A shareholder agreement, or partnership agreement, is a crucial legal document for any company. It outlines the rights, obligations and expectations of the shareholders, as well as valuation methods, management decisions, and many other material items as they pertain to the owners and functionality of the business.
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/partner were to die, become sick or disabled, or simply no longer want to be involved in the business, albeit for a variety of reasons. The Buy-Sell provisions will stipulate the methods for valuating those shares and who has the opportunity to purchase said shares. It can be looked at as a contingency plan and a safety net for the business and the owners.
Imagine this scenario: two individuals are in business together, each owning 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. Let’s assume his spouse is the sole beneficiary to his estate (including his company shares), thus now giving her 50% ownership 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.
So, what can be done to avoid the above situation and ensure the business can survive unanticipated events, such as the premature death of a shareholder? Furthermore, how do we ensure the business owner’s loved ones are receiving fair value for their share in the business, and the surviving owners are not put in a situation that is a detriment to the business on a go forward basis? The first step is having the aforementioned Buy-Sell provisions in the shareholder agreement, and the vital second step is ensuring those provisions are funded. Without adequate capital accessible in the event of needing to purchase an owner’s shares, the Buy-Sell provisions are not effectual. This is where life and health insurance come into play. In the example above, a properly set-up Buy-Sell arrangement would include the necessary funding required to “buy-out” the shareholder’s spouse. Digging deeper, here is how it would look:
- The corporation purchases life insurance policies on the lives of both shareholders.
- When Shareholder “A” passes away, the corporation receives the life insurance proceeds.
- The corporation, with use of the Capital Dividend Account, pays a tax-free dividend to the deceased shareholder’s spouse and in return purchases the shares back.
- The surviving spouse has now received fair market value for the business and Shareholder “B” now owns 100% of the shares.
The end result will be a business that has the opportunity to continue operations, 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, providing liquidity and closure.
DISCLAIMER: this is a surface-level summary of the process – there are various ways to structure the insurance policy ownership and payout methods, and the tax and legal components need to be explored in depth with your trusted professionals.