When two or more individuals decide to start a business, they usually pay close attention to certain organizational details such as the form of the business, distribution of shares, formal incorporation and income tax matters. One area that is too often overlooked is planning for the possibility that one owner will need to sell or divide their share of ownership.
For instance, it can be hard to know what to do when one owner is going through a divorce that could affect ownership of that person’s shares.
One of the most effective methods of avoiding the chaos that can result in such situations is the execution of a buy-sell or cross-purchase agreement when the business is organized.
What is a buy-sell agreement?
A buy-sell agreement is a contract involving all the enterprise’s shareholders or partners. The agreement gives the enterprise or the other shareholders the right to force a shareholder to sell all that person’s interest in the business entity to the company or to the other shareholders. (The disabled or selling shareholder will hereafter be referred to as the “departing shareholder.”)
All buy-sell agreements should contain certain basic clauses.
The most important clause defines the events that can trigger the right to require the sale of the departing shareholder’s equity in the enterprise. The two most common trigger events are the death or disability of a shareholder. Divorce is usually added to this list, because the distribution of the departing shareholder’s equity could result in shares being transferred to the departing shareholder’s soon-to-be ex-spouse.
The buy-sell agreement should provide a reliable method for valuing the company’s equity. Some agreements simply state a price for the equity, but that number may change over time. A better method is to choose a formula, such as net shareholder equity as of the end of the entity’s last fiscal year. A second option is to identify a person or party who is empowered to determine value as of a certain date.
Funding method and mechanics of payment
Very few entities will have enough liquid assets to pay the prescribed purchase price for the interest of the departing shareholder. An effective alternative is the purchase of term life insurance policies on the lives of the shareholders; upon the death of the shareholder, the proceeds of the life insurance policy can be used to pay for that shareholder’s equity.
A knowledgeable life insurance agent can help draft these policies. The agreement should also specify the mechanics of payment and delivery of shares to the surviving shareholders.