Your buyer wants this
One thing that business owners often fail to consider is the end game. You must consider an exit strategy for yourself. Some people rely on the idea of having their business bought out by a larger company or competitor in the future. But ask yourself this: why would someone cut a cheque for your business if there is not an established shareholders’ agreement in place? Their exposure to all the risks we outlined would likely be too much for them to walk into.
Protect yourself and your partner
I’ve met people who try to rationalize not getting an agreement by saying they have the largest ownership interest at 75 percent of the business, while others take the approach that they only have 25 percent. The fact is that these agreements protect the interests of each of the owners. You put your lifeblood into the business; you don’t want it to blow up from something that could have been easily avoided. The 75 percent owner will have more to lose from the investment if the business fails, while the 25 percent shareholder may have most of their wealth invested in the business and cannot absorb the financial loss if it goes under.
Seven main reasons to have a shareholders’ agreement:
- Outlines ways to resolve relationship breakdowns between shareholders.
- Outlines what happens when one person decides to leave the company.
- Defines business succession to the next generation or a third party.
- Outlines financing options if the business needs money.
- Offers structure for handling disputes.
- Outlines the authority of each shareholder.
- Outlines the valuation formula for share transfers.
What Nine Clauses Should Professionals Put In Their Shareholders’ Agreements
- Pre-emptive rights. If new shares are to be issued, current shareholders are offered the right to keep their percentage owned the same, by being able to buy more of the new shares.
- Valuation method and schedule. It’s important to have an accurate valuation for the company in case a shareholder leaves unexpectedly. I strongly suggest that you use the services of an established business valuator who operates at arm’s length to give unbiased and impartial advice.
- Rights of first refusal. When a shareholder sells they must offer shares to existing shareholders first. This helps protect the existing shareholders’ interests.
- Piggyback clause, tag along provision. If a majority of shareholders decide to sell, the minority shareholders have a right to sell too at the same price, thus protecting the minority shareholders’ rights.
- Piggyback clause, drag along provision. If a majority of shareholders decide to sell, the minority shareholders are forced to join the deal at the same terms, thus protecting the rights of the majority shareholders.
- Shotgun clause. This is a favourite among many lawyers I meet. It is a quick method; a forced buyout to resolve a situation where the shareholders can no longer work together.
- Buy and sell agreements. This is where I see most problems occur. People often intend to make sure that in the case of one of the shareholders dying or becoming disabled, the other is able to buy their shares from the spouse and carry on the business.
You have four choices, in the case of one person dying:
- Close the business (best avoided if you can).
- Keep the business going with whomever the shares of the deceased went to, say their spouse or children, and make the best of it.
- Sell your shares, but your valuation and sale options now look much less attractive than the day before your business partner died.
- Buy the shares from the estate of your business partner; often easier said than done.
The first problem I see when the shareholders’ agreement is not set up is that you now are in business with your partner’s spouse who doesn’t know the business, doesn’t care about the business and just wants his/her money out.
The second problem is a provision with a promise to pay but no obligation to pay, and the same thing happens because when it comes to paying the surviving spouse off, “I would if I could but I can’t (because the business can’t afford it) so I won’t.” Again both lose.
There are three types of buy/sell agreements:
- Criss-cross method.
- Corporate redemption method.
- Promissory note method.
- Critical illness insurance and disability insurance. It should be written in very carefully. You want to balance out the rights of the disabled with the rights of the able-bodied person who will need to keep the company going. I again stress to have these definitions, parameters and terminology set up, not just with a lawyer, but with a financial planner as well.
- Key man insurance. This type of insurance enables you to get appropriate protection from the financial risks of losing a key person.
How can I fund a buy/sell agreement?
- Start saving.
- Sell assets of the business.
- Use current earnings of the business.
- Borrow from a bank.
- Buy insurance considering what you want to protect: life, disability, critical illness.
Which will cost you the most? I can’t answer that, but most often the insurance option will cost you the least. You would be funding the solution with cents on the dollar instead of dollar for dollar. It’s worthwhile looking at a permanent insurance option, which you cannot outlive. You need to have a proper assessment done to uncover which of the three permanent insurance options best suits you.
One of the things to consider is whether you are happy with having the insured amount stay the same, or if you would like it to grow over time and by how much. These policies can be tailor made to your company’s needs. But before you make a final decision, get a proper assessment of the costs and coverage you need.
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