Buy-sell agreements between business partners

When two or three people own a business together, they usually think carefully about how to start it and very little about how one of them might leave. Then a partner dies, becomes seriously ill, wants to retire or simply falls out with the others, and nobody knows who can buy their share, at what price, or where the money will come from. A buy-sell agreement answers those questions in advance, while everyone is still on good terms.

This article explains how these agreements generally work. The agreement itself needs to be prepared by a lawyer, and any insurance used to fund it is a financial product that needs advice from a licensed financial adviser.

What a buy-sell agreement is

A buy-sell agreement is a contract between the owners of a business, and sometimes the business itself, that sets out what happens to an owner's interest when specified events occur. It is sometimes a standalone document and sometimes part of a shareholders' or partnership agreement.

At its core, it answers four questions:

1. What events trigger a transfer?
2. Who buys the departing owner's interest?
3. How is the price worked out?
4. How is the purchase paid for?

Why it matters

Without an agreement, the consequences of a partner leaving can be messy:

• If a partner dies, their shares may pass under their will to a spouse or children who have no experience in the business, but now have a say in it.
• The surviving owners may want to buy the shares but have no money to do so.
• The departing owner or their family may need the value of the shares but have no way to sell them.
• Disagreements about price can turn into disputes that damage the business itself.

A buy-sell agreement replaces uncertainty with an agreed process.

Trigger events

Agreements commonly deal with:

• Death. The most common trigger and usually the most important.
• Total and permanent disablement. Where an owner can no longer work in the business.
• Serious illness or trauma. Some agreements include this, sometimes as an option rather than an obligation.
• Retirement or voluntary exit. An owner choosing to leave.
• Bankruptcy or breach. An owner becoming insolvent or seriously breaching their obligations.
• Relationship breakdown. Where a spouse might otherwise make a claim on the shares.

The agreement should define each trigger carefully. A vague definition of "disablement", for example, can become the dispute it was meant to prevent.

Compulsory or optional

Agreements often use a mix of obligations and options. For example, on death the surviving owners might be required to buy, and the estate required to sell. On retirement, the remaining owners might have a right, but not an obligation, to buy, or the departing owner might have to offer their shares to the other owners first. The right mix depends on what the owners want and on tax and legal considerations.

Valuing the interest

The agreement needs a method for working out the price. Common approaches include:

• an agreed value, reviewed and re-signed each year;
• a formula, such as a multiple of average earnings over a set period;
• an independent valuation at the time of the trigger event.

Each has trade-offs. An agreed value is simple but often goes out of date because owners forget to update it. A formula is objective but can produce odd results in an unusual year. An independent valuation is the most accurate at the time but takes longer and can be disputed. Many agreements combine them, using an agreed value with a fallback to an independent valuation if it has not been updated recently.

As a simple illustration, if three equal owners agree their business is worth $1.5 million, each one-third interest is worth $500,000. The question is how the remaining owners would find that amount at short notice.

Funding the buyout

The agreement is only as good as the money behind it. Ways of funding a buyout include:

• Insurance. Many owners use life, total and permanent disability and trauma insurance to fund buyouts on those events. The type of cover, the amount and who owns the policies all have significant consequences, including for tax. These are financial product decisions and must be made with a licensed financial adviser.
• Instalments. The remaining owners pay the departing owner, or their estate, over time. This can strain the business and leaves the outgoing owner exposed to its future performance.
• Business cash or borrowing. The business or the remaining owners may borrow or use reserves, if available.
• Sale to a third party. Sometimes the agreement allows a sale to an outside buyer if the remaining owners do not take up their right.

Retirement and voluntary exits are generally not insurable events, so the agreement should set out how they will be funded, often by instalments over an agreed period.

Ownership structures and tax

How insurance policies are owned and how the agreement is structured can affect whether proceeds are taxed, who receives them and whether capital gains tax applies to the transfer of the interest. Common ownership approaches involve each owner insuring themselves, owners insuring each other, or policies held in a trust. Each works differently.

The transfer of shares or a partnership interest is generally a CGT event for the departing owner or their estate, and the small business CGT concessions may be available if the conditions are met. Getting the structure right needs advice from a lawyer, a tax adviser and a licensed financial adviser together.

Keeping it current

Buy-sell agreements fail most often because they are signed and forgotten. Review the agreement:

• every year, especially any agreed value;
• when an owner joins or leaves;
• when the business changes significantly in size or value;
• when an owner's personal circumstances change, such as marriage, divorce or new children;
• when any insurance funding it is changed.

The agreement should also line up with each owner's will and with the company constitution or partnership agreement.

A buy-sell agreement is a promise to each other's families. It only works if the price is current and the money to pay it is in place.

How we can help

We help business partners value their business, model what a buyout would cost, understand the tax effects of different structures and work alongside their lawyer and licensed adviser. If your business has more than one owner and no agreement, contact us. Our article on family business succession planning covers related issues.

This article is general information only and does not take into account your circumstances. It is not financial product advice. Speak to a qualified, licensed adviser before acting on it.