Shareholder agreements support successful successions
If your business is co-owned, a shareholder agreement can help guide shareholder relationships through specific future events or instruct how specific issues will be handled if they arise. A properly drafted agreement can help ensure a smooth transition in ownership or keep management disputes to a minimum when the unexpected occurs.
The buy-sell agreement
Many businesses have, or should have, a buy-sell agreement in place. This arrangement provides helpful guidelines and instructions for the transfer of shares. It assures:
- Shareholders can convert shares into liquid assets for retirement income
- Shares will only be sold to parties approved by all shareholders
- Shareholders’ beneficiaries can receive diversified assets upon death, and
- Share valuation method is established.
Types of buy-sell agreements
There are two basic types of buy-sell agreements available to shareholders. The third is a hybrid of sorts.
- Cross purchase – An agreement in which the shareholders who will remain with the corporation purchase the shares of one who is retiring or who has passed away.
- Share redemption – The Corporation is required to purchase the shares of a retiring or deceased shareholder. It also can guide redemption for other events like employment termination.
- Combination – The Corporation redeems a certain amount of shares and the remaining shareholders purchase the rest. It may offer shareholders the first option to purchase as many shares as they want, and the Corporation redeems the remaining shares.
Funding the buy-sell agreement
A common method is insuring the lives of the shareholders with either term life (premiums increase throughout the coverage period) or whole life (premiums remain level throughout the coverage period).
With a cross-purchase agreement, you and fellow shareholders purchase policies on each other – which can get complicated if your corporation has more than a couple of shareholders. For example, if your corporation has five shareholders, 20 insurance policies are needed and the plan relies on the continued payment of premiums by each of you.
Under a share redemption agreement, the corporation purchases one policy on the life of each shareholder, greatly reducing insurance costs and simplifying implementation of the agreement.
The value of a successful business will grow over time. If the buy-sell agreement ties the purchase price to fair market value, you should make sure additional life insurance can be purchased over time to keep up with value. This can be taken care of with guaranteed insurability options when the policies are initially purchased.
When a shareholder dies
In the case of a cross-purchase agreement, several issues may arise regarding policy ownership by the deceased and the remaining shareholders.
- For example, the deceased may have owned policies on other shareholders. Those policies likely carry beneficiary designations, usually family members.
- With whole life, the beneficiaries inherit the cash surrender value of the policies.
- With no continued business purpose for the policies, the beneficiaries may elect to choose to cash out the value.
Don’t set it and forget it
When you execute a shareholder agreement, it needs to come off the shelf to be re-evaluated from time to time – preferably annually. Businesses change over time, so you’ll want to know that the contingencies in the agreement are still real possibilities in the future.
Seek professional guidance
There are many types of shareholder agreements and even more factors that go into creating them. The investment of time and fees to hire a qualified lawyer to draft one and review it annually could prove invaluable. It’s also wise to talk to your financial advisor about how an agreement of this type will affect your financial plan.
RE-EVALUATE THE VALUATION
Just because everyone agreed on a particular valuation method back when the shareholder agreement was executed doesn’t mean it’s the best one now. There are many business valuation methods available to value the shares of a departing or retiring shareholder. If another valuation method better fits the needs of the business and shareholders, then it may be time to revise the agreement.
The information contained herein has been obtained from sources considered reliable, but we do not guarantee that it is accurate or complete. Material prepared by Raymond James for use by its financial advisors.