Safeguarding your business with the crucial buy-and-sell agreement every partner needs to consider

Question

I run a business with two partners. Things are fine now, but what if one of us dies? A friend passed away last year, and it ended up in a messy legal fight between his family and the business he founded. How do we protect the business and make sure our families are treated fairly?

Answer

That’s one of the most important questions a business owner can ask. Many South African businesses end up in trouble when a key director dies and the remaining directors do not have a plan of action.

You need to think through what would happen to the business if one of the founders were to become disabled or pass away. Do you really want to have an executor or a spouse who has never been involved in the business before being involved in the decision-making of the company?

A solution is to have a buy-and-sell structure in place. This structure will ensure that if a co-owner dies or becomes disabled, the business will carry on seamlessly, as there is a continuity plan. The remaining owners will buy the shares of the exiting shareholder, and the exiting shareholder or their estate will sell these shares at a pre-agreed price.

This will remove many of the causes of messy legal fights that often ensue when a co-owner of a business passes away. 

A good buy-and-sell agreement sets out: 

• who buys the shares of the deceased or disabled person
• how the price is determined
• where the funding will come from
• how disputes will be resolved

Instead of negotiating with grief or uncertainty, you execute a pre-agreed sale at a pre-agreed valuation.

How a buy-and-sell structure works

A buy-and-sell structure has two elements: the agreement and the funding engine. The agreement is a contract that defines the rules of the game. 

It should cover issues such as what events would trigger the buy-and-sell event. These would typically be events such as death or permanent disability. 

It should also cover items such as how the business would be valued and which director would buy which shares. It should also include timeframes for execution and specify dispute resolution mechanisms.

The funding makes sure the promise can be kept. 

A buy-and-sell without funding is just wishful thinking. Most companies use life cover to fund the shares because the payment will be quick, the funding is predictable and the capital amount is guaranteed. This is also more affordable than stockpiling cash or taking a distressed loan.

The most common way of doing this is that each owner takes out a policy on the lives of the others. When someone dies or becomes disabled, the surviving owners receive the payout and buy the shares as itemised in the buy-and-sell agreement.

There are several ways in which this could be structured, and I would recommend that you consult with a certified financial planner to find the most appropriate mechanism for your business.

The premiums would not be tax deductible, so you would need to budget for them from after-tax money. The proceeds, however, would usually be tax free. 

I would recommend that you keep a simple one-page diagram in your finance file showing the policy owners, lives assured and who pays which premium. I find that having a picture like this really helps everyone know how the plan works.

Valuation of the business

It is vital that you all agree on the value of the company and that this number is arrived at in a transparent and independent way. 

There are several ways of valuing a company, and it is important that you all agree on the method you are going to use. The valuation of the company must be updated each year and the life insurances that you have in place must be adjusted accordingly. This will ensure that all parties are treated fairly and that there are no fights over the value of the company in time to come.

It does take a bit of effort to set up these buy-and-sell structures, and many businesses put off doing so. However, by having one of these in place you protect both the business and the families of the directors in the event of something tragic happening. DM

Kenny Meiring is an independent financial adviser. Contact him at 082 856 0348 or at financialwellnesscoach.co.za. Send your questions to kenny.meiring@sfpwealth.co.za

This story first appeared in our weekly Daily Maverick 168 newspaper, which is available countrywide for R35.