Buy-Sell Agreements in Canada: A Guide for Business Owners

Business continuity planning is a crucial yet often overlooked aspect of owning a private company in Canada. With over 1.2 million small and medium enterprises (SMEs) across the country, unexpected events like the sudden death or disability of a shareholder can jeopardize the future viability of many businesses (Source). This is where buy-sell agreements come in.

These legally binding contracts provide a roadmap for the transfer of ownership interests when certain triggering events occur.

This comprehensive guide will explore the ins and outs of buy-sell agreements, with a focus on how life insurance can provide effective funding to facilitate smooth ownership transitions.

What is a Buy-Sell Agreement?

A buy-sell agreement, also known as a buyout agreement, is a legally binding contract between co-owners of a private company. It dictates the terms and conditions under which an owner’s shares can be transferred upon events like death, disability, retirement, termination of employment, or other departures.

These agreements are also referred to as business succession agreements, business continuation agreements, or business transfer agreements. They aim to protect the financial interests of the departing owner or their heirs while also ensuring the continuity of the business.

Buy-sell agreements are common among private business entities like corporations, partnerships, limited liability companies (LLCs), and sole proprietorships with multiple owners. They can either be a separate contract or be embedded into a broader shareholders’ agreement.

Read more: Shareholder Insurance in Canada

Key Sections and Clauses in Buy-Sell Agreements

While specific terms will vary, most buy-sell agreements contain certain standard provisions and clauses.

Identification of Parties

The agreement clearly identifies the business entity and all owners who are parties to the contract. Details like names, ownership percentages, positions in the company, and addresses are included.

Triggering Events

This section outlines the specific situations or events that will trigger the buy-sell agreement provisions for the mandatory purchase and sale of an owner’s interest.

Common triggering events include:

• Death of an owner
• Long-term disability or critical illness
• Retirement at a certain age
• Termination of employment
• An owner’s bankruptcy, insolvency, or other creditor events
• Legal separation or divorce of an owner
• Breach of a shareholders’ agreement
• An owner’s desire or decision to transfer their shares

The agreement specifies which events require a mandatory buyout and which may provide options like rights of first refusal.

Valuation of the Business

This establishes the formula, methods, or procedures to determine the value of the entire business and the departing owner’s proportional share. Common valuation methods include:

• Preset formula – Such as a multiple of normalized earnings or book value.
• Appraisal – By an independent business valuator selected by the parties. Often used for larger businesses or where owners’ valuations widely differ.
• Third-party offer – Based on the value of bona fide purchase offers received from outside parties, Can incentivize artificially inflated offers.
• Annual review – Requiring periodic appraisals or updates to the valuation formula. Prevents stale valuations.

Setting an agreed-upon valuation method upfront avoids potential disputes later. Valuations should be updated regularly, as company values can change significantly over time.

Purchase Terms and Conditions

This stipulates the terms under which a departing owner or their estate is obligated to sell their interest, and the surviving owners are obligated to purchase it. Key elements include:

• Timing – When the purchase payment is due – lump-sum or over time. This impacts the seller.
• Funding sources – Such as life insurance proceeds, corporate reserves, or bank financing. Impacts the buyer.
• Payment structure – Lump-sum, installments, interest on unpaid balances. Affects both parties.
• Personal guarantees and security – Ensures payment from purchasing owners. Prioritizes seller protection.
• Defaults and remedies – Outlines recourse if a default or breach occurs. Protects the buyer and seller.
• Covenants – Requirements to facilitate the smooth transfer of shares. Serves both parties’ interests.

Restrictions on Share Transfers

This places conditions or restrictions on owners transferring or selling their shares to third parties like non-owners or competitors. Typical restrictions include rights of first refusal, limits on partial transfers, and non-compete clauses.

Restrictions protect the business and give remaining owners priority on available shares before external parties. They prevent shares from falling into the “wrong hands.”

Why Are Buy-Sell Agreements Important?

Buy-sell agreements play a crucial role in business continuity planning for owners of private companies. They offer a number of benefits:

1. Provide an Exit Strategy for Owners

Shares in private companies generally have no ready market or buyers. Buy-sell agreements establish a built-in exit strategy by guaranteeing a market for owners to sell their shares when specific events occur.

2. Support Business Continuity

The unexpected loss of an owner can be devastating for companies. Buy-sell agreements minimize disruption by providing clear steps to facilitate the transfer of shares to surviving owners. They prevent unwanted heirs from gaining control or forcing dissolution.

3. Establish Fair Valuation of Shares

Setting an agreed-upon valuation method removes subjectivity when establishing the value of owners’ interests. Predetermined mechanisms avoid potential disputes between selling and purchasing parties.

4. Ensure Liquidity for Buyouts

By securing advance funding, like life insurance proceeds, buy-sell agreements provide the liquidity to buy out a departing owner immediately according to predetermined terms. This avoids destabilizing the company’s finances.

