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What is a buy-sell agreement and do businesses need them?

SUMMARY

A buy-sell agreement is a legal contract that outlines what will happen with a business owner’s shares if they pass away, become seriously ill or disabled, or leave the company. It’s crucial for business continuity and estate planning, preventing conflicts between personal and business interests. A life insurance death benefit is often used to fund the purchase of shares.

IN THIS ARTICLE

When a business partner dies, not only is it personally devastating, but it can leave questions about how the business will be handled going forward or how shares will be divided.

In this article, we’ll show how life insurance helps business owners ensure there’s a contuinity plan in place to avoid these challenges through buy-sell agreements.

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What is a buy-sell agreement?

A buy-sell agreement is a crucial part of protecting your business and ensuring its survival no matter what. 

  • It’s a legal contract between shareholders or owners of a business
  • It details how the business’ shares may be bought, sold, or redeemed if an owner is no longer a part of the company
  • It’s usually a part of a shareholder’s agreement and a part of estate planning

Buy-sell agreements allow for smooth transition of ownership and smart financial planning that will ensure business continuity for the future.

Do businesses need buy-sell agreements? 

Yes. Businesses need buy-sell agreements to smoothly handle changes in ownership and prevent conflicts that could disrupt operations or even cause the business to fail. They help a business:

  • Ensure continuity
    Have a plan in place for how the business will keep running during ownership changes.
  • Facilitate effective retirement and estate planning
    Leave clear plans for owners to exit the business and for their heirs to receive fair compensation.
  • Minimize potential disputes among shareholders
    With predetermined plans in place, there’s no/less need for disagreements over ownership or future business plans.
  • Prevent unwanted ownership changes
    Block the transfer of shares to outside parties who might not align with the business’ goals.
  • Support succession planning
    Set out a plan for leadership transition beyond individual ownership changes.
  • Create liquidity for business assets and shares
    Ensure there are funds available for buyouts without added financial burden to the company.
  • Establish valuation and buyout terms
    Define the value of the business and terms for buying shares, making transitions fair and transparent.
  • Reinforce business stability to key stakeholders
    Give stakeholders, customers, suppliers, etc., confidence in knowing there are solid plans in place for the business.
  • Safeguard against creditors
    Insurance proceeds cannot be collected by creditors, leaving the business with liquidity for managing ownership changes.

Do you need a life insurance policy for a buy-sell agreement?

No, you do not need life insurance to set up a buy-sell agreement. But, it is very much worth your while to do so. A life insurance payout ensures partners or the corporation:

  • Keep their personal funds
  • Don’t have to take out a loan
  • Preserve business cash flow
life insurance for business

How does a buy-sell agreement work in Canada?

A buy-sell agreement sets rules for what will happen with a departing owner’s shares if something called a “triggering event” takes place. Here’s how it works:

  • The agreement is made, providing detailed instructions about what will happen with a departing owner’s shares and other key information
  • It will come into effect when a triggering event happens, such as if an owner passes away
  • Shares are usually sold to the surviving owners or back to the business
  • Proceeds of a life insurance policy can be used to fund the buy-back, so remaining owners aren’t financially affected by loss of the owner

What are the 4 types of buy-sell agreements in Canada?

There are four main types of buy-sell agreements in Canada, each with their own outcome after a shareholder departs:

  1. Cross-purchase agreement
  2. Stock redemption agreements
  3. Wait-and-see agreements
  4. Hybrid agreements

1 Cross-purchase agreement

With a cross-purchase agreement, the surviving shareholders agree to buy the shares of the deceased owner.
Cross Purchase Buy-Sell Agreement

2 Redemption agreement

In a stock redemption agreement, the business itself absorbs the departing shareholder’s stocks. 

  • The business owns the stock
  • The business stores those shares in its stock treasury
  • This can have implications for the company’s ownership structure, financial position, and governance

Redemption Buy-Sell Agreement

3 Wait-and-see agreement

With a wait-and-see agreement, the surviving shareholders get to decide what to do with the deceased’s shares when the triggering event happens. They usually choose between:

  • The surviving shareholders buying the stock
  • The business buying the stock

A business might choose the wait-and-see option because it gives them time to map out their finances and figure out if they have enough resources to buy back the shares. It takes the pressure off from them having to commit to a plan right away.

