Most people recognise the importance of having a Will to determine how their estate is distributed when they die. If you are self-employed, a partner in a business or co-director of a company, having a ‘Will’ or succession plan for your business is equally important.
Think about what may happen to your business when a key partner dies or is incapacitated. Generally, business partners are mutually dependent – each relying on the other/s for their skills, expertise and capital so that the business can prosper.
The death or incapacity of a key player causes unprecedented interruption. The continuing partners need to fill a void and, unless funds are available to buy out the departing owner’s share, there is uncertainty over the future control and sustainability of the business.
Business disruption due to the death or terminal illness of a partner however, can be controlled through buy-sell insurance and an effective buy-sell agreement.
Why is buy-sell insurance important?
Buy-sell insurance can minimise the impact of losing a business partner by providing lump sum funding towards a partner’s share after his / her death, total and permanent disablement or in the event of trauma. The payment enables the continuing owners to acquire that partner’s share. Insurance funding is considered a cheap funding method to purchase a departed partner’s interest in a business rather than the continuing partners having to find separate funds or borrow money to fund a purchase.
Without business insurance, continuing partners may be unable to fund a buy-out and be forced to wind up the business or transfer the outgoing partner’s share to an unknown party.
If a business partner dies, the business may face demands from that partner’s legal representative to freeze or sell assets in order to satisfy an interest claimed by their estate. The business may also be subject to the unsolicited involvement by the legal representative or other family member of the deceased partner.
Buy-sell insurance and an associated buy-sell agreement prepared by a competent lawyer minimises these risks.
What is a buy-sell agreement?
The buy-sell agreement incorporates the arrangements for partners to hold insurance for events such as death or incapacity of a partner and sets out procedures for acquiring a departing partner’s share.
The insurance and agreement should work together as a business succession plan by providing the funding and process to sustain the business upon the happening of certain events. Disputes are minimised and partners can plan with certainty.
What are the components of the buy-sell agreement?
The buy-sell agreement is fundamental in tying together the policy arrangements and processes for transitioning and sustaining the business when a partner leaves.
The agreement acknowledges the goodwill and value of the business and the respective interests held by the partners. It sets out the rights and obligations of all partners and the process for acquiring and transferring shares.
A typical agreement will consider:
- A buy / sell option for partners to acquire and dispose of shares and the events that will trigger the right to exercise an option, whether they be death, permanent disablement or trauma.
The agreement details the process and timeframe for exercising an option which may vary depending on the type of event. For example, a longer timeframe may be preferable following a traumatic event, giving a partner time to recuperate and return to the business if recovery is possible.
Voluntary events such as retirement and resignation cannot be insured however the agreement should facilitate procedures for buying out the interest of a retiring partner. This may be through an instalment plan with the exiting partner retaining a (proportional) interest in the business until fully paid out.
The agreement should bind the partners’ executors or legal representatives.
- Arrangements for funding insurance, the responsibility for payment of premiums and the types of insurance to be taken out.
The agreement should specify how the policies will be held, which may be by cross-ownership, individual-ownership, through the business entity itself, a trustee or superannuation fund. Each method has its advantages and disadvantages. Your accountant or lawyer will explain these to you and ensure that taxation issues such as capital gains and fringe benefits are considered.
- An agreement for valuing the business and each partner’s share which will be proportionate to their respective contributions.
A starting point for valuing the business may be the market value at the date the insurance is taken out, indexed annually to account for future growth. Your accountant can assist in preparing a formula based on predicted market conditions and future profits – this should be reviewed regularly to take account of changing circumstances and market fluctuations.
- Determining the level of cover required to sustain the business and buy out the relevant share of a departing partner based on the market value and partner’s proportionate interest. Provisions for maintaining and increasing cover in line with the growth of the business should also be included.
- Terms to release the exiting partner from debts, guarantees, securities and future business liabilities.
The sudden death, injury or illness of a key partner can have devastating effects on the value and continuity of a business.
Holding buy-sell insurance with an effective succession plan will minimise the effects of losing a partner and preserve the value and reputation of a business. Partners are then free to focus on the development of the business knowing that their efforts will sustain despite unforeseen events.
The matters to address when acquiring insurance and entering a buy-sell agreement are complex and should always be discussed with your accountant and lawyer. A ‘Business Will’ is a product of careful planning and regular review with your professional advisers.
Tim Donlan is the Secretary of Business Victor Harbor and is the principal solicitor of the law firm Donlan Lawyers. He opened the Victor Harbor office of the firm in 2020 following his family’s move from Adelaide to Port Elliott. He specialises in estate planning and business structuring and also advising small and family businesses about succession and governance. In a former life Tim was an aircraft technician in the Royal Australian Air Force and now also part owns and runs a security and software develop company