There are many ways of dealing with shares should a shareholder die or become ill, could a purchase and sale agreement be right for you?
If a shareholder dies or is forced to leave a business due to ill health, apart from the obvious personal tragedy, it does open the question of what will happen to their outgoing shares.
Depending on what has been agreed in the business’ initial articles of incorporation, the shares will usually go to the shareholder’s beneficiaries or next of kin, or will be taken back into the business.
Typically this will involve some financial compensation to the shareholder’s beneficiaries for the value of the shares.
There are a lot of ways to organise the return of shares to a business.
Shareholder protection is a good way of ensuring the remaining shareholders have the funds available to purchase the remaining shares.
But from a legal perspective, it would help to have an agreement that both the business and beneficiaries agree to the sale of the shares back to the business.
This is when a purchase and sale agreement can help.
What is a purchase and sale agreement?
Sometimes known as a buy and sell agreement, a purchase and sale agreement creates a legally binding contract between the shareholders that any outgoing shares will be sold to the remaining shareholders in the event one of them dies, or becomes critically ill, and can’t stay in the business.
It states that in the event of a death, the outgoing shareholder’s estate must sell shares back to the remaining shareholders using a predetermined formula to work out the fair value of the shares.
Not only does this help create a smoother transition of shares back to the business, it ensures the estate receives the full value of the shares.
How a purchase and sale agreement works
Usually, purchase and sale agreements will fall into two categories, but both have the same results.
One option is to use a cross-purchase agreement.
This involves the remaining shareholders purchasing the outgoing shares and redistributing those shares between them.
The other option is for the business itself to purchase the shares.
In both options, the outgoing shareholder’s estate and the remaining shareholders will be legally required to go through with the sale and purchase.
This is why shareholder protection becomes so important because it makes sure the funds are available in the business for the sale to go through quickly.
Without this protection in place, the remaining shareholders would either have to fund the purchase from their personal finances, or try to get other financing like a bank loan.
The chances of getting a bank loan for this purpose however would be slim, because banks are often reluctant to give loans for share purchases because of the risk involved and the uncertainty around the business.
Why use a purchase and sale agreement?
The main purpose of a purchase and sale agreement is to ensure the smooth transition of any outgoing shares back into the business to prevent unnecessary disruption to the company.
It also prevents the outgoing shareholder’s estate from selling the shares to a third party against the wishes of the remaining shareholders.
But it also provides some clarity for the shareholder’s estate.
That’s because they’ll be sure they’re getting a fair value for the shares they sell back to the business, which can’t always be guaranteed if they went into the open market.
A purchase and sale agreement also sets out the formula by which the value of the outgoing shares will be assessed - which is agreed in advance when the buy and sell agreement is signed.
This can prevent disputes later on if the remaining shareholders and the estate disagree about the monetary value.
Is a buy and sale agreement tax efficient?
While a buy and sale agreement can be an effective way of planning the return of shares to a business in the event of a critical illness or death, it’s worth considering the potential tax implications - particularly when it comes to inheritance tax.
For tax purposes, a buy and sale agreement is judged to be a contract for sale, because shares will be exchanged for cash and the agreement is signed in advance.
This means the shareholder’s estate could be liable to pay inheritance tax on the payout.
Any business property relief for inheritance tax could also be sacrificed.
There’s no getting around this if you do decide to take out a buy and sell agreement, so it’s worth understanding the likely tax requirements in the event you need to buy shares back.
Invest in shareholder protection to protect your company
However you decide to treat the shares of an outgoing shareholder, you’ll need to ensure you have the funds available to buy them back into the business to prevent them being sold to another party.
Shareholder protection provides that level of insurance to make sure you readily have the funds required to purchase any shares and complete the buy back quickly.
This can help to avoid any further disruption in what will already be a very difficult time for everyone involved.
If you want to know more about shareholder protection or have more questions about buy and sell agreements, get in touch.