Wait-and-See Buy-Sell Agreement

4 Hybrid agreement

A hybrid agreement is a mix of cross-purchase and stock-redemption. The surviving shareholders buy back a portion of the shares, and the business buys the other portion.
Hybrid Buy-Sell Agreement

What should be included in a buy-sell agreement?

Buy-sell agreements should include the following key details: 

What is a triggering event? 

The triggering event of a buy-sell agreement is the circumstance when the agreement will take place. A triggering event can be if the shareholder:

  • Passes away
  • Suffers a long-term disability (must be specified) 
  • Is diagnosed with a critical illness (must be specified) 
  • Retires
  • Gets a divorce (often called “marital breakdown” in the agreement)
  • Resigns or is terminated as an employee 
  • Declares bankruptcy
  • Decides to sell their shares

What is a business’ valuation? 

The business valuation is the dollar value of how much it’s worth. This will determine how much the departing owner’s shares can be sold for. That dollar amount has to be stated in the buy-sell agreement. 

If the business can’t state a clear dollar value, they need to state a method that can be used to find out the valuation. And, it has to be able to be independently verified.

What is a funding strategy? 

The funding strategy is how the corporation or other partners will get the money to buy out the departing person’s shares. It’s usually from:

A funding strategy should also consider what happens if the amount of money received from funding is higher or lower than the amount the shares cost.

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How to set up a buy-sell agreement that uses life insurance?

To set up a buy-sell agreement that leverages life insurance, you typically have to follow these steps:

  • Hire a lawyer
    Buy-sell agreements are legally binding, so you have to use a lawyer to set one up. This will also help avoid expensive legal disputes if a disagreement comes up.
  • State a business value
    The partners or shareholders use a formula or independent evaluator to determine how much the business is worth. 
  • Buy the insurance policies
    Each owner will get a policy equal to the value of their stake in the company. You may also choose to buy a guaranteed insurability rider to plan ahead for if the business’ value increases in the future. (Learn more)
  • Triggering event occurs
    If a business owner passes away or any other triggering event happens, the insurance payout is also triggered. The surviving owners then use the insurance payout to buy out the other shareholder’s stake.

Who is the beneficiary of a buy-sell agreement?

There can be several beneficiaries when life insurance is the funding strategy of a buy-sell or shareholder agreement, such as: 

  • The surviving partners of the business
    When the surviving partners are the beneficiaries, they receive the payout and use it to buy out the shares, meaning they’ll each own more shares. 
  • The corporation
    If the corporation receives the death benefit and makes the buyout, then the shares are settled (meaning they’re basically erased). The remaining shares are now worth more because fewer outstanding shares are left.
  • The deceased’s estate (surviving family)
    After the partner or corporation gets the insurance payout, they buy the shares from the deceased owner’s estate. And the money paid to the estate usually ends up going to the owner’s surviving loved ones.
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Who should be the insurance beneficiary, and who should pay for the policy, depends on the business’ needs. For example, if the business has many owners, it may be easier to have the corporation as the beneficiary instead of the firm’s partners.
Learn more about business-owned life insurance

Frequently asked questions about buy-sell agreements

Yes. Buy-sell agreements are generally legally binding as long as the parties signed the agreement while they were of sound mind. If you properly drafted an agreement with an experienced corporate lawyer and signed it at their office, it’s most likely legally binding.

The state and future of the business may be very uncertain if you don’t have a business continuity plan in place or a buy-sell agreement.

  • Remaining partners will be left to decide what to do with the shares
  • This may cause tension or arguments among remaining partners
  • Resulting disagreements can disrupt business, causing confusion and stress for customers, employees, and stakeholders

Buy-sell agreements ensure your business avoids these problems, and life insurance works hand-in-hand to ensure secure funding is in place. 

In short, it leaves business owners like you with little to worry about if something happens to a shareholder, or to you, in the future.

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KEY TAKEAWAYS

  • Buy-sell agreements detail how a business' shares may be bought, sold, or redeemed
  • Life insurance is commonly used to fund the purchase of partner shares when a partner passes away
  • Setting up buy-sell agreements allows a business to avoid future conflict during a business’s transition period after a partner passes away

By Jiten Puri
CEO & Founder, Insurance Advisor, LLQP
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