What happens in a business when you only own half the pie?

What is a business Buy-Sell agreement?

A Buy-Sell agreement is a documented contract between two or more business partners where they agree ahead of time, how their valuable interests in the business will be transferred to the remaining owner(s) if one business owner suffers a documented trigger event.

  • Such trigger events could include death, serious illness or injury, permanent disability, retirement or resignation.

When would I need a Buy-Sell agreement?

You need a Buy-Sell agreement whenever you are in business with another person.

Why would I need one?

For the majority of small business owners, the ownership of their business is one of their main financial assets; and for many, their ability to ever afford to retire is actually tied to its successful future sale.

For small business owners and their families, there is a lot riding on the stability of their business, growing its value, and ultimately getting back the money it owes them through a successful sale to another person.risks of business partner working together sapience financial

Why hasn't my Accountant advised me about this need?

  • Many business owners like to think their Accountant will proactively advise them of every single risk to be managed in their business.
  • Many Accountants think their business owner clients will proactively ask them for advice about the risk to be managed in their business.

You can see how missed expectations can lead to a core business risk being missed.

What does a Buy-Sell agreement cover?

Businesses involving multiple owners should always have a governing document that outlines what has been agreed to by partners and stakeholders, and what will happen if a particular event occurs.

The 'Will' of the Business

A Buy-Sell agreement is often considered the 'Will' of the multi-owner business and documents ahead of time the agreed method of dealing with an owner's exit from the business. The urgency of establishing this agreement is that most business exits are unexpected, unplanned, and high-risk to all parties.

  1. The first part clarifies the agreed valuation method of the business and what the insurable trigger events are.
  2. The second part of the agreement addresses how to pay for the departing owner's share of the business.

Agreements usually also cover:

  • The specific trigger events to be covered by the agreement,
  • Whether a sick or injured partner can still draw an income from the business, and for how long.
  • What method of business valuation will be used if one owner’s share of the business needs to be sold,
  • Give the parties to the agreement the option to purchase another partner’s interest following certain agreed trigger events, usually the death or incapacity of a partner, but also divorce, and
  • Require the remaining parties to the agreement to purchase and buy out the existing partners (or their families who may inherit the ownership shares of a business) in a set period of time, and
  • Set out the funding method to be used – usually a Life insurance policy, a Critical illness or Disability policy – to buy out a partner's share of the business.

Funding a Buy-Sell agreement

Life Insurance is commonly used to fund a trigger event departure as it avoids the need for remaining owners to use personal savings or borrow money. Insurance covers trigger events such as death, total and permanent disability, or serious illness or injury that also meets the terms of the insurance policy.

Other funding options (such as savings, loans, investment bonds, or deferred purchase agreements to make payments over a number of years) need to be considered for any trigger events in the agreement not covered by the insurance. Examples are retirement or resignation bankruptcy or directorship disqualification.

How relevant is a Buy-Sell agreement at the early stage of business?

A Buy-Sell agreement is a core business legal document that only reduces the risk once it is in place.

  • If your business partner had to leave the business tomorrow, how would you afford to buy out their share of the business?
  • What would happen if they sold their share to a competitor?
  • What would happen if they used the company chequebook to purchase a Ferrari and then abandoned the business and their financial responsibilities to it (because it's only your home that was used to cross-secure the company debts)?
  • What would happen to the business if their share was inherited by their family members whose plan for the business was very different from your own?

How would this put at risk everything you have built so far?

Not having a documented Buy-Sell agreement is beyond high risk

Not having a Buy-Sell agreement in place usually leads to decision deadlock during the most stressful time in a business ownership transfer, litigation, and the destruction of the business value, when faced with the unexpected departure of a business owner.

Problems associated with business partners departing a business because of unexpected sickness, injury, disability, terminal illness or even unexpected death, are best managed ahead of time by making a Buy-Sell Agreement between the business owners and partners.

Without a written Buy-Sell Agreement about this, you could end up in business with your former partner's family.

Where to now?

