Many business owners overlook one of the most crucial aspects of long-term stability: planning for shareholder transitions?
Over the lifespan of any business, shareholders inevitably come and go. While business owners are often rightly focused on growth and expansion, many overlook one of the most crucial aspects of long-term stability: planning for shareholder transitions.
Whether through retirement, disability, or death, a shareholder’s departure can significantly disrupt a business, unless there is a clear plan in place. One of the most effective, yet frequently overlooked, tools for managing this risk is a combination of a buy/sell agreement and Key Person insurance.
What is a shareholder Buy/Sell Agreement?
A buy/sell agreement is a legally binding agreement between shareholders, the company, and often a designated insurance policy stakeholder. It sets out the terms for transferring shares in specific situations - most commonly, the death/permanent disability of a shareholder.
The agreement sets out who can buy the departing shareholder’s interest, how the shares will be valued, and how the transfer will happen. Just as importantly, it addresses the critical question of funding ensuring that a transition does not put undue strain on the continuing shareholders.
The role of Shareholder Insurance
Planning is critical, but funding is an important addendum of a buy/sell agreement. This is where Key Person insurance plays an essential role.
Key Person insurance (usually life and/or disability insurance) is taken out on each relevant shareholder. If a triggering event occurs, the insurance payout provides the immediate liquidity needed to fund the share buyout, without forcing the remaining shareholders to scramble for resources or take on unwanted debt.
Key components to consider
- Insurance policies
In most cases, the company will pay the premiums for the insurance policies, and a stakeholder is named as the beneficiary. The designated stakeholder holds the proceeds on trust and applies the funds strictly according to the terms of the buy/sell agreement.
- Defining triggering events
Triggering events typically include death or total and permanent disability, but depending on the company’s needs, they may also cover events such as retirement, resignation, or insolvency. A well-drafted agreement clearly defines these events to eliminate uncertainty, ensuring that all parties understand when and how the terms of the agreement will come into effect.
- Managing loan accounts
Many shareholders have loan accounts with their companies, either as creditors or debtors. If these balances are significant, it can complicate an exit event.
An effective buy/sell agreement not only outlines how shares will be purchased but also addresses how shareholder loan accounts will be handled. It should clearly state whether insurance proceeds may be used to settle these accounts, the order of priority for payments, and the steps to take if insurance proceeds are insufficient to cover all obligations.
- Determining share valuation
Establishing a fair and transparent valuation method is critical. Whether by pre-agreed formula, independent appraisal, or periodically updated valuations, the agreement should specify exactly how shares will be valued at the time of a triggering event.
Why a Buy/Sell Agreement matters
Safeguards ownership integrity
Without a buy/sell agreement, a departing shareholder’s shares could end up in the hands of heirs, spouses, or third parties who may not share the company’s vision. A properly structured agreement ensures that ownership remains with individuals who are aligned with the business’s long-term goals.
Minimises shareholder disputes
Clear, predefined terms greatly reduce the potential for disputes among remaining shareholders or with the families of departed ones. In emotionally charged times, certainty and structure are invaluable.
Protects the shareholder’s finances
Insurance funding means the shareholder can meet its obligations without taking on burdensome debt or selling assets under duress.
This article is of a general nature and is not intended to be relied upon as legal advice.
Saurav Satyal is an Associate at Urlich Milne Lawyers, providing support to Andrew on matters related to shareholder issues, contractual agreements, business restructuring, and capital raising for small to medium-sized enterprises. Saurav’s email address is saurav.satyal@uml.co.nz.
