What would happen to your business if you or your business partner passed away?
If you passed away tomorrow, would your family want to take over your role in the business?
What about if you become totally and permanently disabled and can never work again, would you prefer to sell your share of the business? Alternatively, if your business partner passed, would you want their family taking control of their share of the business? Could you afford to buy them out? What if they do not want to sell?
There is a legal document that can create an obligation for a party to sell upon a trigger event such as passing away or becoming totally and permanently disabled. This is known as a buy/sell agreement.
Put simply, a buy/sell agreement is like a Will for a business.
When the agreement is well-executed and funded, it is an effective mechanism for business owners to transfer share and/or control if something should happen to one
of them. And, unlike a handshake agreement, a good buy/sell agreement provides transparency and certainty to all parties involved.
But to work effectively a buy/sell agreement needs to be funded. In other words, the surviving owner will often need the funds to buy the departing owner’s interest in the business. There could be a range of funding options, including drawing on business or personal assets or taking out a loan, however, to avoid having to nd this money at such a stressful time, funding with an insurance policy can be an effective and relatively inexpensive option.
Case study – how an insurance funded buy/sell agreement could be used.
Nick and Tom are 50/50 business partners in a company worth $6 million. Nick passes away and his shares pass to his wife Jan as per his will. Tom needs to find $3 million to buy out Jan. But Jan may think the business is worth more and ask for $4 million, or she may wish to take up a principal position in the business, replacing Nick. Jan has no legal obligation to sell the shares to Tom, and Tom has no obligation to buy the shares from Jan. This is where a buy/sell agreement comes in.
Let’s assume that Nick and Tom had a legally binding buy/sell agreement in force at the time of Nick’s death, which was funded with insurance. In accordance with this buy/sell agreement, Nick took out a $3,000,000 life insurance policy in line with the value of his share in the business. Nick passes away and, Jen, as the nominated beneficiary is paid $3,000,00 tax-free.
Tom then triggers an option in the buy/sell agreement that requires Jen to transfer the shares she has inherited to himself. But unlike an ordinary share purchase transaction, Tom doesn’t actually have to outlay $3 million on settlement. That’s because the buy/sell agreement recognises the $3 million insurance policy proceeds received by Jen as consideration for the sale of the shares. In other words, Jen is deemed to have received $3 million in sale proceeds by virtue of her being the nominated beneficiary on Nick’s life insurance policy.
In the end, Jen has received $3million tax free for transferring the shares that she inherited from Nick, to Tom. Meanwhile, Tom has assumed full control of the company as the sole shareholder/director.