Howard-Jones Insurance Services Inc.

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Funding of Buy / Sell Agreements

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Many co-owners of small businesses tend to function on a trust relationship without a written agreement to govern their activities. Each owner trusts that the other owners will act according to the relationship they have enjoyed. It may put the business at risk to place too much trust in this verbal agreement.

In particular, four things can happen to affect the relationship of many business owners:

Peter Howard-Jones
  1. The death of one of the owners;
  2. The permanent disability of one of the owners;
  3. The retirement of one of the owners; or
  4. Disagreement between the owners about how the business should be run

In all of these situations, the owners can find themselves dealing with quite a different situation than the one governed by the verbal agreement.

If an owner dies, the remaining owners are now dealing with the heirs and executors of the deceased owner. Do the heirs know anything about the business? If an owner becomes disabled or retires, the remaining owners are now dealing with an individual concerned with getting his or her "fair share" but who is no longer actively contributing to the business. In the case of disagreement, the remaining owners are now dealing with a hurt and angry individual.

When the business loses an owner, the remaining owners find themselves with essentially four options:

  1. They can close down the business, but who would want to do that after all the time, energy and money spent?
  2. They continue the business with the new owner of the former owner's shares, but do they want to be in business with an unknown party?
  3. They can sell the shares, but who will buy them, and at what price?
  4. The fourth option is to buy the shares from the disabled, retired or departed shareholder or the estate of the deceased shareholder.

This option makes a lot of sense. However, the question arises as to where the remaining owners will get the capital to make the purchase. Usually, the owners have invested most of their available capital in the business. They can borrow if their debt load is not already too severe. They can start a sinking fund today, but do they have the available cash flow? How much should they save?

A business should always have a shareholder's agreement in place, more commonly called a Buy-Sell Agreement. This legal document covers the terms of ownership and operation of the business and usually deals with the above-mentioned scenarios. The agreement often includes a formula or process for valuing the business to simplify the buy-out of an owner.

Simply put, the agreement should deal with:

  1. Who will buy the shares;
  2. What the terms of the sale will be;
  3. When the sale will take place;
  4. How much the purchase price of the shares will be.

To ensure the agreement is viable, proper funding must be in place. Without proper funding, agreements can fall apart. The remaining owners benefit from a funded buy-sell agreement because the business is able to continue on with no unknown players to deal with. The ownership transition is handled smoothly, quickly and effectively.

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