There are many upsides to being in business with someone else, companionship, shared risk and access to complementary skills and greater resources, to name a few. However, if you have a partner or co-owner, it is important to protect yourself against the unexpected – what we call the ‘Seven Ds’: Death, Disability, Divorce, Default, Departure, Disagreement and Deadlock. ‘Seven D’ events are usually unplanned and in addition to being a personal setback, require considerable skill to navigate in a commercial context.
When one of these events occurs, often one of the business owners will want to take ownership and control of the business and the other owner (or their family) wants funds to maintain their lifestyle. A lot of questions then arise, namely, at what price can one owner buy-out the other owner and how will the buy-out be funded?
We come across many situations where otherwise diligent business owners, their staff and clients are adversely affected by a lack of preparation in respect of the Seven Ds. To protect your business, you should consider from the outset how you will ensure a fair and final transition for owners out of your business if one of the Seven D events occurs.
At a time when all parties are on an equal footing and before an event has occurred, business owners are advised to enter into an agreement that anticipates a departure from the business and how it will be funded - These types of agreements are commonly called ‘Buy-Sell’ Agreements.
What do you need to know?
A Buy-Sell Agreement, also known as a ‘buy-out’ agreement, governs the exit of owners from a business. The structure of the business doesn’t matter, the business can be operated through a unit trust, a company, a partnership, or any other type of business structure that allows for more than one owner.
These agreements are often executed between the business entity (if it has separate legal status) and any individual owners or structures through which they are operating. The key purpose of the agreement is to grant an option to:
‘continuing’ owners, so that they have ‘first-dibs’ over the purchase of the outgoing owner’s share; and
‘outgoing’ owners, to have their share purchased by the business entity or the continuing co-owners.
Well-drafted Buy-Sell Agreements anticipate the key issues facing the company when an owner exits. They are tailored to accommodate the needs of the business, the individual stakeholders and are appropriate for the industry.
There are four core issues addressed in a buy-sell agreement:
What event or events ‘trigger’ a buy-sell option?
What will happen if (or when) that event occurs?
How will the out-going owner’s interest in the business be valued?
How will the buy-out be funded by the business or its continuing owners?
It is important that the answers to these questions are practical and match the realities of the owners’ circumstances.
Comprehensive buy-sell agreements often provide several mechanisms setting out how the outgoing owner’s share will be valued and transferred upon their departure. This is to account for the many ways an owner may depart from the business.
In some agreements, terms dealing with the rights of the outgoing owner’s family members (in cases of death or disability), the procurement of insurance payments, and nominations for the outgoing owner’s replacement, are also included.
In situations where the outgoing owner is likely to continue in business after former co-owners have departed, the agreement may also include ‘non-compete’ provisions and clauses limiting the use of intellectual property and confidential information to prevent the outgoing owner from using their resources and knowledge to compete with the business.
Key things to note
Buy-sell agreements are powerful instruments. You are effectively agreeing to sell your business, albeit only if certain event happen. It is therefore difficult to overstate the importance of obtaining an agreement that is tailored to your ownership situation. Two key things to be aware of:
Think about valuation carefully. A fixed agreed value provides certainty, but the value can easily go out of date.
Insurance policies. Often insurance policies are used to fund a buy-out. There are a number of ways to structure the ownership of any insurance policies to fund a buy-out. However, how an insurance policy is owned can have different tax outcomes. You will need to ensure your lawyer takes this into account when structuring the Buy-Sell Agreement and your financial planner will need to ensure the policy details properly reflect this.
It pays to be pre-emptive
It is axiomatic that even the most successful businesses have the potential to collapse into failure owing to unforeseen events. Ultimately, Buy-Sell agreements are a useful tool to ensure that not every random event will result in catastrophe for the business and its people. A Buy-Sell Agreement provides clarity and promotes fairness during times where one has neither the time nor energy to consider the ‘bigger picture’.
If you are a conscientious business owner looking to take steps to protect your business, a Buy-Sell Agreement is a good place to start.
This information is provided solely for general information purposes and is not intended as professional advice. Readers should not act on the information contained therein without proper advice from a suitably qualified professional.
We expressly disclaim all liability for any loss or damage to any person or organisation for the consequences of anything done or omitted to be done by any such person relying on the contents of this information.