Thinking About The Unthinkable – Why You Need A Buy/Sell Agreement
What happens if a Shareholder suffers from a critical event?
The thought of what happens if you suffer from a critical event (e.g. death, disablement or critical illness) can be a morbid one. No-one likes to think about these particular events until they actually happen, and in the case of death that is obviously too late!
Unless there is an agreement between the shareholders which outlines what happens to a shareholder’s shares when a critical event occurs, those shares will be dealt with in accordance with that shareholder’s Will. This can mean that the remaining shareholders are left in business with the trustees or beneficiaries of the deceased shareholder’s estate; something that they did not envisage when the company was formed.
A company should therefore have an agreement (e.g. a Shareholder Agreement or Buy/Sell Agreement) which requires a shareholder to sell their shares to the other shareholders if a critical event occurs.
Assuming there is an agreement in place, how do the other Shareholders fund the purchase of those shares? If the company is successful, then raising the necessary funds to purchase a shareholder’s shares for market value, and repay their current account, can be a scary thought.
Life Insurance for Shareholders
Companies will often arrange a life insurance policy over each of the shareholders, which would be triggered by a critical event.
The proceeds from this insurance policy would be used to fund the purchase of shares held by the shareholder which has suffered a critical event (Affected Shareholder), and also repay any loans owed to the Affected Shareholder by the company.
What is a Buy/Sell Agreement?
A Buy/Sell Agreement (BSA) is an agreement between the shareholders that sets out the process to be followed if a shareholder suffers from a critical event. Here is how the process usually works:
- The BSA will require the Affected Shareholder to transfer their shares to the remaining shareholders;
- When a critical event occurs, the insurance proceeds will usually be paid to an independent stakeholder (e.g. a lawyer or accountant);
- The stakeholder will pay the proceeds to the Affected Shareholder (or their estate if applicable), and in return the Affected Shareholder (or their executors) is required to transfer its shares to the other shareholders.
A good BSA should:
- Outline how the shares are valued when a critical event occurs, and it is important to seek accounting advice on this point;
- Determine how a shortfall or surplus in the insurance proceeds is treated; and
- Determine the priority between repaying the Affected Shareholder’s current account and paying the purchase price for the Affected Shareholder’s shares.
It is still important to have a good Shareholder Agreement alongside a BSA, but at the very least a BSA ensures that a shareholder (or their executors) will be required to sell their shares upon the occurrence of a critical event.
Arranging life insurance and drafting a robust BSA is important risk management for any profitable company with multiple shareholders.
The above information is of a general nature only. You should contact our firm for advice relating to your specific circumstances.