In this second edition of our series on the risks that a business owner may face, we focus on a buy and sell arrangement as an exit strategy where there are two or more partners in a business.
A business needs to prepare for the event of one of more of the partners in the business dying or becoming disabled. Putting a buy and sell arrangement in place can ensure a smooth transfer of business interests between partners. This guarantees continuity for the business and peace of mind for the deceased or disabled partner and their family.
The business entity
Replacement of a deceased or disabled partner in a business can take time with sometimes dire consequences on the operational ability of the business. Offering the shares or members’ interest to remaining shareholders or members, or even an outside party, has certain legal requirements. A shareholder’s 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 is important to note that in terms of the Companies Act, no other agreement may supersede the shareholder’s 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.
Let’s look at 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 follow:
Market value R15 000 000
Less: Liabilities (loan accounts) R 3 000 000
Total value R 12 000 000
From this example it is 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 important to seek professional advice for each situation to determine what the best structure will be.
The remaining owners of a business may be faced with some challenges when a co-owner suddenly dies or becomes disabled. This may 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.
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 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
- The funding mechanism that will be used to buy the deceased partner’s share
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
The real owners of the business must be party to the agreement. Issues like whether all parties are selling and in the same proportion needs to be decided upfront. Also ensure that where a trustee as representative of a Trust is involved in the agreement, that the necessary resolution and power of attorney has been granted to that trustee.
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 many times 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 negative estate costs and taxes.
4. Funding mechanism
The agreement needs to state what mechanism will be used to fund the purchase and sale transaction. Should the agreed mechanism fail, provision must be made for alternative means.
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.
The agreement will only be valid if the registered owners of the shares / member’s interest sign the agreement. Be careful of in-community-of-property marriages – the spouse will also have to sign the agreement. Many agreements fail because the wrong parties have signed 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 to cover the actual market value of the shares or member’s interest being purchased.
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 his life which was assured. If correctly structured, a policy funding a buy and sell agreement transaction will not be subject to estate duty.
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.
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.
If you need help with structuring the right buy and sell agreement, contact Servo Fiduciary Services on firstname.lastname@example.org.