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Risk Management: When is a Buy-Sell Agreement useful?

Do you own a business with one or more individuals? Is your family involved in the business? It is probably safe to assume that you want the business to continue after you’re gone or for you to keep it running if a co-owner or partner dies first.

But circumstances can get in the way. If adequate provisions aren’t made, the business may flounder if a leadership void isn’t filled. Or bitter family disputes can tear the organization apart. In the end, a “distress sale” may leave your heirs with substantially less than the company’s current value.

Everyone is familiar with wills and the need for everyone to have one in place, but fewer people are aware that a business counterpart exists that can be very helpful in managing the exit of an owner in the event of their unexpected death or incapacity. In today’s post, we will be discussing a buy-sell agreement, a document that is often referred to as a ‘business will’. 

What is a buy-sell agreement?

A buy-sell agreement is a document that allows the parties to set out how their interests in a business will be dealt with upon a trigger event. This trigger event would generally be an involuntary event such as a party’s death and may also include total and permanent disability, trauma and critical illness. The agreement functions by means of put and call options, and binds the continuing owners of a business to purchase a party’s interest upon the occurrence of the trigger event.

When is it necessary and what does it do?

It circumstances where a business has more than one owner, that business should generally have a well-drafted buy-sell agreement in place. In essence, the agreement will manage the exit of an owner, and potentially the addition of a new owner. For example, if one owner dies, their spouse or partner may inherit an interest in the business and subsequently decide to take on an active role. It is understandable that most business owners would not appreciate the idea of being suddenly forced to have a new partner without being able to have a strong voice in the decision. 

How does it work?

The key mechanism of the agreement will work in one of two ways. Firstly, it may by that by exercising a call option, the continuing owners force the departing owner or their legal representative to sell their interest onwards to the continuing owners. Alternatively, the second option would be that upon exercising a put option, the departing owner or their legal representative compels the continuing owners to purchase the departing owner’s interest in the business. 

The agreement will be tailored to the specific entity’s business structure, such as a proprietary company, unit trust or partnership. It will generally be fully funded by the proceeds of a life insurance policy, whereby the departing owner or their estate is to be paid by the insurer an amount equivalent to the departing owner’s interest in the business in the event of their death or total and permanent disability. 

What are the benefits of a buy-sell agreement?

There are a number of important benefits provided to a business by having a buy-sell agreement in place, particularly in relation to risk management. It is an integral part of the planning process of any business. Some of these benefits include:

  • Significantly reduces the risk of any potential ownership disputes upon the occurrence of a trigger event; 
  • Provides greater ongoing certainty to business operations; 
  • Provides financial compensation to the outgoing proprietor or its estate for the disposal of its interest in the business upon the trigger event;
  • Allows a continuing proprietor of a business to easily purchase the outgoing proprietor’s interest upon a trigger event; and 
  • Provides financial protection and benefits in the event of one partner’s death or incapacity, as the surviving owners can focus on the impact of that partner’s absence rather than worrying about purchasing the share in the business or preventing a third party from gaining control of it. 

Conclusion

When a business has more than one owner, its owners should consider what is to happen to a business in the event of one of its owner’s death or other circumstances leading to their absence. One such option that can help with the planning process is a buy-sell agreement. If your business does not have a buy-sell agreement in place, we recommend obtaining legal and tax advice from our experienced team today to provide a greater level of certainty and risk-management to your business. 

Harris Gomez Group is a Common Law firm, with offices in Santiago, Bogotá, and Sydney. We also have legal teams in Peru, Bolivia, Ecuador, Brazil, and Argentina. Over the last 18 years, we have been supporting foreign companies with their growth in Latin America. Many of our clients are technology companies, service providers and engineering companies that focus on the mining, energy and infrastructure markets.

To better understand how we can support your management team in the Region, please contact Cody Mcfarlane at cmm@hgomezgroup.com