  1. Contact Sapience Financial and request a pre-insurance assessment on the business owner's insurability.
  2. Request your accountant to provide a Business Valuation
  3. Determine the percentage of business ownership, each owner holds
  4. Request a life insurance quote on each business owner to the value of their business interests to start your conversations.
  5. Then Insure your business to the value of the business valuation
  6. Document your plans in a legally drafted Buy-Sell Agreement.
  7. Store the executed document in safe keeping, preferably offsite.
  8. Meet with your Sapience Financial Adviser every 2-3 years to confirm the business valuation is still current and adjust your insurances as needed to match any future valuation changes.

This way all the business owners (and their families) will have certainty there is an agreement in place ahead of time, just in case, that provides certainty and clarity about what happens if one of the business owners or partners unexpectedly exits the business.

How we can help?

There are three elements needed in the creation of a Buy-Sell agreement provided by three separate professionals all working together; your Accountant, your Solicitor, and your Sapience Business Financial Advisor acting as your project manager for this key business transaction.

  • Sapience Financial works with your Accountant (who provides your business valuation) and your Solicitor (who drafts the Agreement) to provide the funding strategy (using life insurances on each of the business owners) to help fund your Buy-Sell agreement and its valuation purchase price, using Life Insurances.

Contact us for a confidential chat about your needs.

Related: Key Legal Documents for Business Owners

a quite unassuming male employee responsible for producing the bulk of the business revenue

The biggest manageable small business risk is the least talked about by small business owners

We don’t always talk about what we should

Talking about what would happen to your business if, an owner or key person suffered a serious illness or even died from a stroke, is not the usual topic of conversation around the BBQ with mates. But we do talk about what would happen if the shop burnt down, the computers were stolen or the roof was ripped off by a storm, and the warehouse flooded. Small business owners are particularly exposed to this risk. It’s the serious illness or death of your Key Person(s).

If you avoid difficult questions, ‘you’re outta business already and just don’t know it – but your suppliers might already suspect’.

The most important asset to a business is not the obvious physical assets but the key person or persons.

How to recognise a Key Person in your business

When it comes to Key People, there’s usually one in every business. But how do you recognise them and how do you measure the potential loss to your business if they suddenly stopped working?

Most businesses have one or more key persons whose skill, knowledge, experience and leadership ensure the success of the business.

  • A Key Person is usually someone whose unique identifiable skill, knowledge, experience, leadership, or commercial profile contributes to the financial success of a business directly or indirectly.
  • A Key Person in any business may generally be defined as one whose death, disablement, or early retirement may have an adverse economic effect on the business.

It is important to identify these key people and to quantify the adverse effect that is likely to be suffered by the business in the event of death, disablement or illness. Only then can you begin to see what's really at risk and begin to plan for the unexpected.

Insuring your business for Key Person Replacement

Key Person Replacement insurance cover provides a short term solution to a help a business fund the cost of a replacement where the business owner is a key person in their business, and a replacement is required if they are unable to perform their duties during disablement.

The biggest risk is often the easiest to protect - if you can recognise it first

Although the number of key people in a business will change from business to business, there will usually be at least one. A key person is usually someone whose skill, knowledge, experience, or leadership contributes to the financial success of a business directly or indirectly.

They’re someone whose potential absence from the business, because of serious illness (or even death), would have serious effects on the business's future profit. Whether that’s because customers and suppliers begin losing confidence in the business's future or because the loss of expertise means the immediate loss of capacity to complete a current contract, key people have a direct impact on the bottom line.

Key people might include:

Managing Director or Chief Executive Officer
Chief Financial Officer
Chief Technology Officer
Partner in a Partnership
Senior Sales Manager
A License holder or Copyright or Patent Owner
an Employee with a particular skill or technical expertise

Why don’t we talk about this more?

Some business owners take the ‘head in the sand approach’ saying ‘if it’s important my accountant will surely tell me about it,’ while the accountant says ‘if the client has an important question they will ask me about it’.

  • And so the circle of dis-ownership and avoidance of essential questions goes around and never really gets sorted until the lawyers get involved later.

If your business employs staff, you’re legally required to have compulsory Worker Compensation Insurance in place to protect your employees from accidents in the workplace. But when it comes to your key people, this is one manageable business risk that’s usually left unprotected; even though it can literally mean ‘the end of the business itself and the income it provides.

