Secure Your Business Future with a Buy-Sell Agreement
Singapore’s Small & Medium Enterprises (SMEs) account for more than 97% of businesses in Singapore.
However, many SMEs business owners don’t have a plan for what will happen when they retire and leave their business.
The transition can be difficult without a plan, and the business may fail.
A Buy-Sell Agreement provides a structure to ensure a smooth transition and protect the interests of the owners and the business.
Table of Contents
1. What Is A Buy-Sell Agreement?
- A Buy-Sell Agreement provides a structure to ensure a smooth transition and protect the interests of the owners and the business. It is essentially an agreement between business owners which specifies the provisions for death, incapacity, retirement, or business withdrawal.
2. Purpose Of A Buy-Sell Agreement?
- The primary purpose of a Buy-Sell Agreement is to ensure that the business continues and that the departing owner (or his beneficiaries) receive a fair market price for their interest in the business.
- This is why this Agreement is vital for business owners since it can help avoid disputes among the owners.
3. How Does A Buy-Sell Agreement Structure Work?
- A Buy-Sell Agreement sets out the terms and conditions, thereby providing a structure for the smooth continuation of the business.
- The business owners would have to arrange a funding mechanism to ensure the funds required for the buy-out will be ready and available.
4. Case Scenario – TANWONG Pte Ltd
NO BUY-SELL STRUCTURE IN PLACE
Mr Tan and Mr Wong jointly own and operate a car repair workshop.
The workshop has been successfully running for over 35 years, with the two businessmen sharing ownership equally. They have been friends and business partners for a long time and operate the business informally.
They made all business decisions jointly or strived to reach at a mutually acceptable compromise even when they didn’t initially agree. This approach has worked well for them, as they could maintain the trust and cooperation essential for a successful business partnership.
Mr Tan dies suddenly of a heart attack, leaving no will.
By the intestacy succession laws, his wife owns half of his assets, and his two sons share the other half.
Mr Tan’s assets comprise his shares in TanWong Pte Ltd.
Mr Wong now finds himself in a difficult position because he has to work with Mrs Tan and her two sons.
- They all have equal voting rights on the company’s board.
- Through the unexpected demise of his business partner, Mr Wong now finds himself in a regrettable position of having business owners imposed upon him with no genuine interest or knowledge of the business.
BUY-SELL STRUCTURE IN PLACE
The situation illustrated above could have been avoided by executing a Buy-Sell Agreement between the business owners while Mr Tan was still alive.
Suppose Mr Tan and Mr Wong had met up with their lawyer and agreed on the terms of a Buy-Sell Agreement while Mr Tan was still alive.
- In that case, they could have mutually agreed to allow either party to buy the other’s shares at a specified price on the demise of either party.
- Additionally, they could also have bought insurance policies on each other’s lives, with the result that upon the death of either business owner, the beneficiary of the policy (the surviving business owner) can use the insurance proceeds to buy the deceased’s share of the business from his next of kin.
In this case scenario, on Mr Tan’s death, Mr Wong would become the business’s sole owner, TanWong Pte Ltd. At the same time, Mr Tan’s heirs would receive a fair value for his shares in the business.
5. Funding A Buy-Sell Structure
- There several options to fund a buy-sell structure:-
- Cash payments from personal savings,
- Third-party borrowing,
- Sale by instalments,
- Disability insurance, or
- Life insurance.
- One of the most common and effective methods of funding a buyout of a disabled or retiring partner is the use of insurance policies since this method provides several advantages over other methods of funding.
6. Types of Buy-Sell Agreements
The funding mechanism and the business structure are critical considerations in deciding which type of Buy-Sell Agreement is best for your business.
A. Cross-Purchase Agreement
- This is the most common type of Buy-Sell Agreement used by business owners.
- In a cross-purchase arrangement, each business owner buys life insurance for the other owners.
- In the event of an owner’s death, the surviving owners use the insurance proceeds to buy the deceased owner’s share of the business.
- This setup is suitable for businesses with a small number of owners.
B. Entity Redemption Agreement
- In entity-purchase arrangements, the owners’ life insurance policies are bought by the business itself.
