Buy-Sell Agreements in a Succession Plan
You are in business with one or more business 'partners'. Most likely all of the business owners
are involved in the day to day running of the business. But what happens if you or they die or
retire from the running of the business? Here we set out some of the problems you may encounter unless you have a proper business succession document (often called a Buy/Sell Agreement). We also set out some of the options and issues in putting in place a proper Buy/Sell Agreement. These issues are the same regardless of whether your business is run via a company, unit trust or partnership. https://jump.africa/
These are some of the common problems business owners can encounter when one of the above events occurs: disputes between the continuing owners and the incoming owner of the business (the incoming owner may acquire his or her interest under the will of the deceased former owner). This often occurs as the new owner does not understand the business or does not have the respect of the other business owners; in a private business the sale of a portion of the business to an outside party is often not possible (i.e. there is limited external liquidity). So really there can only be sales between business owners. However, without an agreement:the incoming owner (under a will) cannot force the other business owners to buy his or her portion of the business; and the remaining business owners cannot force the sale of the deceased business owner's portion of the business; even if all of the owners want a sale to occur there is not sufficient funding to allow this; the owners who still work in the business become disgruntled with having to pay ongoing returns to the new passive owner (i.e. the estate of the deceased owner); and concerns about the continuity and viability of the business, including from employees, customers, bankers, suppliers and creditors who may leave or discontinue support (particularly where the owners are in dispute).
Putting in place a Buy/Sell Agreement can avoid some of the above and provide certainty for
business owners. In simple terms a Buy/Sell Agreement provides a framework under which business owners can sell their interest in the business or buy the interest of a co-owner. For tax purposes (see below) Buy/Sell Agreements usually use options to buy or sell on a defined trigger event (e.g. death of an owner). Usually: the owners not subject to the trigger event have a right but not an obligation to buy the exiting owner's interest in the business (Call Option); the owner subject to the trigger event has a right but not an obligation to make the remaining owners buy his or her interest in the business (Put Option).
As an alternative, a buy back/redemption agreement could be considered. Under such arrangements the trading entity (e.g. company) rather than the other owners buys back the exiting
owner's shares (note there are Corporations Act requirements which apply to share buy-backs).
Another alternative is to have a sale of the whole business on a trigger event occurring. We don't
look at these two options in this paper. We now look at some of the issues you need to
consider and resolve to ensure you meet your needs.
You need to work out the trigger events or conditions which lead to a sale of a business interest. These are often tailored to and limited by funding available for any purchase (see below). There are two broad trigger event categories being: involuntary or insurable trigger events (death, critical illness, and total permanent disability); and voluntary or uninsurable trigger events (retirement, resignation or lawful termination of employment).
Call Options are generally granted on the happening of both involuntary and voluntary trigger events. Put Options are generally granted on the happening of involuntary trigger events. As insurance is not available for involuntary trigger events you may need to consider price reductions or payment over time (vendor finance provisions).
The price at which an exiting owner's interest in the business is to be sold should be fixed under
the Buy/Sell Agreement and reviewed at agreed intervals. Alternatively the parties should agree to an appropriate valuation methodology and/or an expert valuation process. Careful thought should be given to any scenarios that might justify a reduction of the price payable. For example, a reduction might be appropriate in the case of Put Options for voluntary trigger events as mentioned above (say if an owner is forced out for breaching a Shareholders' Agreement or their employment is terminated for fraud). A reduction might also be appropriate in circumstances where an exiting owner fails to maintain an insurance policy as required under the Buy/Sell Agreement or otherwise invalidates an insurance policy.
A Buy/Sell Agreement is often fully or partly funded by insurance policies. For tax purposes generally 'principal ownership' is used (meaning each owner of the business owns their own
insurance policy). There are other options for insurance policy ownership but these can have
adverse tax consequences (including Capital Gains Tax outcomes on the payment of the
insurance policy proceeds). There may also be tax differences in the treatment of insurance
premiums. So tax advice is critical on these issues.
As an alternative, the owners may decide to use their own capital, borrow money to finance the
sale, and/or enter into a vendor finance arrangement. However, it is difficult to predict if at the time a sale is required the owners will have the funds available to make the purchase. Parties should consider the timing of the payment (up front lump sum or paid over time by way of installments). If payment is to be made over time by way of installments (vendor finance), security (e.g. a mortgage) and interest should also be considered.
Capital Gains Tax
Care must be taken when drafting Buy/Sell Agreements. Options should be used to avoid unintended Capital Gains Tax (CGT) consequences. The entry into of virtually any agreement can be a CGT event. However, a Buy/Sell Agreement using options without consideration will not trigger any CGT liability at the time of signing. Rather, the CGT event and resulting CGT liability will occur on the exercise of the options (i.e. when an unconditional agreement to buy and sell an interest in the business comes into force).
Likewise, where a business succession agreement (including a Buy/Sell Agreement) does not use options but makes the sale of a business interest conditional on an event occurring, the CGT event will not occur on signing but on that condition being satisfied. If the Buy/Sell Agreement includes vendor finance CGT must be carefully considered. Otherwise, a seller will incur the CGT and liability in one year but may only receive the sale price over a number of years.
David G Komatz has 49 years experience in all phases of accounting, leadership, management and Human Resources. His articles on succession planning have been written after extensive research into the topic and applying his many years of experience to the topic.