Measuring the cost of loss of a Key Person

In the event of a key person’s death or disablement, a business may be forced to sell assets to maintain cash flow – particularly if creditors press for payment or debtors hold back payment. Similarly, customers and suppliers may not feel confident in the trading capacity of the business and its credit rating could fall if lenders are not prepared to extend credit. Outstanding loans owed by the business to the owners (or their beneficiaries) may also be called up for immediate repayment.

What happens if this risk is not managed and something happens?

This is when a business owner pays the full cost of not having that initial conversation about managing their key people.

The lawyers from the bank, the past shareholders (or even the estate of a past non-executive Director) begin to look for ways to recover their losses. They will start searching for someone to sue to allege professional negligence and demand compensation from:

  • the company Partners or Directors, for breaching their various fiduciary duties, and
  • the company Accountant or Business Coach or Advisor, alleging professional negligence for not proactively identifying a key business client risk.

Why is this important?

  • Because the overwhelming number of small business owners and directors (and their families) have their personal assets on the line and at risk of forfeiture.

Key Person Insurance | Anthony & Gary's Story

Anthony & Gary case study

How one business protected itself through a Key Person insurance strategy.

Anthony runs a small electrical engineering firm, providing IT services to a number of local councils and some local infrastructure managers.

Gary is the Sys Admin running the IT stack and is a Key employee of the business and is responsible for generating about $200,000 of business revenue each year.

  • Anthony realises Gary is critical to the immediate survival of his business and estimates it would take 12 months to find and train a suitable replacement, if Gary became disabled or died.
  • Anthony estimated that if Gary were unable to work, the net profit of the business would fall by $200,000 pa.

This would place the business, and Anthony, under significant financial pressure.

Anthony calculated the risk of the potential business loss as:

  • Annual fall in net profit $200,000
  • Cost to hire a replacement $25,000
  • Cost to train a replacement $25,000
  • Total business risk to be covered $250,000

As most businesses don’t have an idle $250,000 available, Anthony’s company took out a life insurance policy on Gary’s health and life for $250,000 to protect itself from the risk of suddenly losing its Key Person — Gary.

If Gary died or becomes permanently disabled, the insurance policy payout could be used to replace the fall in net profit of $200,000 over the next 12 months, and cover the cost of finding and training a replacement for Gary.

The Business now feels more stable with a Plan B in place, and the confidence it creates is felt by its customers too.

Taxation of Insurance Benefits

When it comes to an understanding of the tax position of this type of strategy, speak with your accountant first but usually, the purpose of the insurance cover will determine whether the premiums are tax deductible and how the proceeds are taxed.

  • As a general rule, if the purpose of insurance is to protect the revenue of the business, through the replacement of lost sales or provision for increased expenses, the premiums will be tax deductible, and the payout assessed as income.
  • A sample company record or minute document that can be used to record the purpose of the insurance strategy can be found here.

What happens if my Key Person is only temporarily off work?

The absence of a key person due to temporary disablement can place a business under the same significant stress that occurs in the event of serious disability or death.

  • A temporary disability is statistically more likely to occur than a permanent disability or death. Temporary disabilities for a Key Person could be from any cause, including a physical injury, early-stage cancer or a minor heart attack.
  • When it comes to understanding the risk of having multiple key persons in a business you can see our table here.

Confidence in business comes from the financial strength, present, and future of the business. So next time you’re having the BBQ with mates, you be the one to ask, ‘Who contributes the most revenue and value to your business’ and what would happen to the business's future, if that stopped tomorrow?

Don’t let missing a hard conversation force you to lose everything you’ve worked so hard for.

How We Can Help

Recognising your business's Key Person and Key Revenue Maker is an important part of protecting your business revenue and your family, from the business. 

Contact us for a confidential chat about your needs.

Non-Disclosure Agreements - the small business essential

Of the many key lessons to be learned early in business, undoubtedly one of the most important is about properly managing business information and privacy as a critical business function. If you can't manage that process, your time in business is short. It starts with an appreciation that there is a hierarchy of business information.

Some business information is private, some is confidential knowing the difference between the two is key to a competitive business.

