Understanding Buy/Sell Agreements

When multiple individuals enter a business arrangement, one important planning measure is to ensure a smooth transition of ownership to the remaining business partners in the event of the death, disablement or traumatic health event of a business owner. This is the role of buy/sell agreements in business succession planning.

What is a Buy/Sell agreement?

A buy/sell agreement is made up of a transfer agreement and a funding agreement.

The transfer agreement relates to the transfer of the departing owner’s interest in the business to the surviving owners should a trigger event (commonly death, disability or traumatic health event) occur.

The funding agreement relates to how the departing owner or their estate will be compensated for surrendering their interest in the business. Insurance policies are a common way to fund a buy/sell agreement.

Why is a Buy/Sell agreement important?

Critical illness, total and permanent disability or death of a proprietor can have a dramatic effect on a business. The following are some real problems that could arise:

  • The outgoing proprietor (or in the case of death – his / her estate) may make demands for the business to be wound up or for their interest in the business to be paid out.
  • In the case of a critical illness or injury, such as heart attack, stroke or cancer, there can be a misunderstanding as whether or not the ill proprietor can take time off work to recuperate, and if so, for how long.
  • In the case of death, the estate of the deceased proprietor may insist on immediate and direct involvement in the control and operation of the business, but may not have the relevant training, experience or expertise.
  • In the case of death, the estate of the deceased proprietor may be forced by circumstances to sell his or her interest in the business to an outside buyer for an amount lower than its true value.

A Buy/Sell agreement can provide a ready buyer and seller, ensuring a fair, pre-agreed price or an agreed method to determine price, without significant delay.

Ownership structures 

When using insurance to fund a Buy/Sell agreement, there are a number of different ownership structures which may be considered:

  • Self ownership
  • Cross ownership
  • Corporate ownership
  • Discretionary trust ownership

Your accountant and financial adviser will be able to discuss any relevant taxation / CGT implications.

Other Issues to consider

Arriving at a suitable valuation for the business and ensuring all parties (and the beneficiaries of each party) are aware of, and comfortable with the valuation method.

Ensuring there are adequate funds available – through optimum levels of insurance and correct ownership of policies.

Stan & Oliver’s Story 

In 2003, Stan and Oliver started a business together.  The start-up capital and purchase of business assets was valued at $500,000.  Stan developed the business products and services.  Oliver managed the administration and key relationships with their clients.Two years later Oliver died from cancer.  The business value had increased to $1,500,000.  Stan wanted control of the company, but Oliver’s wife, Wilma, wanted a fair value for Oliver’s share in the company, which she had inherited upon Oliver’s death. 

Wilma refused to sell her shares to Stan unless he paid what she wanted.  Stan said that he couldn’t afford to purchase the shares at the price Wilma was asking, as he couldn’t get financing from the bank now that Oliver had gone.  Wilma looked to sell her shares to an outside party, but as there were problems with the business, she had difficulty obtaining a fair value. Wilma was forced to work in the business with Stan in order to support her and the family.  Stan resented her being part of the business since she had no expertise in the industry.  He felt he was doing all the work and sharing the profits with her.

Had Stan and Oliver taken out an appropriate amount of insurance, Stan could have paid Wilma for the shares and been free to run the business on his own.  Wilma would have had funds to live on and would be free from the involvement in the business. An appropriate amount of insurance would be 50% of the business value at a cost to the business.  Provided by CommInsure Claims. 

How can a Financial Advisor Help?

This is general advice only and should not be relied on unless first discussing with a licensed Financial Planner.


Disclaimer

The information contained on this website is for general information only and should not be relied upon unless you first discuss your circumstances with a Licenced Financial Planner.

The Authorised Representative of Alea Insurance Pty Ltd ACN 107 647 192 is Steve Wilson (AFSL No: 331367) who is licensed by ClearView Financial Advice Pty Ltd ACN 133 593 012.