Business Succession Planning Part 1: What a Shareholder's Agreement Means to You
There are way too many business owners out there who assume that their business will provide for them in retirement, without actually considering how the business should succeed them.
And more business owners yet who are part of partnerships with other owners who all start as friends or family members with the best of intentions, but don't stop to consider and prepare for the inevitable - be it the death or disability of an owner, a marriage breakdown, or a falling out between co-owners.
Without properly giving these scenarios due consideration and preparing for them diligently, disaster can prevail.
A Shareholder's Agreement is one such way to cover off the bases and provide a road map for the tricky world of life's twists and turns.
A Shareholder's Agreement is also known as a Buy-Sell Agreement, or Business Will. Although there is reference to shares in both the title and many of the clauses, similar agreements are drafted for non-corporate partnerships and will cover many of the same issues.
What's Covered in a Shareholder's Agreement
A Shareholder's Agreement will dictate exactly what happens when:
- A partner wants to sell their share
- A partner becomes disabled
- A partner dies
…among other life circumstances that may affect the business, which we will discuss below.
Advantages of a Shareholder's Agreement
- Preserves value of the business
- Satisfies the needs of surviving owners
- Minimizes tax implications
- Maintains harmony between surviving family members and business partners (in the event of a death or disability)
Clauses to Include
Following are a number of clauses that business owners may want to consider putting into their Shareholder's Agreement:
This clause will dictate the restrictions on each owner's ability to sell, give, or bequeath their share of the business to anybody outside of the group of owners without prior permission or approval.
Obviously this is important, in order to maintain the synergy and efficiency flow of the business's operations.
How will the company be valued in the event of a sale (either of the business entirely or of an owner's share thereof)? Will you have a professional valuation? Or use the adjusted book value, or capitalized earnings, or a combination?
3) Funding Clause
This details how the owners can buy the shares of a disabled or deceased owner through the use of specific insurance policies. (These will be addressed below and in future articles in this series).
4) Payment Clause
This specifies exactly how payment can be made when buying another owner's share. Options include a lump sum, instalments, as well as the interest charges on unpaid balances.
5) First Right of Refusal
First Right of Refusal allows a co-owner who wants to sell their share of the business to do so, but they must first offer their share to the other co-owners. If they refuse to buy, the selling co-owner has the right to sell to a third party at the same price they offered to the co-owners or higher (but not lower).
6) Shot-Gun Clause
"You buy me out right now, or else I'm going to buy you out"!
With this clause, an owner would approach the other owners and offer to sell their share of the business for "x" dollars. If the other owner(s) refuse to buy, then their share of the business will be bought for that price. It is often used in the event of a falling out of the owners, as it culminates in one of the partners being bought out.
This gets sticky if one of the owners is in financial trouble and the other owner knows about it and exploits it. They can offer to sell their share under the shot-gun clause, knowing that the owner in financial trouble doesn't have the ability to pay up. Then, the sneaky one has the right to buy out the other owner. And unless this clause is worded correctly, the price could be well under the fair market value, but the owner in financial duress would have no choice but to sell at that price if they can't buy out the other owner at the same price.
If one of the owners becomes permanently disabled (or disabled long term without an end in sight), such that they can't perform their tasks as part-owner, it is often best that their share is bought out. Issues to address in this section of the agreement include:
- How the buyout is funded (since the individual owners or company books probably don't have the cash hanging around to do this - there are insurance policies for this sort of transaction)
- Terms of the disability which will trigger the buyout. For example, how long must the disability continue before the buyout process begins, and exactly what are the criteria the disability (and its effect on the business).
Similar to disability, how is the deceased owner's share dealt with? Usually life insurance on the life of each business owner is used to fund the buyout, but even then there are different ways to structure the policy.
It can also be written into the buy-sell agreement that the deceased's shares are to be bequeathed to a spouse or child until their own death, at which time the shares are sold to the remaining owners or redeemed back to the company itself.
So many business owners assume that their business will somehow take care of them in their retirement years, not knowing exactly how. Salaries and bonuses are often the main form of income (rather than share dividends), so when the salary stops as the active work does, what will provide for retirement income? Will there be money in the company to buy out the retiree's share? Proper structure and funding around retirement is an essential part of the buy-sell agreement and business succession plan.
10) Marriage Breakdown
If one of the owners gets divorced, that owner's shares may be subject to a division of property along with everything else that gets split. This can obviously wreak havoc with a business, if a divorced spouse suddenly becomes part owner of a business they had no previous involvement in when the marriage was on solid ground.
As with any legal agreement, thorough discussion is a pre-requisite to a trip to the lawyer's office. The topics covered off above are rarely ones that just "come up" over drinks after work, so a special and concerted effort must be made to ensure the business will continue to run smoothly and successfully in the event that life throws us those inevitable curve balls.