Buy-sell agreements: cross-purchase vs entity purchase, valuation clauses, and funding with insurance

Two partners own a firm. One dies. His shares pass under his will to his wife, who now owns half of a business she has never worked in, needs the income from, and cannot sell to anyone but the surviving partner, who cannot afford them. Every outcome from there is bad for both: a forced sale at a discount, a dividend policy fought over at every board meeting, or a lawsuit. The buy-sell agreement is written the day before, when both partners are alive and can agree.

The price is the fight. Options: a fixed value reviewed annually (and never reviewed, so the price is a decade stale), a formula (a multiple of earnings or revenue, updated each year end), or an independent valuation at the trigger (fair, slow, expensive, and argued over). Most well-drafted agreements use a formula with an independent valuation as the fallback, require the owners to sign the annual number, and set a floor equal to the insurance in place. The tax authorities in the United States, Canada and Australia will not accept a buy-sell price as the estate value unless it was arm's length and binding in life as well as at death, so the formula has to be defensible.

Two owners, 50% each, business valued at US$4 million. Under a cross-purchase agreement each insures the other for US$2 million. On the first death the survivor receives US$2 million tax-free, pays it to the estate for the shares, and owns 100% with a US$2 million basis in the shares bought. The widow has cash instead of half a company. The premiums, perhaps US$4,000 a year each for ten-year term at forty-five, are the cost of that certainty. Disability cover on the same terms covers the trigger that is statistically more likely before sixty-five, and is the cover most agreements forget: a disabled partner who cannot work and cannot be bought out draws a salary from a business the other partner is now running alone.

Permanent disability, divorce (so an ex-spouse cannot end up an owner; the agreement gives the company or the other owners a right to buy any shares awarded in a property settlement), bankruptcy, retirement, departure, and, in some agreements, a "shotgun" clause for deadlock. Each needs a price and a funding source; insurance covers the first two, and an instalment plan over three to seven years with security over the shares usually covers the rest. Good-leaver and bad-leaver pricing (full value for retirement, a discount for a breach) is standard in shareholders' agreements and belongs here too.

In the shareholders' agreement or the partnership deed, cross-referenced by the company's constitution, with the policies listed in a schedule and the insurer told the agreement exists. The will should leave the shares to the estate or a trust, not to a named person, so that the agreement can operate; a will that leaves the shares to the widow directly creates the problem the agreement was drafted to avoid. In Australia, the family trust that usually owns the shares needs the agreement to bind the trustee; in the United States, S-corporation status needs the buyer to be an eligible shareholder.