By Tim Downing, Partner
Tragedy, like death or total and permanent incapacity – not really an opening line to make you want to read on, is it? But it is important for co-owners of any business to think about, and put measures in place to address, what happens to the equity interest of a co-owner who passes away or suffers an incapacity that prevents that person from working again.
A Buy/Sell Agreement, considered to be a form of Business Will, is a solution that co-owners of any business should contemplate putting in place to address this issue.
Whilst the focus of this article is on the equity ownership interest, co-owners should also plan for other risks to the ongoing operation of the business as a result of such tragedies and consider what mitigants to put in place. This includes the risk of a material decline in revenue or cash flow, ability to service debt and managing and securing relationships with stakeholders, including customers, clients and suppliers.
The “equity piece”
The equity interest of a business partner is often one of the most valuable assets they own. Apart from the capital value, equity often grants a degree of control and involvement over the strategic decisions of the business through voting rights and a share of profits.
In the event of the death or incapacity of one of the co-owners, key issues emerge, such as:
- What should happen to the ownership of the business and therefore the equity interest of the impacted co-owner?
The co-owner or the family / estate often want or need to transfer the equity interest to a third party to realise the value in the asset that is the equity interest (and financial circumstances may dictate that this occur as soon as possible). The remaining co-owners may not want to be involved in business with the family / estate of the impacted co-owner or any unknown third party who might be interested in buying the equity interest.
- Are there sufficient funds to buy out the equity interest of the impacted co-owner?
The remaining co-owners may not be in a position to quickly and efficiently access the capital required to fund the purchase of the impacted co-owner’s equity interest. So how can this be addressed?
Without a plan, the business and its remaining co-owners can be left exposed, distracted from running the business and having to think about attending to these matters at a time when they are dealing with the loss of the co-owner.
A Buy / Sell Agreement is a contract between co-owners with the overarching aim of setting out how and when the equity interest of the impacted co-owner can be transferred to the remaining co-owners if certain events occur, including how the value of the equity interest is determined and funded. This can be a stand-alone agreement or the arrangements can be found in a Shareholders’ Agreement (or similar document governing co-ownership, such as a unitholders’ or partnership agreement).
Key features of a Buy / Sell Agreement
Key features of a Buy / Sell Agreement include:
1. Trigger events
A Buy / Sell Agreement will set out the trigger events that permit a transfer of the impacted co-owner’s equity interest. Generally this will be in the event of a co-owner’s death or total and permanent disability (TPD). Trauma events may also be a trigger, though this is less common as a co-owner may be able to return to work following such an event.
Where insurance is used as a funding solution, the trigger events will need to be aligned with the type of insurance each individual partner takes out (ie life, TPD and/or trauma cover).
In times of grief, and when there are competing financial pressures and interests, disagreement on valuation can draw out the process of the impacted co-owner’s equity interest being transferred and the value realised, in addition to attracting more costs and disputes between the parties.
As such, documenting an agreed and appropriate valuation method and process as to how the equity interest of any impacted co-owner is determined is another critical element of a Buy / Sell Agreement. A valuation mechanism is also important for establishing the level of any insurance cover that is needed and may also be used to enable access to a forward underwriting facility, which allows the life insured to increase their cover on each option date without having to provide further evidence of insurability (which may be critical should an insured’s health decline).
3. Funding Methods – insurance and other options
In addition to having agreed triggers and valuation mechanics, the co-owners need to turn their mind to how the purchase price will be funded.
Insurance is a common funding solution, whether solely or in combination with other sources of capital such as existing cash reserves, bank debt and/or agreeing on vendor terms. Where insurance is used a Buy / Sell Agreement will generally require that the value of each co-owner’s equity interest is insured and, subject to the relevant trigger events, will typically involve life, TPD and/or trauma insurance. However, the ability to put an insurance policy in place for each co-owner will depend on the insurability of that co-owner, with factors such as occupation, health and age all relevant.
It may therefore be required, or just prudent, for the terms of the Buy / Sell Agreement to outline how the purchase price is to be funded where insurance is not available or in circumstances where there is a shortfall of insurance.
It is also important that the preparation of a Buy / Sell Agreement that contemplates insurance as a funding solution be done in parallel with an insurance underwriting process.
4. Tax considerations and insurance policy ownership structure
Co-owners should ensure that they obtain tax advice as to the potential implications of the trigger events when putting a Buy / Sell Agreement in place. This is because on a trigger event occurring there will be a transfer of the impacted co-owner’s equity interest (eg shares, units, partnership interest) and taxes such as a capital gains tax will be relevant.
When insurance is to be used as a funding solution, tax advice is also key to determining the appropriate insurance policy ownership structure and how any insurance proceeds will or may be taxed in the hands of the recipient. There are various different ways in which an insurance policy can be held for these purposes, including self-ownership (where the co-owners hold an insurance policy on themselves), cross-ownership (where the co-owners hold insurance policies on their other co-owners) and business ownership (where the business itself owns the policies).
Mills Oakley can assist business co-owners with the process of creating and documenting a Buy / Sell Agreement. If you would like to discuss such an arrangement, please feel free to reach out to the contacts below.
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