Business information by its nature is ‘porous’ and easily disseminated by those who may not recognise its value. In many business conversations, while privacy is implied, you have no direct control over your information, unless it's documented.

There's a problem when privacy is only implied

What is a Non-Disclosure Agreement (NDA)?

A Non-Disclosure Agreement, (aka NDA or Confidentiality Agreement), is a legal document signed by both parties to a conversation agreeing to keep specific information confidential and not be used outside that conversation.

  • Confidentiality agreements can run indefinitely, covering the parties' disclosures of confidential information at any time, or can terminate on a certain date or event.
  • A Mutual Non-Disclosure Agreement (MNDA) simply means all parties to the agreements are subject to identical non-disclosure obligations with identical access and use restrictions on the information disclosed by the other party. All the Non-Disclosure Agreements provided by the Sapience legal team are drafted as mutual non-disclosure agreements (MNDA's)

A Note about Privacy and if it relates to small business

The next key lesson to be learned early in the business is that privacy is not the same as confidentiality and that many small businesses are not governed by the Australian Privacy Act, so alternative arrangements need to be created to address small business privacy needs.

Insight: Most Small Businesses are not covered by the Privacy Act 1988 , but some are. A small business is one with an annual turnover of $3 million or less. The annual turnover for the purposes of the Privacy Act includes all income from all sources. It does not include assets held, capital gains or proceeds of capital sales. To see if your small business needs to comply with the Privacy Act see OAIC Privacy Checklist for Small Business

Small Business Bigger Thinking

It's time for all small businesses to rethink their approach to better protecting their confidential information and to become comfortable talking about minimum standards of privacy and confidentiality and Non-Disclosure Agreements.

Ask yourself how many external suppliers come into contact with specific information about your business, its strategy, its process, its financials, and its future plans. If that information was made public would it be both detrimental and commercially adverse?

Put it another way:

  • would you lose a competitive advantage?
  • would your business become less valuable and less ‘salable’?
  • would you become vulnerable to harsher financial negotiation with a supplier if they knew your full financial position?

Recognise the value you bring and document the value of its protection

Non-Disclosure Agreements are a respectful way to approach a new relationship - make the offer rather than wait for the request.

Why do I need a Non-Disclosure Agreement?

NDAs are useful when entering into any of the following relationships:

  • Intellectual property that is a result of creativity like manuscripts, inventions, or new trade procedures that one might copyright, patent, or trademark
  • Customer information and data like names, contact information, or purchase histories
  • Accounting or business contact information (eg. suppliers' names and information)
  • Business strategies or goals
  • Business strategy and development plans and profit margins and projections
  • Marketing practices, service procedures, and product information
  • Technical "know-how" and production methods
  • Confidential Information is also generated as a result of privileged consultations with professionals such as financial advisors, lawyers, advisors, and doctors and may also be subject to additional data protection laws.

Subcontractor risk and the emergence of Outsourced Small Business Teams

Today's modern small business can consist of a team of distributed team members around the country (or the globe) and this affects privacy confidentiality and commercial expectations.

It's time to change the way small businesses manage their disclosure obligations.

A common example is the Accounting profession.

  • Accountants who use external or subcontracted bookkeepers need to have confidentiality agreements in place as business financial documents are vulnerable structural business information. If the subcontractor is not covered by an employment agreement that specifically addresses the issues of privacy and confidentially, the accountant may be at risk.

Non-Disclosure Agreements and the tail of the One Thousand Dollar Suit.

One of the questionable business metaphors you may encounter involves the story of the legendary $1,000 suit.

So the story goes, while you might not recognise what a $1,000 suit looks like, the customers you want to attract would instantly recognise what a $1,000 suit looks like – so you must buy one – as they would then quickly identify you as an individual of both desirable character and business expertise (and expensive fashion sense).

While I've always thought this story was akin to the declaration, ‘the emperor is not wearing clothes', the idea does have merit when it comes to using a high-quality Non-Disclosure Agreement.

People who understand the value behind the use of an NDA do appreciate the higher grade of business acumen that you're bringing to the conversation

How we can help

Non-Disclosure Agreements are an important part of protecting yourself and your business (and sometimes even your family). Non-Disclosure Agreements are a respectful way to approach a new relationship - make the offer rather than wait for the request.