5. Limit Involvement of Non-Active Owners

Owners face the risk of having to partner with unqualified or disruptive heirs of a deceased owner. Buy-sell agreements allow the remaining active owners to regain full control.

6. Facilitate Ownership and Management Succession

For many businesses, ownership and management are intertwined. Buy-sell agreements allow companies to execute their desired leadership succession plan when an owner departs.

7. Provide Peace of Mind for Owners

The certainty provided by these agreements offers owners peace of mind that their families will be compensated fairly for their interests in the business. For remaining owners, the business will remain in good hands.

While buy-sell agreements involve some trade-offs, such as requiring heirs to sell shares, the benefits for business continuity and owner interests usually make them a worthwhile investment.

How Do Buy-Sell Agreements Work?

Buy-sell agreements provide a ready framework that kicks into action when certain predefined triggering events occur. Here is an overview of how they work:

1. Triggering Event – An event outlined in the agreement occurs, such as an owner’s death or divorce. This initiates the buy-sell provisions.
2. Valuation – The departing owner’s proportional interest in the company is valued per the agreed methods. This establishes the purchase price.
3. Notice and Offer – The departing owner’s estate or successor notifies the company and provides an offer to sell their interests per the agreement.
4. Acceptance – The surviving owners accept the offer to purchase the departing owner’s shares at the established price.
5. Buyout and Transfer of Shares – The departing owner’s shares are purchased by the surviving owners or the company. Full payment and share transfers typically occur simultaneously.
6. Continuation of Business – With the departing owner’s shares redistributed, the company continues normal operations with minimal disruption.

Life insurance is commonly used to provide funding for the share purchase at the time of a buyout event. We will examine this in more detail later on.

Pros and Cons of Buy-Sell Agreements

Pros

• Provides business continuity by keeping ownership control intact and preventing unwanted transfers
• Sets valuation method in advance, avoiding potential disputes between selling and purchasing parties
• Allows smooth, seamless transfer of ownership interests to chosen successors
• Gives owners a clear exit strategy under agreed terms, ensuring liquidity
• Establishes a guaranteed buyer for the departing owner’s shares
• Ensures a fair price for the owner’s proportional share of the business
• Provides funds to settle the departing owner’s estate taxes and other liabilities
• Compensates the owner’s heirs and provides estate liquidity

Cons

• Can require the departing owner’s heirs to sell the inherited shares, even if they want to retain ownership
• Must be reviewed and updated regularly as business values, ownership, and priorities change over time
• Imposes a mandatory buyout obligation on surviving owners, regardless of circumstances when triggered
• May cause friction between the deceased owner’s heirs and surviving owners
• Requires heirs to understand the agreement’s implications on their inheritance
• Can be complex and expensive to set up customized legal, tax and insurance advice

Types of Buy-Sell Agreements

Buy-sell agreements can be structured in several ways, with the most common approaches being:

Cross-Purchase Agreement

With a cross-purchase agreement, the individual owners purchase life insurance policies on the lives of each of the other owners. If an owner dies, the surviving owners receive the life insurance payouts from the policies they own on that deceased owner’s life. They can then use these proceeds to purchase the deceased owner’s shares directly from their estate.

A cross-purchase structure allows the remaining owners to get a step-up in the cost basis of the newly acquired shares. However, the number of policies required can become administratively complex as the number of owners increases.

Redemption (Entity-Purchase) Agreement

Under an entity-purchase agreement, the company itself purchases life insurance policies on the lives of each owner. When an owner dies, the company receives the life insurance proceeds and uses them to redeem or buy back the deceased owner’s shares from their estate.

This structure simplifies policy administration for companies with many owners. However, it may not provide a step-up in basis for the shares of the remaining owners.

Hybrid Agreement

A hybrid buy-sell agreement combines features of both cross-purchase and entity-purchase models within a single contract. It offers flexibility in terms of whether the company, the surviving owners, or both can purchase the departing owner’s shares when triggered.

The hybrid approach brings together elements of both basic structures into one agreement. This can help optimize the buy-sell plan for the owners’ specific needs and circumstances.

In summary, the cross-purchase, redemption, and hybrid models represent common frameworks for buy-sell agreements that can be tailored to a given company’s situation.

Funding Considerations for Buy-Sell Agreements

Buy-sell agreements are only effective if they are funded in advance. There are several options business partners can consider:

Self-Funding

Rather than purchasing life insurance, the company itself saves and reserves sufficient capital to purchase an owner’s interest when the need arises.

Pros

• Does not require payment of insurance premiums

Cons

• Ties up capital that could be utilized for growth or operations
• Risk of insufficient funds in case of premature death of an owner
• May require urgent asset sales or unplanned financing when triggered

Borrowing

The company or remaining owners borrow the required funds from a commercial lender when the buy-sell agreement is activated.

