Imagine this scenario…. Michael, James, and Nadine are shareholders in a successful business, MJN Solutions. The shares in the company are fairly evenly split reflecting the contribution that each has made to the business, with Michael and James each holding 35% and Nadine holding 30%. They have been working together for years to build the business to its current level. The business is now worth around $4 million and is still on a growth path. While no one is related to each other, everyone is close. They have had their disagreements but they trust each other and respect each other’s ability. It’s a fairly common scenario.
But one morning Michael and Nadine are shocked by a call from James’ wife Monica, telling them that James has died in a car accident.
If you are in business with shareholders, your business faces a major potential threat and its shareholders unexpected personal costs, if one of your fellow shareholders dies or becomes permanently disabled. And, the situation can be exacerbated where the shareholders are not related.
Good planning through buy/sell agreements and appropriate insurance can make all the difference.
For many businesses, if no pre-existing arrangements are in place, the death of a shareholder can mean having an unknown person (the beneficiary of the shares) actively involved in the business or an unwilling shareholder. The alternative is for the original shareholders to find the cash, then and there, to buy back the shares. Think about the value of your company…do you have enough cash to quickly fund the buy back for another shareholder?
What does a buy/sell agreement do?
Many companies do not have a plan in place that contemplates the untimely death of its shareholders or a break-up of the shareholders, and as a result, do not have buy/sell agreements in place.
Buy/sell agreements are legal documents that define what happens in an event that may trigger the disposal of a shareholder’s interest in a company. Amongst other things, the agreement determines how the company will be valued, and how shares can be disposed of in a series of scenarios including death.
Outcome 1 – Nothing planned
Michael and Nadine have a problem beyond dealing with the demise of a close friend and trusted professional in the business. While everyone knows that the unexpected can happen, nothing was planned or put in place to manage a worst case scenario.
James’ shareholding and the rights that come with it, transfer through his estate to his wife Monica. Monica however wants nothing to do with the business that consumed so much of her husband’s time. She just wants to cash out the shares and get on with her life.
MJN Solutions is still on a growth path and does not have the cash available to buy back James’ shares. This means that Michael and Nadine now need to personally fund the purchase of Monica’s shares (assuming they can come to an agreement about what the company is really worth). If they are unable to come up with the money, then Monica will become an unwilling shareholder.
Outcome 2 – Pre planning
Michael, James and Nadine worked with their accountants to put a buy/sell agreement in place to manage succession and unplanned events, such as the death of one of the shareholders. The buy/sell agreement defines how MJN Solutions will be valued and how the equity will be managed. In this scenario, the buy/sell agreement states that James’ shareholding will be purchased by Nadine and Michael if James dies or becomes permanently disabled.
During the planning process, the funding arrangements necessary were put in place should the buy/sell agreement be triggered. In this scenario, Michael, James and Nadine opt to manage the funding through an insurance policy taken out in their own names (another way would be to fund the policy through a self managed superannuation fund - although there may be changes in this area with the ATO flagging that they will soon release their position on insurance held through superannuation for buy/sell agreements. Whichever way you go, it will be important to get current, structured advice in this area).
When James dies, the insurance proceeds are used to purchase James’ shareholding. As a result, neither Michael nor Nadine are out of pocket or take on debt, they own an increased share of the business, they avoid having an unplanned shareholder running the company, and they can get on with business.