Buy-Sell Agreements: How to Write & Fund Them in Singapore
You may be working hard to build a profitable and flourishing business in Singapore today. But what if something happens to you and/or your co-owners one day? How will you be able to protect and ensure smooth succession of your business?
Business succession planning may provide the answer to the uncertain and unpredictable future. Specifically, you may wish to consider drawing up a buy-sell agreement to protect your Singapore business in times of unexpected events.
What is a Buy-Sell Agreement?
A buy-sell agreement is a contract that stipulates how the remaining owner(s) of the business is/are to buy over the shares of an outgoing owner upon the occurrence of a “trigger” event. A trigger event refers to an event that happens to a business owner(s) such that the business owner(s) exits the business. Some possible trigger events include:
- Death of a business owner;
- Retirement of a business owner;
- Total and permanent disability suffered by a business owner;
- Critical illness of a business owner;
- Bankruptcy of a business owner.
As an agreement that is legally binding between co-owners or partners of a business, a buy-sell agreement is important since it ensures that matters pertaining to the management and succession of the business were planned beforehand. It establishes procedures for the sale and purchase of shares, minimising possibilities of unhappiness and eventual litigation in future.
For example, in the absence of a buy-sell agreement, a spouse of an outgoing owner who was never involved in the business may inherit the shares. This might consequently create tension and problems in running the business if the spouse starts changing how things are done at the business for the worse.
Ideally, the buy-sell agreement should be comprehensive and would provide clear directions on matters such as:
- What happens to the shares of the outgoing business owner;
- How owners can sell or transfer shares;
- The price at which shares are to be bought over;
- How the purchase of the shares will be funded;
- Conditions for buying out the shares of the outgoing business owner.
Types of Buy-Sell Agreements
Generally, there are 2 types of buy-sell agreements:
An entity buy-sell agreement, also known as a redemption agreement, involves the business entity buying over the shares of the outgoing business owner upon a trigger event. This means that the business will enter into an agreement with each owner, on the understanding that the entity will purchase their respective interests in the event of a trigger.
Cross-purchase buy-sell agreement
A cross-purchase buy-sell agreement involves the transfer of shares to the remaining business owners upon a trigger event. Thus, upon a trigger event, the remaining surviving business owners will purchase the shares from the outgoing business owner as arranged in the agreement.
For example, X and Y are the owners of Corporation Z. X enters into a cross-purchase buy-sell agreement with Y. X dies. Y will purchase X’s shares according to the agreement.
Funding a Buy-Sell Agreement
Besides knowing what kinds of buy-sell agreements exist, you may be wondering how the purchase of shares under a buy-sell agreement would be funded.
The most common and preferred method would be via an insurance pay-out. While death and disability are usually covered under the insurance, coverage may be extended to include other trigger events in the buy-sell agreement, including bankruptcy.
Life insurance policies can be used to fund both types of buy-sell agreements mentioned above. The number of policies required, however, would depend on the type of agreement and the number of shareholders.
In the case of an entity buy-sell agreement, the entity would usually take out an insurance policy for each business owner. Upon a trigger event, the pay-out from the policy of the outgoing owner will be used to purchase his shares. Thus, the business is the owner, premium payer and beneficiary of the insurance policy that will be used to fund the agreement.
A cross-purchase buy-sell agreement would require all business owners to purchase insurance policies on each other’s lives. Then, upon the trigger event, the proceeds from each of the remaining owners’ policies will be used to purchase the shares from the outgoing owner.
Alternatively, other possibilities for funding include:
- Sinking funds: Holding back of business profits in order to cover the cost of a buy-sell agreement.
- Instalment: This involves buying over the shares by a series of partial payments over a period of time.
- Borrowing of funds: Business owners may attempt to acquire a loan for the purchase of the shares.
Despite these alternatives, there are clear benefits to the method of purchasing life insurance policies to fund buyouts. While an insurance would be able to guarantee the availability and sufficiency of funds for the buyout of the shares, the other three methods may affect cash flow and incur additional costs such as interest.
Choosing the Type of Buy-Sell Agreement
When deciding which type of buy-sell agreement would be more suitable, you should consider the following factors:
Number of shareholder(s) and insurance policies
Due consideration must be given to the number of shareholders or business owners involved, as it would affect the number of insurance policies that must be taken out.
For an entity buy-sell agreement, the number of insurance policies needed to fund it is relatively simple. Essentially, the number of policies required is equal to the number of business owners. For example, if there are 5 business owners, then only 5 policies need to be purchased.
For a cross-purchase buy-sell agreement, however, each business owner has to purchase and own life insurance on the lives of the others.. As a result, the policies purchased may outnumber the business owners as compared to an entity-buy sell agreement.
The number of policies can be calculated using the formula: n x (n-1), where n is the number of business owners. For example, if there are 5 business owners, the total number of policies to be purchased is 20 (using the formula: 5 x (5-1) = 20), which is 15 more than the number of policies required for an entity buy-sell agreement.
As a result, where there are multiple business owners, a cross-purchase buy-sell agreement can be cumbersome given the number of policies required to fund it.
In such cases, an entity buy-sell agreement may be more efficient and easier to administrate.
Willingness and ability of remaining business owners to buy over the shares
In a cross-purchase buy-sell agreement, the parties will be buying over the shares of the outgoing party. Hence, it is important that the owners have the desire to gain such extra shares in the first place.
Additionally, the business owners should also have the means to buy over the shares when the time comes. In this respect, parties must consider the method of funding that is sustainable and workable.
If the business owners are unwilling and/or do not have the means to participate in a cross-purchase buy-sell agreement, they may wish to consider an entity buy-sell agreement instead.
Shareholding implications upon the buying over of shares
Quite apart from the act of buying over the shares, one must also consider and contemplate the implications of the buyback. For instance, where the trigger event concerns a bankruptcy, and the shares bought back are to be retired (i.e. cancelled), these shares cannot be reissued and will no longer have financial value.
Drafting a Buy-Sell Agreement
In light of the importance and impact of buy-sell agreements on your business, such agreements must be carefully drafted.
If you are drafting one on your own, the agreement should generally contain the following essential terms:
- Trigger events: Clearly stipulate what types of events would constitute a trigger event. This could include death, permanent disability, retirement or bankruptcy of a business owner.
- Payment structure and financing: Set out information on who may purchase the shares, how much shares are allowed to be purchased, and how payments for the purchase would be made. Acceptable payment methods could include life insurance policies, instalments or other methods as mentioned above.
- Fair price valuation: Set out how the value of the business is to be determined, whether by a fixed formula or by a professional appraiser. This would ensure that there will be no disputes with regard to the valuation of the business, and enable owners to anticipate the amount of funding required for a buyout. This is especially important where the shares that are bought back are to be retired.
- Right of first refusal: Third-parties are not permitted to purchase the outgoing shares unless the other business owners have waived their right to purchase them.
You may also wish to consider engaging a lawyer for assistance on drafting a buy-sell agreement that would suit and protect you and your business.
A buy-sell agreement is a beneficial exit strategy for business owner(s) to handle any unexpected events that may arise in future. Give yourself peace of mind by preparing and planning early.
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