Buy-Sell Agreements : The Essentials
Many SMEs don’t have a retirement plan. A Buy-Sell Agreement ensures a smooth transition and protects owner and business interests.
However, many SMEs business owners don’t have a plan for what will happen when they retire and leave their business. The transition can be difficult without a plan, and the business may fail.
A Buy-Sell Agreement provides a structure to ensure a smooth transition and protect the interests of the owners and the business.
1. What Is A Buy-Seller Agreement?
A Buy-Sell Agreement is a legally binding contract between business owners that sets out the terms and conditions that will apply in the event of specific events, such as death, disability, retirement or withdrawal from the business.
The primary purpose of a Buy-Sell Agreement is to ensure that the business continues and that the beneficiaries receive a fair market price for their interest in the business. Therefore, this document is vital for business owners because it can help avoid disputes among the owners about the future of the business, and it can help ensure that the business is sold fairly and orderly.
While a Buy-Sell Agreement provides a structure to ensure the smooth continuity of a business, a crucial issue remains – how the business owners will source the funds necessary to buy out the interest of the deceased or disabled owner?
Several options to fund a Buy-Sell Agreement, include cash payments from personal savings, third-party borrowing, sale by instalments, disability insurance, or life insurance.
One of the most common and effective methods of funding a buyout of a disabled or retiring partner is using life insurance policies. This method provides several advantages over other methods of funding.
A lump-sum payment to the deceased shareholder’s estate is generally the best way to proceed when a shareholder dies. This is because life insurance proceeds are available to fund the payment and are generally free from taxes. Additionally, the cash values in the policy can be utilised for the buyout of a retiring or disabled partner while allowing the withdrawing partner to keep the policy.
Although insurability may be a problem due to differences in age or state of health of the shareholders, differences in the premiums can be addressed by appropriate compensation measures.
2. How Does A Buy-Seller Agreement Work?
Case Scenario – TanWong Pte Ltd
Mr Tan and Mr Wong jointly own and operate a car repair workshop. The workshop has been successfully running for over 35 years, with the two businessmen sharing ownership equally. They have been friends and business partners for a long time and operate the business informally. They made all business decisions jointly or strived to reach at a mutually acceptable compromise even when they didn’t initially agree. This approach has worked well for them, as they could maintain the trust and cooperation essential for a successful business partnership.
Mr Tan dies suddenly of a heart attack, leaving no will. By the succession laws, his wife owns half of his assets, and his two sons share the other half. Mr Tan’s assets comprise his shares in TanWong Pte Ltd. Mr Wong now finds himself in a difficult position because he has to work with Mrs Tan and her two sons. They all have equal voting rights on the company’s board. Through the unexpected demise of his business partner, Mr Wong now finds himself in a regrettable position of having business owners imposed upon him with no genuine interest or knowledge of the business.
Case Scenario – TanWong Pte Ltd: Buy-Sell Agreement at Work
The situation illustrated above could have been avoided by executing a Buy-Sell Agreement between the business owners while Mr Tan was still alive.
Suppose Mr Tan and Mr Wong had met up with their lawyer and agreed on the terms of a Buy-Sell Agreement while Mr Tan was still alive. In that case, they could have mutually agreed to allow either party to buy the other’s shares at a specified price on the demise of either party.
Additionally, they could also have bought insurance policies on each other’s lives, with the result that upon the death of either business owner, the beneficiary of the policy (the surviving business owner) can use the insurance proceeds to buy the deceased’s share of the business from his next of kin.
In this case scenario, on Mr Tan’s death, Mr Wong would become the business’s sole owner, TanWong Pte Ltd. At the same time, Mr Tan’s heirs would receive a fair value for his shares in the business.
3. Who Should Execute A Buy-Sell Agreement?
A common misconception is that any business owner, including a sole proprietor, can execute a Buy-Sell Agreement. However, as the parties to a Buy-Sell Agreement include all the business owners, it would be impossible for a sole proprietor to execute such an agreement.
While sole proprietors can also undertake business succession planning, the mechanisms for succession planning for sole proprietors relates to Keyman Insurance”.
The types of business organisations that benefit the most from executing a Buy-Sell Agreement are partnerships and corporations. These organisations typically have the most at stake regarding the business’s ownership and management. By having a Buy-Sell Agreement in place, these organisations can ensure that the business can continue operating in the event of the death or disability of one of the owners or managers. This can be critical for preserving the value of the business and ensuring that it can continue to generate profits for the owners.
4. When Should A Buy-Sell Agreement Be Executed?
Many owners of successful businesses put off executing a Buy-Sell Agreement until it’s too late. Business owners need to create a Buy-Sell Agreement as soon as possible. This will help ensure that the business can continue to operate smoothly in the event of the death or disability of one of the owners. By creating the Agreement now, you can avoid costly and time-consuming disputes later.