for all parties involved. At a basic level there are two methods that buy/sell arrangements at death can be structured. Either the surviving shareholders can purchase the deceased’s shares or the corporation can purchase the deceased’s shares by redeeming the shares. If the agreement provides that the surviving shareholders will purchase the deceased’s shares, then the buy/sell obligation may be funded with insurance owned by the shareholders using the “criss-cross purchase” method. The buy/sell agreement may also be funded with insurance owned by the corporation and completed using the “corporate redemption” method.

Within each of these methods are structures that take into consideration equitable funding of premiums between partners; tax consequences for all parties; utilization of the capital dividend account; the adjusted cost basis of the insurance policy; the use of holding companies; stop-loss rules; potential grandfathering of tax legislation; creditor protection; GRIP (general rate income pool) balances; legal considerations; and overall complexity of the situation.

Other considerations when it comes to a buy/sell agreement is that it is not something a single advisor should consult on. It is recommended you have your corporate lawyer draft the agreement, your accountant review the tax ramifications of how the agreement works, and a Financial Advisor or life insurance agent properly review the funding.

Alternative to funding a buy/sell agreement (other than insurance)

Many businesses are worth far more than what they have in the bank and even if they have enough money in the bank, it usually does not make sense to spend all that money on a buyout. So how could a buyout be funded?

  • Alternative 1: One common method is a savings or sinking fund. This is where a percentage of revenue or profits from the business is set aside or invested over a set number of years into a separate account to eventually fund a buyout. The difficulty with this method is that the savings are often insufficient and what happens if one of the partners passes away unexpectedly? Will a savings plan be depleted to pay for unforeseen expenses? Also, with an accumulation of cash, there may be tax consequences to be considered.

  • Alternative 2: Another option is to buy out the shares using installment payments over time to the disabled/deceased shareholder or their estate/family. However, installment payments also provide no guarantee that corporate profits will be able to support the future buyout. Until the full share transition has been completed, the disabled or deceased's estate and family members with a partial interest can create control issues of the company and become a drag on the company cash flow.

  • Alternative 3: Businesses may also acquire funding from a bank when a partner dies to avoid cutting into corporate profits or retained earnings to fund the buyout. However, a business may not qualify for the loan at the time when it is required and even if it can qualify, the surviving owner(s) may have to sign for funds which exposes personal assets. A loan waters down the share value of existing shareholders until the loan is repaid. Depending on the type of business or the deceased partner’s role, the death of an owner can cause sales to decline which compounds the problem of cash flow concerns. Loan interest payments may also put constraints on corporate cash flow and reduce the business’ ability to make further loans that may be necessary for operations.

Benefits of working with an Independent Broker rather than a Captive Agent

Unbiased, professional advice is particularly important when sourcing a life insurance policy for a buy/sell agreement. Business owners and entrepreneurs are generally very busy people without a lot of time to rate shop and meet with multiple agents.

One primary difference between a Captive Agent vs an Independent Broker is the number of insurance carriers they represent. Captive agents are generally only allowed to represent one company, while independent brokers work for themselves and offer a much broader product selection representing multiple carriers. This allows for an independent broker to better meet the clients needs and budget constraints.

For business owners who work in higher risk industries or have pre-existing health concerns, independents have access to a wider variety of policy options. Being able to have that array of options allows for the independent broker to find appropriate coverage for the unique risks of that particular business or individual. Ultimately, you will want to work with an advisor you trust to help you make an informed decision.

If you are interested in finding out more about life insurance and how it can help you, reach out and start a conversation today!

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