How a standard Buy-Sell Agreement Works
A standard Buy Sell Agreement is drafted to apply only to ‘involuntary’ departures from a business caused by insurable events such as death, total and permanent disability or trauma and then only if insurance is able to be put in place to cover those events. It does not apply to ‘voluntary’ departures, such as an owner retiring or resigning from the business. Nor does it apply to an owner’s inability to work due to a condition not covered by insurance. If the owners want the Buy Sell Agreement to apply in these situations, it will need to be individually tailored to do so.
A standard Buy Sell Agreement is drafted on the basis that all of the owners of the business will be a party to the Agreement. If an owner does not wish to be a party to the Agreement, it will need to be individually tailored to cater for that situation.
1 The basic operation of the Buy Sell Agreement
A Buy Sell Agreement is a legal agreement between the owners of a business that obliges an owner to sell their interest in the business to the other owner(s), and for the other owner(s) to buy that interest, in certain circumstances – hence the name ‘Buy Sell Agreement’.
The particular circumstances (‘trigger events’) that trigger those obligations in our standard Buy Sell Agreement are the insurable events covered by the insurance policies specified in the Agreement. These may include the death and/or total and permanent disability (‘TPD’) of an owner and/or the inability of an owner to work due to a condition covered by trauma insurance (depending on what is specified in the Agreement).
The Agreement requires the owners to take out and maintain insurance cover for these ‘trigger events’ for specified amounts.
Where an individual holds their interest in the business directly, they take out insurance over their own life and health.
Where an individual holds their interest in the business indirectly through an entity such as a family company or family trust, the insurance is often (but subject to advice) taken out by that entity but over the life and health of the individual.
Subject to the exception mentioned below, where a trigger event occurs affecting an owner (the ‘affected owner’):
- the affected owner has a put option to require the other owner(s) (the ‘remaining owner(s)’) to buy them out; and
- the remaining owner(s) have a call option to buy out the affected owner,
for the purchase price specified in the Agreement, with the insurance proceeds received by the affected owner because of the trigger event effectively being treated as part of the consideration they receive for the transfer of their interest in the business to the remaining owner(s).
The exception referred to previously is trauma insurance. In that case, a trauma event will only trigger the put and call options if the affected person is unable to work for the business in the same or a similar capacity for a continuous period of 6 months.
2 Option exercise periods
The timeframes during which the remaining owner(s) may exercise their call option, or the affected owner (or their estate) may exercise their put option, for the different trigger events are:
Potential trigger event for Death or TPD*
Exercise period: The 6 month period beginning on the later of
(a) the occurrence of the death or TPD, or
(b) the date the affected owner notifies the other owner(s) that it has received the insurance proceeds under the death or TPD policy**
Potential trigger event for Trauma:
Where the trauma affects an insured person and they are unable to resume working for the business in the same or a similar capacity for a continuous period of 6 months
Exercise period: The 6 month period beginning on the later of
(a) the date that the insured person has been absent from work for a continuous period of 6 months as a result of the trauma, or
(b) the date the affected owner notifies the other owner(s) that it has received the insurance proceeds under the trauma policy**
* The actual trigger events that apply to each owner will be specified in a schedule to the Agreement.
** If the insurer disclaims liability, then the period mentioned in (b) runs from the date the affected owner notifies the other owner(s) of that fact.
For these purposes, ‘death’, ‘TPD’ and ‘trauma’ are given the same meaning as in the insurance policies taken out under the Buy Sell Agreement. This ensures that the Buy Sell Agreement dovetails in with those policies.
In each case, the earliest the exercise period will start is when the relevant insurance claim is paid. As a consequence, there will generally be a time lag between a trigger event and when the affected owner (or their estate) is paid for the sale of their interest in the business and the parties should plan their affairs accordingly.
3 The calculation of the purchase price
The Buy Sell Agreement specifies an agreed total value for the business and then allocates a ‘proportionate share’ of that total value to each owner by reference to their percentage ownership interest in the business.
The general principle underlying the Buy Sell Agreement is that if an owner is affected by a trigger event and the put or call option exercised, they should receive their proportionate share of the agreed total value of the business. To the extent possible, this is met by the pay-out on the insurance policy which covers that trigger event. If the insurance pay-out does not fully cover the affected owner’s proportionate share then (subject to the exception mentioned below) the remaining owner(s) must make up the shortfall.
This is achieved in the Buy Sell Agreement by making the purchase price for an affected owner’s interest equal to the difference between their proportionate share of the agreed total value of the business and the amount of insurance proceeds they receive under the relevant insurance policy. The affected owner therefore receives the full value for their interest in the business through the combination of their insurance pay-out and purchase price payable by the remaining owner(s).
There are 2 exceptions to this. The first is where the amount of insurance proceeds received by the affected owner is equal to or greater than the value of their interest in the business. In that case, the application of the formula in the previous paragraph would lead to the purchase price being zero or a negative number. To avoid legal complications that can arise in such a case, the Buy Sell Agreement specifies a minimum purchase price of $1. Where this exception applies, the affected owner receives the full value for their interest in the business through their insurance pay-out, plus an extra $1 from the remaining owner(s).
The second is where the insurance proceeds received by an affected owner are reduced due to a default on their part (eg because they fail to renew their insurance or to comply with their duty of disclosure and the insurer disclaims liability or reduces the payout under their policy). In that case, the remaining owner(s) effectively get a credit for the amount of insurance proceeds that should have been received by the affected owner but for that default. This is to ensure that the remaining owner(s) are not prejudiced in their ability to buy out the affected owner by something that the affected owner has done or failed to do.
