By James McFarland, Director of Insurance and Corporate Employee Benefits
In over 30 years of business Stanford Brown has gained extensive experience partnering with small to medium sized business owners. As “small business” owners ourselves, we understand that the business is your passion, your life, and your retirement plan. We partner with business owners to help them achieve both their personal and business goals. We find that business owners are so busy in the day to day demands of running a business, little time is left to plan and protect the business.
Often overlooked by small business owners is the importance of making sure that they have the right structures in place to protect both themselves as shareholders and the business in the event of a shareholder exiting.
There are three main ways a shareholder may exit the business:
- Voluntary Exit – planned retirement or career change
- Forced Exit – causes may include a dispute amongst shareholders, a disengaged or absent shareholder, non-performance of a shareholder, bankruptcy or fraud
- Involuntary Exit – the Death or severe illness/disablement of a shareholder
A well-constructed shareholders agreement will make provisions on how to treat an exit from the business under the above three circumstances.
Issues that arise in the event if an involuntary exit may include:
Also, a business generally depends on a few people to produce the profits, provide the capital or manage the business. Without a well-prepared business protection plan, there may be significant financial hardship for the remaining business owners, as well as for the surviving family members.
Buy Sell or Exit Agreements
Generally known as a succession agreement the Buy Sell or Exit Agreement is essentially a pre-nuptial agreement for the business.
The terms are outlined in the company’s Shareholder Agreement or a subsequent addendum and sets out a contingency plan to cater for the interests of all owners in the event of an involuntary exit from the business.
The shareholders generally agree to:
- have control of the business retained by the remaining principals
- ensure the outgoing principal/their estate receives fair and equitable value for the release of their equity and control.
A well-structured agreement will address four major issues:
- The share transfer mechanism (Put & Call Option)
- The payment terms for the exit
- The business valuation methodology
- The funding solutions
Put and Call Options
The most commonly used mechanism to transfer the shares in the event of a trigger event is called a Put & Call option. A Put & Call option requires:
- the remaining shareholders to buy the shareholding from the exiting shareholder or their Estate and;
- the exiting shareholder or their Estate must transfer the shares
The Put and Call option creates certainty for both sides of the transaction by providing:
- Certainty for the departing owner or their Estate, enabling them to realise the value of their shares within an acceptable timeframe and at a pre-agreed price/valuation.
- The family of a deceased shareholder are not forced to work in or contribute to the running of the business.
- Likewise, the remaining shareholders are not forced to work with the family members of an exited shareholder who may not be qualified or suited to appropriately contribute to the business.
- The Estate does not have the discretion to sell shares to a third party, such as a competitor.
Without this agreement in place the business is not compelled to purchase the shares from the exited/deceased shareholders Estate, nor is the exited/deceased shareholder required to sell the shares.