Buy-Sell Arrangements
A buy-sell arrangement is a legal and binding contract specifying how much of a share a business can be reassigned in case the co-partner or owner of a private corporation or business leaves or passes away. For instance, a partner may leave due to an unfortunate event that caused a severe injury, a divorce, bankruptcy, termination, or if they wish to retire. Canadian Business advises companies to create buy-sell agreements, so an enterprise does not fold in case any of these calamitous incidents take place.
It is often stipulated that the share left behind gets sold to the continuing partners, remaining shareholders, or other third parties. The primary purpose of attaining a buy-sell arrangement is to facilitate a smooth transition of shares without endangering the fiscal well-being of a business. Additional names in relation to a buy-sell arrangement include a business will, business prenup, or buyout agreement.
Common Types of Buy-Sell Arrangements
Two common kinds of buy-sell arrangements include the following:
- Cross-Purchase Agreement: In a cross-purchase agreement, a company’s shareholders or partners can buy the shares or interest of a partner who retires, becomes incapacitated, or passes away. A life insurance policy is often referred to in the event of a death to determine the exchange of value. Partners can, for instance, receive a proportional distribution amount based on their stake in the business.
It can be beneficial to have a cross-purchase agreement if there are only a couple or few partners of similar ages. If a co-owner passes away, for instance, their life insurance policy funds may be used to purchase their interest. Disability insurance can be bought in preparation for possible incapacitation as well. If a partner retires or divorces, more comprehensive agreements can be listed out. There is often a predetermined buyout price or a valuation formula for some cross-purchase agreements.
- Redemption Agreement: In a redemption agreement, the company entity purchases the shares or stocks of a business. It allows business owners to plan in advance the terms of buying or transferring ownership interests in case a partner leaves the company. The business itself becomes obliged to redeem the ownership interest of the owner who left. Moreover, the redemption agreement outlines what events would result in a sale, redemption, or transfer of ownership interest. They also help protect remaining owners from unknown successors and potential conflicts of interest if a partner departs.
Examples of everyday triggering events include a partner’s death, long-term disability, divorce, or retirement. Other possible measures include personal bankruptcy, the conviction of a crime, termination of employment, and loss of a professional license.
Some businesses choose to get a mix of the cross-purchase agreement and redemption agreement, where an individual owner can purchase some shares, or the partnership can buy some.
Financing Buy-Sell Arrangements
Funding is required to ensure money is accessible to purchase the shares of the partner who has departed or become disabled. Several funding options include:
- Sinking Fund: A sinking fund consists of a pool of money a business sets aside for a particular purpose. Companies who have the financial ability for extra resources on the side can refer to additional funding in case a partner departs prematurely.
- Financial Institution Loan: A loan may be given after a financial institution places debt covenants on a company that can restrict the ability to pay dividends or use its assets. The value of shares may be diluted until the loan is paid back.
- Buying out Shares: Buying out a departed partner’s shares can be costly if they are paid in lengthy installment periods, such as over the course of ten or twenty years. The business would not gain any value for those payments, either.
- Life Insurance: Life insurance can usually be the least pricey alternative while providing an instant cash flow. It can come with tax benefits to the departing partner or surviving shareholders. As a result, it tends to be the desired funding option for many buy-sell arrangements.
When funding through life insurance, the arrangement can be corporately owned or personally owned. In other words, the corporation or shareholder can pay for the premiums. When deciding which route to take, keep in mind how many shareholders exist, their age, and their health conditions. Review a company’s tax leverage and determine how premiums will be met to maintain good standing. Continue to update existing agreements as shareholders change or as the business grows.
Valuation Mechanisms
A buy-sell arrangement determines what type of valuation mechanism ought to be used to establish the purchase price of outstanding shares after a triggering event happens. The most often used tools include the following:
- Fixed Price Agreement: Future purchases are set at a fixed dollar amount by affirming the value of the company’s equity. While the price is fixed at the outset, it can also be periodically adjusted when shareholders meet annually, for instance. However, the fixed price can be outdated as a business grows, and varying triggering events can result in different values.
- Formula Agreement: A business valuation is determined by a formula based on numerous company operations, such as setting a book value and appraising the fair market values of certain assets such as equipment, real estate, and fixtures. The amount of revenue and other business earnings can also be calculated into the formula agreement. However, not all formulas can provide accurate valuations over time, and values of interest can be unrealistic based a triggering event’s timing. What may have worked in one instance can be inapplicable in the future. Hence, companies can get an independent valuator to calculate the fair market value of their enterprise.
- Business Valuation Agreement: A business valuation agreement puts together how many future transactions will be assessed. One or more business appraisers may be referred to determine the price points and all parties approve of the process. However, this method can be costly and take time to figure out the final value.
FINAL THOUGHTS
Establishing a buy-sell agreement can safeguard your business to resume operating even if a partner departs or moves on. The company can avoid significant liquidity issues or infighting amongst the remaining stakeholders, so the firm does not fall apart.
To learn more about various types of buy-sell arrangements, contact the experts at Hometown Life Insurance. Our licensed professionals will be happy to answer any questions you have.
