It is important for business owners to have a succession plan in place for their business, particularly when there are two or more stakeholders with each playing a key role in the business’ operations.
A proper succession plan provides a safeguard in the event one of the business partners wants to step away, or if they die or become ill or injured and cannot continue in the business.
Typically, if a person dies their assets (including any interest they own in a business) passes to their estate. This means the continuing business partners may end up in business with a person’s immediate family, who may either lack the requisite skills and qualifications or simply not be the right fit. Sometimes the continuing business partners may not have the funds to buy out the departing partner (or their estate) potentially resulting in a deadlock.
A Buy Sell Agreement provides a solution that ensures a smooth transition of ownership to the continuing business partners whilst minimising the interruptions to the business itself.
What is a Buy Sell Agreement?
A Buy Sell Agreement is a contract between two or more business partners that governs how their interests in the business are to be dealt with in the event of one of the partners dies or suffers a total and permanent disability (“TPD”) or critical illness or trauma.
Typically, it obligates the departing owner (or their estate) to sell their interest, and the continuing business owners to buy that interest. It also sets out the method used to fund the transfer of that interest.
A Buy Sell Agreement typically features three components:
- Option component: This is triggered by the death or TPD or critical illness, for example:
a. by exercising a call option, the continuing partners force the departing partner (or their estate) to sell the departing partner’s interest;
b. by exercising a put option, the departing partner (or their estate) force the continuing partners to purchase the departing partner’s interest;
- Valuation component: This sets out how each partner’s interest is valued. Typically, this would be the market value of the interest (as determined by an independent valuer), but it can also be as agreed between the parties or as calculated using an agreed formula.
- Funding component: This sets out the source of finance to facilitate the transfer of interest, for example:
a. Insurance covering the death, TPD or critical illness. Each business partner would need to be covered by a policy, and the level of cover under each policy needs to reflect the value of that partner’s interest in the business;
b. Alternatively, funding can be supplied by way of a cash buy-out or a loan, or buy way of a company buy-back of shares.
Ownership of the Insurance Policy
There are different approaches to insurance policy ownership:
- Self ownership: Each business partner takes out their own insurance policy.
- Cross ownership: The partners take out insurance policies over each other.
- Business/company ownership: The company operating the business takes out insurance policies over each of the partners. Insurance proceeds then facilitate a company buy-back.
- Insurance trust ownership: The parties establish a trust and the trust takes out insurance policies over each of the partners.
Choosing the appropriate ownership structure will depend on the structure of the business itself, whether it is likely there will be frequent changes to the ownership, the insurance premium payable and who has the means to pay it, and any tax implications relating to the payment of premiums and the receipt of insurance proceeds.
It is important you obtain the advice of your accountant and/or financial advisor when considering the appropriate insurance ownership structure, and that you utilise your insurance broker to ensure the insurance policy and level of cover are sufficient.
For any advice regarding Buy Sell Agreements or the succession of your company, partnership, joint venture or trust which operates a business, please feel free to reach out to our commercial team.