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The ins and outs of a buy and sell agreement

Oct 4, 2015

Tanya Lochner of Glacier Fiduciary Services discusses a buy and sell agreement as an exit strategy where there are two or more partners in a business.

buy-sell agreementA business needs to prepare for the event of one or more of the partners dying or becoming disabled. Putting a buy and sell agreement in place can ensure a smooth transfer of shareholding between partners. This guarantees continuity for the business and peace of mind for the deceased or disabled partner and their family.

Replacement of a deceased or disabled partner in a business can take time, sometimes with dire consequences on the operational ability of the business. Offering the shares or member’s interest to remaining shareholders or members, or even an outside party, has certain legal requirements. A shareholders’ agreement or Memorandum of Incorporation seldom makes provision for all the practical aspects of transferring ownership to new parties. A separate buy and sell agreement is therefore required to ensure that all the necessary requirements and relevant processes are set out meticulously. It’s important to note that, in terms of the Companies Act, no other agreement may supersede the shareholders’ agreement or Memorandum of Incorporation. It is therefore necessary to ensure alignment of the buy and sell agreement and Memorandum of Incorporation.

Another aspect to consider is whether the deceased or disabled partner had a loan account that the business owes to him or her. The executor of the deceased partner’s estate will call up the loan account, which affects the value and risk profile of the business.

An example

X-success (Pty) Ltd is currently valued at R15 000 000. There are two loan accounts owing to the two shareholders of R2 000 000 and R1 000 000 respectively. The valuation of the business will therefore be as follows:

Market value                                         R15 000 000
Less: Liabilities (loan accounts)       R 3 000 000
Total value                                            R12 000 000

From the example it’s clear that if the loan account is not settled first, the value of the business will be R12 000 000 as opposed to R15 000 000.  It is therefore important to make provision for both the loan accounts as well as the full market value of the business in the buy and sell agreement and underlying funding.

There is currently a debate about whether the loan account/s should be included in the buy and sell agreement and attached value of the business.  It is therefore important to seek professional advice for each situation to determine what the best structure will be.

The partners

The remaining owners of a business may be faced with some challenges when a co-owner suddenly dies or becomes disabled. These include not having the resources to purchase the available shares or having to deal with a surviving spouse or family member as a new partner.

They may also be faced with an executor who interferes with the business or wants to sell the shares to the highest bidder.

The agreement

A properly drafted buy and sell agreement will ensure certainty for the business entity as well as the owners of the business.  Essentially it will provide:

  • Certainty on what will happen with a partner’s share in the business, should she or he pass away;
  • Mutual agreement between partners about what valuation method will be used to determine the market value of the business;
  • The timeframe within which transfer must take place; and
  • The funding mechanism that will be used to buy the deceased partner’s share.

Structuring the agreement

Structuring the agreement correctly is of utmost importance. Let’s look at some of the important elements of the agreement.

1. Parties to the agreement

It’s important to ensure that the real owners of the business are party to the agreement. Issues such as whether all parties are selling, and in the same proportion, need to be decided upfront. Also ensure that where a trustee as representative of a Trust is involved in the agreement, the necessary resolution and power of attorney have been granted to that trustee.

2. Sale

The transaction needs to be set out in clear terms and conditions of who is selling what to whom. It must place an obligation on the seller to sell ownership to a specified buyer who is obligated to buy at an agreed predetermined price.

3. Purchase price

This is often the most problematic aspect of the sale.  Parties need to agree on what valuation method will be used for the business. There are different ways in which to value the business, including the Earning/Yield method, Net Asset Value or Price/Earnings value. Unfortunately, often the value of the business is linked to the life insurance policy taken out to buy out the deceased partner’s share. The risk with using this method is that the actual market value of the business at date of death may be substantially different from that of the policy proceeds, which will result in donations tax and a possible loss in the estate duty exemption on the buy and sell policy.

4. Funding mechanism

The agreement needs to state what mechanism will be used to fund the purchase and sale agreement.  Should the agreed mechanism fail, provision must be made for alternative means.

5. Termination

Termination of the agreement also needs to be specified. It is especially important that provision is made for the event of simultaneous death of all the parties to the agreement.

6. Signatures

The agreement will only be valid if the registered owners of the shares / member’s interest sign the agreement in the presence of witnesses.  Be careful of in-community-of-property marriages, as the spouse will also have to sign the agreement.  Many agreements fail because not all the parties have signed the agreement or have signed it incorrectly.

The funding mechanism

Traditionally, a life insurance policy is used to fund the sale and purchase of the shares or member’s interest.  It is important that the policy be structured correctly to sufficiently cover the actual market value of the shares or member’s interest being purchased.  If correctly structured, a policy funding a buy and sell agreement transaction will not be subject to estate duty.

In terms of section 3(3)(a) of the Income Tax Act, any amount due and recoverable under any policy of insurance which is a domestic policy (as defined in section 1 of the Act) upon the life of the deceased is regarded as deemed property of the deceased.  The requirement for inclusion in the estate of the deceased as deemed property for estate duty purposes is not whether the deceased was the owner of the policy or not, but whether it was her or his life which was assured.

If any of the parties are not insurable for whatever reason, there are alternative ways to address funding of the transaction.  An investment account can be set up or the agreement can make provision for the purchase price to be paid in instalments over a specified term.

Conclusion

It is essential that all the elements discussed above be taken into consideration when deciding on how to structure a buy and sell agreement for your business.  It requires expertise and knowledge on both legal and insurance aspects to ensure the full benefits will be achieved from the transaction.

Glacier by Sanlam offers a wide range of financial solutions, designed to assist affluent clients to create and preserve their wealth throughout their lifetime.

5 Comments

  1. what happens to a buy and sell agreement with regards to an inactive co-shareholder?

    Reply
  2. Who is the policy owner: the individuals or the company?

    Reply
  3. Can spouses that are 50/50 partners in a business do a buy&sell agreement?

    Reply
    • Hi Maya,

      Myself and my husband have a business together, which we own 50/50. We would like to do a buy and sell agreement whereby we buy each other out on death and disability. As we are both partners in the business but also each other’s heirs (in terms of our Wills), will we need to adjust our sums assured to account for estate duty or will the life assurance policy proceeds still be exempt from estate duty and income tax in our estates, even though the policy proceeds ultimately also accrue to ourselves?

      As I have it, as we are both partners in the business, premiums will not be paid by ourselves as lives assured and the purpose of the policy is to acquire each other’s shares, the policy proceeds should be exempt from estate duty?

      Secondly, should we include a non-executive director as partly to the buy and sell – to either buy our shareholdings outright (our full 50% shareholdings) or in equal shares (i.e. 25% to to the remaining shareholder and 25% to the non-executive director), will we need to adjust the sums assured to account for estate duty?

      Your clarity in this respect will be appreciated.

      Reply

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Maya Fisher-French author of Money Questions Answered

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