To illustrate with an example, suppose owner A has a 60% interest, and owner B a 40% interest, in a business with an agreed total value of $1 million. The ‘proportionate share’ for A’s interest will be $600,000 and for B’s interest will be $400,000. Suppose A can only get TPD cover of $500,000 but B can get TPD cover for the full $400,000 and that is what the Buy Sell Agreement specifies for each.
In this scenario, if A suffers a TPD event, the purchase price payable by B for A’s interest will be $100,000 (the difference between A’s proportion share of the agreed total value, ie $600,000, and the insurance pay-out received under A’s TPD policy, ie $500,000). A receives the full $600,000 for their interest in the business, partly through the insurance pay-out and partly through the purchase price paid by B.
However, if the insurer refuses to pay out on A’s policy because, for example, A failed to make proper disclosure of an existing condition that contributed to the TPD event, B will still only have to pay $100,000 to buy A’s interest. A would only get $100,000 for their interest in the business (which is fair vis-à-vis B because it was A’s fault that they missed out on getting the extra $500,000 insurance pay-out).
On the other hand, if B suffers a TPD event, the purchase price payable by A for B’s interest will be $1. B will receive the full $400,000 value of their interest in the business under their TPD policy plus the minimum $1 purchase price payable under the agreement.
4 Updating the agreed total value for the business
The Buy Sell Agreement requires the parties to review the agreed total value of the business at least every 12 months. If they are not able to agree on the value, it can be referred to an independent valuer for determination.
If there is a change in the agreed total business value, the parties are required to review their insurance cover and update the Buy Sell Agreement by completing and signing a replacement Schedule 2. Until all owners have signed the replacement Schedule 2, the old valuation continues to apply.
Note that the owners cannot update the total business value once a trigger event has occurred. It is therefore important that the owners review the valuation of the business regularly and update the Buy Sell Agreement and the underlying insurance policies whenever there is a material increase in that value.
5 Some things that aren’t covered in the Buy Sell Agreement
The Buy Sell Agreement will only apply where an owner is unable to work in the business because of an insurable event specified in the Agreement (as mentioned above, this may include death, TPD and/or trauma). There may be situations where an owner has to, or wants to, exit the business that won’t be covered by the Buy Sell Agreement, including:
· an owner wanting to retire for age-based reasons or to resign for non-health reasons;
· an owner being unable to work because of an illness or malady not covered by insurance;
· an owner being affected by an event that is covered by a general or specific exclusion under their insurance policy that prevents them from making a claim under the policy.
You should consider with your advisers if or how these events should be dealt with and, if necessary, seek legal advice about the amendments needed to the Buy Sell Agreement for that purpose.
6 Termination of the Buy Sell Agreement
The Buy Sell Agreement will terminate automatically if:
· all of the owners agree;
· all of the relevant insurance policies are terminated or lapse;
· there is a change in the ownership interests in the business;
· the business (if it is a company) or an owner becomes insolvent;
· an option is exercised under the Agreement; or
· an option is exercisable under the Agreement but is not exercised during the applicable exercise period.
All of these events require the owners to reassess their position and to renew the Buy Sell Agreement if they wish it to continue to apply.
An owner can also terminate the Agreement if another owner materially breaches a material obligation under the Agreement.
7 Other material matters
If there are 2 or more remaining owners, the obligations of the remaining owners under the put and call options are joint and several. This means that if one of the remaining owners defaults in meeting their obligations to the affected owner, the other(s) become responsible for making good that default.
Where the business is set up as a company, upon the transfer of the affected owner’s interest to the remaining owner(s), the remaining owner(s) are required to assume all liabilities of the affected owner under any personal guarantee that the affected owner has given in respect of the company. At the reasonable request of the affected owner, the remaining owner(s) are also required to use all reasonable endeavours to have the affected owner released from any such guarantee.
Where the business is set up as a partnership, upon the transfer of the affected owner’s interest to the remaining owner(s), the remaining owner(s) are required to assume all liabilities of the affected owner connected with the partnership (for example, under any loans, property or equipment leases or guarantees). At the reasonable request of the affected owner, the remaining owner(s) are also required to use all reasonable endeavours to have the affected owner released from any obligations of the partnership to third parties.
To bring some finality to the relationship between the parties, the Agreement also provides that upon the transfer of the affected owner’s interest to the remaining owner(s), the affected owner releases the remaining owner(s), and the remaining owner(s) release the affected owner, from any claim or action which they may have against each other in connection with the business, other than under the Buy Sell Agreement. Each owner should consider carefully with their advisers whether the inclusion of such a release in the Buy Sell Agreement is appropriate in their particular circumstances.
If the name of the business includes the name of the affected owner, then unless otherwise agreed by the affected owner or unless the name in question is also the name of the/a remaining owner, the remaining owner(s) are obliged to cause the business to change its name to a name that does not include the affected owner’s name.
An owner is prohibited from granting any security over their interest in the business (eg a charge or mortgage to a bank) as that would interfere with the rights of the other owner(s) to buy their interest (if any owner has already granted security over their interest in the business, they must disclose that fact to the other owners and each of the owners must seek legal advice about the effect of that security before entering into the Buy Sell Agreement).
An owner must also ensure that any Will they have does not conflict with their obligations under the Buy Sell Agreement.