  • We can supply these legal documents.

Contact us for a confidential chat about your needs.

Related: Key Legal Documents for Business Owners

What is a Shareholders Agreement?

A shareholders agreement sets out the rights and obligations of the shareholders of a company.  It's a commercial way of agreeing on rules and procedures for governance in advance and helps avoid future disputes and ambiguities.

Who should consider it?

While not required by law, a shareholders' agreement is essential for companies if they have, or will have, more than one shareholder. Even if your company is not planning to raise capital immediately, it is important that a shareholders agreement be implemented as soon as it appears that there may be more than one shareholder.

Whether your company will benefit from a Shareholders’ Agreement will depend on many factors, including where your company is at in the corporate lifecycle.

For example, companies with a Sole shareholder that sit in the start-up phase are unlikely to see the benefit of implementing a shareholders’ agreement. However, if you’re in the growth phase, and looking to bring external investors on board, it would be the opportune moment to implement a shareholders’ agreement as it would return real value. But before we go too far, what is a shareholders’ agreement, and why do you need one?

When to put a Shareholders Agreement in place?

Put a Shareholders Agreement in place when you first incorporate the company and all parties are keen to work together. Later on, circumstances may change, and resentment may build between shareholders as the problem of life and business may cause some shareholders to become less than supportive of the business direction and management approach.

It is, however, never too late to build a Shareholders Agreement.

How is a Shareholders Agreement different from the Company Constitution?

A shareholders’ agreement allows for clarity around the rights, responsibilities, and processes available and expected of members and the board.

  • A Constitution contains information about the day-to-day, administrative matters of the company, including share class permissions, whether the replaceable rules under the Corporations Act apply, and whether the company can coordinate resolutions by way of circular resolution, as opposed to having to meet and resolve decisions in person.
  • Whereas a shareholders’ agreement governs the relationship between shareholders, the board of directors, and the company. It also outlines processes and mechanisms available to shareholders and Directors. This includes processes relating to the power to replace directors, the transfer of shares to third parties, mergers and acquisitions, and shareholder disputes.

While there may be some overlap in the general topics covered in the constitution and shareholders’ agreement, the shareholders’ agreement is much more detailed in outlining the specific processes, mechanisms, and relationships of the members of a company.

Plan today to avoid unnecessary disputes tomorrow

Regardless of whether members are friends and or family, a well-drafted shareholders’ agreement can avoid potentially costly disputes by ensuring all shareholders are on the same page, are aware of their rights and obligations, and sets out processes and procedures for dispute resolution.

Common clauses addressed in Shareholders’ Agreements

The specific clauses and processes drafted into a shareholders’ agreement are specific to each company and its unique circumstances. Thus, it is beneficial that the clauses are drafted by an experienced corporate legal advisor to ensure that all of the clauses appropriately reflect the requirements of each of its members, including minority shareholders while remaining compliant with ASIC and the Corporations Act.

Eight benefits of a Shareholders Agreement

A tailored Shareholders Agreement;

  1. Outlines the basis for important decision-making and restricts the power of directors where necessary
  2. Protects the owners, directors and the company against the actions of others
  3. Minimises business disputes between owners – makes it clear how decisions are made and provides dispute resolution
  4. Assists in getting bank finance – shows stability to potential partners
  5. Prevents changes in one shareholder’s personal circumstances from affecting the company or other shareholders
  6. Protects the rights of minority shareholders and the investment value of their shareholding
  7. Lists and sets out procedures if a shareholder decides to sell their shares

The Shareholders Agreement need to address:

  1. Share splits and types of share
  2. Voting rights of shareholders
  3. Actions that require shareholder consent
  4. Shareholders when they are also company employees
  5. Pre-emptive rights for the transfer of shares
  6. New shares
  7. Share valuation
  8. Shareholder liability when the company is in debt
  9. Share disposal
  10. Confidentiality

How we can help

A Shareholders Agreement is an important part of protecting your business and your family, from the business.

  • We can supply this legal document.

Contact us for a confidential chat about your needs.

Related: Key Legal Documents for Business Owners

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