Should your business partner die, who would inherit his portion of the business, his wife, or his children? The sudden death of a shareholder in a closely held corporation can be a significant loss to the company’s on-going operations. It will leave a hole in the management team and could cause severe strain in decisions made by the surviving partners and new partner. The death of an important shareholder may also create enough concern at the corporate bank to freeze lines of credit or in the extreme, to call outstanding loans.
In married situations, it is typical for one spouse to leave the entire estate to the other and vice versa. If no other arrangements have been made the spouse of the deceased becomes the new shareholder. Is the spouse competent to have a say in the running of the business? Does the spouse want to continue to own a portion of the business? Does the surviving partner or partners like the spouse? There is an easy way to avoid the confusion and possible conflict that may arise in such a situation. That is the buy/sell agreement. There are a number of “triggering events” whereby the agreement may take affect. Death, retirement and disability are most often cited and one or all of them may be addressed in the agreement.
Let’s use a simple example of an incorporated business (although it may not be incorporated) that is today valued at $1,000,000 by the corporate accountant, where there are three partners, each owning one third (1/3). The company has been increasing in value at an average rate of 7% per annum. If this rate of increase continues, the company’s value will be about $2,000,000 in ten years. With this information, the partners approach the corporate lawyer in order to create a document that when signed by each partner will require the estate of the deceased to offer his shares to the surviving partners in proportion to their current holdings. Notice the word “offer”. This wording creates a choice for the surviving partners. In fact, they may decide the heirs to the estate would be a welcome addition to the partnership. However, this is not typical. For the surviving partners, they may be required to purchase or may just be offered the right of first refusal. A valuation formula is written into the agreement, so that whenever a death occurs there is no argument regarding valuation. As one can imagine, there are numerous clauses that could be written into a buy/sell and variations to the proportion of shares offered to each partner. Keep in mind that there are a number of ways of structuring a buy/ sell and the lawyer and accountant should both be involved. Knowing each partner’s personal and financial situation will assist them in structuring a document that will work best from an estate planning and tax perspective. Once a buy/sell agreement has been signed off by all shareholders the next step is how to fund the purchase of shares. This will be discussed in a follow-up article