What would happen if a co-owner of your business suddenly passed away, became bankrupt, retired or became permanently unable to work? What would happen to their interest in your business?
In this article, our Estate Planning team, has considered these questions and explains the importance of putting in place an appropriately drafted Buy/Sell Agreement (and corresponding insurance) to ensure certainty when business partners divorce.
Consider the following scenario:
- X and Y are shareholders of a company, say ‘ExampleCo Pty Ltd’.
- ExampleCo Pty Ltd operates a successful business which has experienced recent market growth.
- X and Y have not entered into a Buy / Sell Agreement (or anything similar) and do not have corresponding insurance in place.
- Suddenly, Y passes away.
What happens to Y’s shares in ExampleCo?
Generally speaking, if business co-owners do not agree otherwise, a business owner’s interest (e.g. shares in a company, units in a trust or a partnership interest) will pass to their estate on their death. This could result in a range of adverse implications including:
- significant interruption to the business (for example, in the scenario above, X will need to consider the interest of Y’s estate when making decisions at shareholder level);
- a forced sale of the business to provide finance for the family of the deceased co-owner;
- the outgoing owner (or their estate) receiving an amount that is far less or more than ‘market value’ for their interest in the business; and
- challenges or disputes in relation to matters such as ownership / control of business assets, whether the family members of a deceased co-owner are entitled to participate in the running of the business and how much is to be paid for the deceased co-owners interest in the business.
These circumstances can continue for a long time causing significant damage to the business and its reputation (particularly if the ongoing business owners are unable to reach agreement with the deceased owner’s estate quickly). In the scenario above, this could spell disaster for X and ExampleCo Pty Ltd in circumstances where the business was just beginning to gain traction in the market.
Buy/Sell Agreements are contracts between the owners of a business used in the context of business succession to allow for the sale of a co-owners’ interest on the occurrence of a specified triggering event, such as their death, permanent total disablement (PTD), bankruptcy or retirement (Trigger Event). There are many different ways these agreements can work. For example, the agreement can allow the remaining owners (or the business itself) to purchase the outgoing co-owner’s interest (i.e. a call option). Alternatively (or sometimes concurrently), the agreement could allow the outgoing co-owner (or their estate) to sell their business interest to the remaining owners (i.e. a put option). Often the agreement is structured with both a put and a call option.
Buy/Sell Agreements are commonly used in conjunction with an appropriate policy of insurance to ensure that the remaining owners have the capacity to fund the acquisition of the outgoing or deceased owners’ interest. Upon the occurrence of a Trigger Event, the remaining owners will apply the “pay-out” from the insurance policy to pay the outgoing principal’s business.
There are a broad range of ways that a Buy/Sell Agreement can be structured (including in relation to who has the right to buy / sell a business interest on the occurrence of a Trigger Event and in whose name insurance will be taken out), each having different tax consequences. A poorly drafted Buy / Sell Agreement can have detrimental tax consequences for the continuing business owners and the existing owner (or their estate). We work closely with our clients’ accountants to ensure that Buy / Sell Agreement are prepared to have the intended tax outcomes.
While every business relationship is different, in our experience, it is usually easier for co-owners to reach a more reasonable position regarding the treatment of their respective business interests if appropriate action is taken before a Trigger Event occurs or becomes impending. It may become far more difficult to reach a fair agreement (or any agreement at all) in circumstances where an owner has decided (or is forced) to retire or otherwise exit the business because the continuing owners and exiting owner will have completely different objectives. These issues can be largely avoided by investing time in implementing a business succession plan (including a Buy / Sell Agreement).
This article was co-written by Lawyer, Erin Brown.
This article is not legal advice. It is intended to provide commentary and general information only. Access to this article does not entitle you to rely on it as legal advice. You should obtain formal legal advice specific to your own situation. Please contact us if you require advice on matters covered by this article.