One often overlooked component of a shareholder agreement is the Buy-Sell Provisions. This is a clause that outlines the course of action if a shareholder or partner were to die, or become sick or even disabled.
This includes when they no longer want to have any involvement in the business, for a variety of reasons. The Buy-Sell provisions will lay out the methods for valuating those shares and who has the opportunity to buy them. It’s seen as a contingency plan and a safety net for the business and the owners.
A shareholder agreement, or partnership agreement, is a crucial legal document for any company. It outlines the rights, obligations and expectations of the shareholders. It also looks at valuation methods, management decisions, and many other material items. These all pertain to the owners and functionality of the business.
Here are how Buy-Sell Provisions would work. Imagine this scenario:
Two individuals are in business together. Each of them own 50% of the shares of a successful business valued at $2 million (each of their shares having a fair market value of $1m). Suddenly and unexpectedly, Shareholder “A” passes away. His spouse is the sole beneficiary to his estate (including his company shares). Now, she has 50% ownership of the company.Does Shareholder “B” want to be in business with his late partner’s spouse? Does the surviving spouse have any interest in being an owner of the business? More often than not, the answer to both questions is no.
How can we avoid the above situation? We need to ensure the business can survive unanticipated events, such as the premature death of a shareholder? Let’s go one step further.
How do we ensure the business owner’s loved ones are receiving fair value for their share in the business? And at the same time ensure that the surviving owners are not put in a situation that is a detriment to the business going forward? The first step is having Buy-Sell provisions in the shareholder agreement.
The vital second step is ensuring those provisions are funded, because without enough capital accessible in the event of needing to purchase an owner’s shares, the Buy-Sell provisions won’t work. This is where life and health insurance come into play. In other words, a properly set-up Buy-Sell arrangement would include funding to “buy-out” the shareholder’s spouse.
Digging deeper, here is how it would look:
- Firstly, the corporation purchases life insurance policies on the lives of both shareholders.
- When Shareholder “A” passes away, the corporation receives the life insurance proceeds.
- With use of the use of the Capital Dividend Account, the corporation pays a tax-free dividend to the deceased shareholder’s spouse and in return purchases the shares back.
- After that, the surviving spouse has now received fair market value for the business. Therefore, Shareholder “B” now owns 100% of the shares.
The end result will be a business that has the opportunity to continue operations, and not bogged down by potential ownership issues and costly, time-consuming litigation. For the family of the deceased, this removes the stress and uncertainty over how to receive fair value for the business. It also provides liquidity and closure.
DISCLAIMER: this is a surface-level summary of the process for funding Buy-Sell provisions. There are many ways to structure the insurance policy ownership and payout methods. The tax and legal components need to be explored in depth with your trusted professionals. Contact me today to start the process.