How do buy-sell agreements—funded by life/disability insurance—set triggers, valuation, and financing to ensure ownership transitions?
In my previous articles of this series, I addressed the use of the estate freeze and family trusts in business succession planning. In this article (part 3 of 4), I address buy-sell agreements as a tool in business succession planning.
What Is a Buy-Sell Agreement?
Buy-sell agreements are contractual arrangements that define the rights and obligations of shareholders during business ownership transitions. These agreements often include provisions for triggering events such as death, disability, or retirement, and may involve life insurance policies to fund the purchase of shares. Financing and valuation methods are critical components of these agreements, ensuring fairness and liquidity during the transition. Below, I explain the role of buy-sell agreements, their structuring, triggering events, financing mechanisms, and the use of life insurance to facilitate smooth transitions in ownership.
Role of Buy-Sell Agreements
Buy-sell agreements are essential tools to facilitate smooth transitions in business ownership, defining shareholder rights and obligations during such transitions. They provide clarity and structure, reducing the risk of disputes among shareholders. For example, in family businesses, these agreements can define the terms under which shares are transferred, ensuring the financial health of both the withdrawing shareholder and the business itself. Particular buy-sell clauses, such as shotgun provisions (requiring one party to sell its shares to the other party or to buy the other party’s shares at a set price), provide a defined mechanism and avoid potential shareholder deadlocks.
Use of Life and Disability Insurance
Life and disability insurance can play a critical role in buy-sell agreements by providing liquidity to fund the purchase of shares upon triggering events like death or disability of a shareholder. Insurance that is payable upon specific triggering events works to minimize the risk that the financial burden of a share purchase jeopardizes the transition and even the business’s viability. However, unequal premiums or tax implications must be carefully addressed in order to avoid paralyzing disputes.
Triggering Events
Triggering events are central to buy-sell agreements, and their inclusion is intended to provide a level of certainty when specific events occur in the life of the business and its shareholders. A triggering event is an event specified within the buy-sell provision that may change certain elements of the rights and obligations of the shareholders affected, and may require that the shareholders take certain steps regarding the ownership of the business. Common triggering events include retirement, death, or disability, but may also include voting deadlocks, defaults by a shareholder or group of shareholders, or some other circumstance as defined by the shareholders in their buy-sell agreement.
Financing and Valuation
Structuring the agreement to include clear provisions for financing the purchase of shares and valuation is crucial. Financing provisions can include life and disability insurance, predetermined payment plans, or dividend payouts. For instance, agreements may use fixed prices, formulas, or appraisals to determine the value of shares, and to facilitate fairness and transparency. Such valuations can be completed by a certified professional upon mutual agreement of the shareholders, and may be based on the most recent financial statements of the business or the value at some other predetermined date.
To summarize, buy-sell agreements are vital components of business succession planning, providing structure, clarity, and financial security during ownership transitions. Consulting proactively with legal and tax professionals to tailor their buy-sell agreements to their specific circumstances, business owners can ensure a smooth and secure transition of their family business. If you would like to discuss your business succession planning opportunities, please contact Pavel Malysheuski at Boardwalk Law: [email protected] / 905.863.7428.
