For family-owned businesses more than most, the ability to control what happens to their shares can be a matter of business survival or failure. The limited market for shares and the small number of shareholders means that the unregulated sale of just one person’s shares, or lack of life-insurance policies to finance the purchase of shares, can send tremors through the company.

Despite this vulnerability, research suggests that fewer than half of family-owned businesses have a buy-sell agreement spelling out when, how, and to whom shares in the business can be bought and sold, and have established financing mechanisms such as life-insurance policies to fund them. The others may be relying on an informal “understanding” among family members, opening them up to many scenarios that could threaten the company’s identity or even send it into a so-called fire sale of forced liquidation.

For example, what happens when the shareholding mother of the family unexpectedly dies? Does anyone in the family have the funds to buy her shares? If so, which family member? Is there adequate life insurance in place to cover the purchase price? Or what happens when the shareholding son gets divorced and his now-hostile ex-wife receives shares as part of the settlement? Informal agreements and assumptions are not enough: the business needs a formal document with legally binding provisions for these circumstances.

A typical buy-sell agreement has four core components:

1. A list of who has the right to own a stake in the business. For instance, will it be acceptable for a family member to sell her or his shares to a non-family member? Can only non-voting shares be sold to non-family members, while all voting shares must remain in the family? Does family mean only bloodline family, or does it include those who have married in?

2. A list of what can trigger the sale of shares. The typical triggers for required sale and purchase of shares are death, critical illness, or disability; retirement; divorce; partner dispute; personal bankruptcy; or simply a partner’s decision to exit the business. Each trigger is given a clear, agreed-upon, and legally binding definition.

3. An agreed way of valuing the shares. This is most often done through an up-to-date independent business valuation. In Canada, business valuations are done by members of The Canadian Institute of Chartered Business Valuators, financial professionals who have undergone rigorous training in this process.

4. The way the sale will be financed. If the financing for the purchase of the shares isn’t in place, the rest of the buy-sell agreement is useless.

Life insurance offers effective and flexible options for financing the purchase of shares

In the case of an unforeseen death, one of the most effective ways of financing the purchase of shares is through life insurance. This method guarantees that funding will be available, reduces the tax hit, and provides a source of ready cash at a time when the business might need it the most.

Life-insurance financing can be set up in a number of different ways, depending on what the buy-sell agreement calls for upon the triggering event. The main structures are:

A. Criss-cross. This type of insurance can be used when the buy-sell agreement stipulates that the surviving or remaining co-owners must purchase the deceased or departed owner’s shares, and that the deceased or departed owner, his/her partner, or his/her estate must sell those shares to them. The partners take out life-insurance policies on each other. Upon the triggering event, the surviving or remaining active partner(s) receive the tax-free insurance benefit from the insurer and use it to pay for the shares.

B. Promissory-note. Used under the same buy-sell requirements as the criss-cross method, here the company owns life-insurance policies on each co-owner and receives the tax-free insurance benefit upon the triggering event. The surviving or remaining partners buy the shares using a promissory note; the company then gives them the insurance benefit amount out of its capital dividend fund, allowing them to pay off the promissory note.

C. Share-redemption. This structure is used when the buy-sell agreement requires the company itself to purchase the shares of deceased or departed partner. Therefore, it is the company that takes out a policy on each co-owner and pays the premiums. Upon the triggering event, the company simply uses the insurance benefit to purchase the shares.

For triggers where life insurance does not apply, such as retirement, divorce, or dispute, different means of financing the purchase of shares must be used. These can include using money from a dedicated share-purchase fund, getting an external loan, or taking out an equity loan. The agreement will stipulate terms of payment to the person selling the shares, sometimes requiring that he or she accept installment payments at a set interest rate.

It can be hard for family-business members to think of their share-owning relatives as shareholders, co-owners, or partners rather than as “Mom”, “Dad”, “my son”, “Aunt Betty”, and so on. However, the “familiness” factor is exactly what makes the business so vulnerable to uncontrolled movement of its shares. When any disruption in the relationships among a handful of people has the potential to jeopardize the identity or even survival of the business, drawing up a buy-sell agreement is a measure well worth the effort.

Life insurance can offer many advanced and complex options for minimizing taxes and providing financing when an occasion for selling shares arises. Talking to a life-insurance expert is a must during the drawing up of a buy-sell agreement. At The Targeted Strategies Group, we have a team of professionals, including insurance specialists, CPAs, lawyers, and actuaries, who can assess your needs and build tailored insurance solutions around the complexity of buy-sell agreements for your business.