- If an owner passes away, the business buys the deceased owner’s share of the business with the money from the insurance.
- This setup is suitable for businesses with multiple owners.
C. Hybrid Buy-Sell Agreement
- The hybrid arrangement combines elements of both cross-purchase and entity redemption arrangements.
- Each owner of a business in a hybrid arrangement can decide if they want to buy out the “exiting” owner’s shares (like in a cross-purchase agreement) or have the business buy back the shares (like in an entity redemption agreement).
- This flexibility allows business owners to tailor the agreement to their needs and circumstances.
7. Key Provisions Required In A Buy-Sell Agreement
A properly drafted agreement must contain the following 3 key provisions.
A. Triggering Event
- A triggering event is an event that would activate the agreement.
- Common triggering events include death, disability, and retirement.
- In the case of the death of an owner, a lump sum payment is usually paid to the deceased owner’s beneficiaries.
- In the case of a disabled owner, provisions of the Buy-Sell Agreement would allow the disabled owner to exit the business with an agreed payout.
- In the case of a retiring owner, the provisions of the agreement would usually provide for the retiring owner to exit the business with an agreed payout.
B. Valuation Method
- The valuation method used to determine the value of the business is critical. To prevent disputes between the owners, it is important to select a method for valuation that is fair and acceptable to all.
- The agreement should set out a method of valuing the business in the event of a triggering event.
- To prevent disputes between the owners, it is important to select a method for valuation that is fair and acceptable to all.
It’s best to consult a professional business valuation expert who can provide valuable guidance in choosing the best valuation method that accurately assesses the business’s value and ensures a fair outcome for all parties.
C. Funding Mechanisms
- To ensure sufficient funds to buy out the interests of the departing owner, it is necessary to determine the funding mechanism of the buy-sell.
- Funding mechanisms include cash payments from personal savings, third-party borrowing, sale by instalments, disability insurance, or life insurance.
- Cash or Personal Savings
- This means that all business owners would use their own cash or personal savings to fund the buy-out.
- Third-Party Borrowing
- This means that business owners or the business itself would obtain some form of financing to fund the buy-out.
- Instalment Purchase
- This means that the remaining owners pay the purchase price of the shares to the departing owner by way of regular instalment payments over an agreed period.
- Life Insurance
- This means that each business owner is both a policyholder and the beneficiary of a life insurance policy. In the event of a triggering event, the insurance proceeds would then be used to purchase the departing owner’s share in the business.
- Cash or Personal Savings
8. Who Should Execute A Buy-Sell Agreement?
- A common misconception is that any business owner, including a sole proprietor, can execute a Buy-Sell Agreement.
- However, as the parties to a Buy-Sell Agreement include all the business owners, it would be impossible for a sole proprietor to execute such an agreement.
- While sole proprietors can also undertake business succession planning, the mechanisms for succession planning for sole proprietors relates to “Keyman Insurance“.
- Partnerships and companies are the types of businesses that can gain the most from signing a Buy-Sell Agreement.
- With a buy-sell structure in place, these business owners can make sure that the business can keep running even if one of the owners or managers passes on or becomes otherwise unable to do so.
- This can be critical for preserving the value of the business and ensuring that it can continue to generate profits for the owners.
9. When Should A Buy-Sell Agreement Be Executed?
- Many owners of successful businesses put off executing the agreement until it’s too late.
- Business owners need to create a Buy-Sell Agreement as soon as possible.
- This will help ensure that the business can continue to operate smoothly in the event of the death or disability of one of the owners.
By creating the Buy-Sell Agreement now, you can avoid costly and time-consuming disputes later.
Editor’s Note: This article was originally published in March 2023 and has been completely revamped and updated for accuracy and comprehensiveness.
No one ever expects to die or become disabled, but the truth is that it can happen to anyone at any time. If something happens to one of the owners of your business, the rest of the team will need to know what to do. Who will take over the business? How will the finances be handled?
We can help you create a Buy-Sell Agreement tailored to your business needs. We will work with you to ensure that all your bases are covered and that the Agreement is clear and easy to understand. By creating the Agreement now, you can avoid costly and time-consuming disputes later. Speak to us to get started!