There are several methods of organising the exchange of shares and funds.

Here is one called the cross-purchase method, which is the most commonly used method.

In a cross-purchase agreement, the remaining shareholders purchase the shares of the departing shareholder. To ensure that funds are available at the time of buyout, shareholders commonly purchase life insurance policies on one another’s lives.  In the event of a trigger event like death, the proceeds from the policy are used towards the purchase of the deceased’s shares.

When setting up a buy-sell agreement, never just adopt an off-the-shelf set of standard trigger events.

Imagine the three partners of a music production company coming together to set up a buy-sell agreement with standard trigger events that did not include deafness. Then one day, one of the partners becomes deaf from an accident and is unable to produce music anymore. He has to leave the business but the buy-sell agreement is not triggered to effect the exchange of shares and funds.

Spending time to lay out the trigger events that are relevant to the company is a critical task. That is because there isn’t a set of trigger events that applies in all situations.

A buy-sell agreement can be funded with term or permanent life insurance. Each has its own benefits.

Term insurance is more affordable. It provides temporary coverage for a specific period of time although it has no cash value. It is an attractive option where there are cash flow and budgetary constraints. The tenure of the policy should be at least till the retirement of the shareholder or the mandatory retirement age (if any) by the company, whichever is later. It is recommended that the tenure be extended till the maximum such as 99 years so that even if the shareholder retires, the policy can be transferred to the shareholder as a legacy for his family.

Permanent life insurance such as whole life insurance, on the other hand, offers protection for life. In addition to the death benefit it provides, permanent life insurance accumulates cash value. That money can be used to fund all or a portion of a buy-sell agreement. And after a period of time, the cash value can accumulate to an amount that is larger than the amount of premiums paid. At that point, it is as if the insurance had been obtained for free.   

Upon retirement, the policy could be transferred to the partner and his family and the family can further benefit from the proceeds upon his death.

Trigger events can be insurance-funded and non-insurance-funded.

Insurance-funded trigger events

• death
• critical illness
• terminal illness
• total permanent disability

Care should be taken to make sure that the definitions of these trigger events as defined in the agreement are aligned with how the life insurance policies define them. As definitions change such as for critical illness, it is prudent for the shareholders to revisit the agreement every two to three years or as needed.

Non-insurance-funded trigger events

Any event can be included as a trigger event as long as it is relevant to the company and the industry it belongs to.

Examples of such events might include any shareholder:

• Going missing for a period of time and is later declared dead
• Being declared bankrupt by a court order
• Being declared mentally incapable as defined by the Mental Capacity Act
• Going through a divorce
• Retiring
• Getting convicted of a criminal offence and is imprisoned for a time
• Acting in a way that damages the reputation of the company

Fair market value is the price at which the shares would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

Deciding on what the FMV is of a company can be tricky because it is not only quite subjective, the value can easily change when business conditions change from month to month. In the end, the shareholders have to agree among themselves what the value is as far as the buy-sell agreement is concerned.

It is best to engage a professional appraiser such as an accountant to perform the valuation.  The following clause may be added to your buy-sell agreement: “The company shall obtain a fresh valuation from a professional appraiser such as an accountant every 1 to 3 years or when needed.”

Whenever a valuation is done, the shareholders have to review how funding is to be arranged. If the company’s value has risen by a large amount, should new insurance policies be purchased or a larger amount of funds be set aside? The buy-sell agreement should leave room for adjustments.