Pros

• Does not require large upfront reserves or insurance payments

Cons

• Sudden debt burden can cripple the company precisely when stability is crucial
• Loan approval is not guaranteed for a business dealing with the loss of an owner
• Surviving owners may need to personally guarantee or collateralize the loan

Promissory Notes

The company provides a promissory note to the departing owner’s estate, promising to pay the purchase price over time with interest.

Pros

• Immediate payment is not required

Cons

• Risk of default if business performance declines
• Exposes heirs to business continuity risks until fully paid
• Note payments reduce the business’s cash flow

Life Insurance

The company and/or owners purchase life insurance policies to cover the respective buyout amounts under the agreement.

Pros

• Proceeds available exactly when required at the time of triggering event
• Affordable premiums, especially when owners are young and healthy
• Tax advantages as proceeds are income tax-free to beneficiaries
• Policy cash values provide living benefits
• Creditor protected asset

Cons

• Requires underwriting approval
• Premiums are not tax deductible for the business

Life insurance generally provides the most cost-effective and efficient way to fund buy-sell agreements. The death benefit alone can be enough to cover the full buyout amount. For larger or growing companies, additional term riders or permanent policies with cash values can supplement coverage as needed.

We will examine buy-sell agreement insurance funding options in more detail later in this article.

How Much Does Funding With Life Insurance Cost?

Life insurance premiums vary based on several factors:

Factors Affecting Premiums

• Age and health of insured owners
• Type and amount of coverage
• Policy terms such as level or increasing premiums
• Length of coverage for term policies

Sample Annual Premiums for $1 Million Coverage

How to Buy Life Insurance for Funding Buy-Sell Agreements

When obtaining life insurance, key considerations include:

• Policy Owner – Corporation vs. individual shareholders
• Insured Lives – Joint vs. individual policies
• Policy Types – Term vs. permanent coverage

Tax Implications of Buy-Sell Agreements

Taxes represent a key consideration when structuring buy-sell agreements. While certain aspects provide income tax advantages, there are also limitations to be aware of.

Tax Advantages

• Life insurance death benefits are income tax-free
• Redemption payments to owners are classified as capital gains rather than dividends
• Step-up in the cost basis of shares for remaining owners
• Potential to credit Capital Dividend Account (CDA) when the corporation owns policies

Tax Limitations

• Life insurance premiums are not tax deductible for the business
• Transferring policies between entities may trigger taxable capital gains
• Timing constraints around sharing corporate CDA with departing owner’s estate
• Restrictions on utilizing corporate surplus to fund share redemptions
• Limits on claiming capital losses on share dispositions to offset owner’s capital gain taxes

Consulting knowledgeable tax, legal, and insurance advisors can help structure the agreement in a tax-efficient manner. Buy-sell agreements should be drafted with tax impacts in mind.

Using Life Insurance to Fund Buy-Sell Agreements

Life insurance is an integral element in funded buy-sell agreements. It offers a variety of benefits:

1. Guaranteed Liquidity

Life insurance provides an immediate influx of cash exactly when needed at the time of the triggering event. Surviving owners or the company aren’t forced to tie up operating capital or liquidate assets on short notice to fund the buyout.

2. Affordable Cost

The premiums required to maintain life insurance are relatively low compared to the payoff amount. Premiums can be structured to fit the budget of the business owners.

3. Income Tax-Free Proceeds

Unlike cash redemption or corporate reserves, life insurance proceeds are income tax-exempt. Beneficiaries can utilize the full amount to fund the share buyout.

4. Removes Risk

Remaining owners aren’t burdened with debt, forced to find financing, or required to pay in installments. Life insurance eliminates reliance on the company’s financial health or the bank’s willingness to lend.

5. Policy Cash Value

Permanent life insurance accumulates cash value that can provide living benefits to owners. Available for buyouts, retirement, or other business transitions.

6. Asset Protection

Life insurance enjoys creditor protection in many cases, shielding proceeds from business creditors or owner’s personal creditors.

7. Customizable Solutions

A variety of policy types and ownership structures can be tailored to the company’s specific continuity needs.

Life insurance policies should be an integral component of any funded buy-sell agreement and integrated accordingly into the contract terms.

Buy-Sell Agreement Insurance Policy Types

The main types of life insurance policies used to fund buy-sell agreements include:

Term Life Insurance

Provides death benefit protection for a set period of time, such as 10, 15, 20, or 30 years. Ideal for business partners who expect to exit within a certain timeframe. Offers guaranteed levels of coverage at an affordable cost.

Permanent Life Insurance

Offers lifelong death benefit coverage. Premiums may be flexible or fixed. Policy accumulates cash value that grows tax-deferred. Suitable for business owners with longer-term continuity needs. Allows accessing living benefits through policy loans and withdrawals.

Survivorship or Second-to-Die Life Insurance

Covers two insureds, with the death benefit paying upon the death of the second insured person. Used when multiple business owners require coverage. It can provide higher death benefits for the same premium as individual policies.

Disability Buy-Sell Insurance

Pays out benefits if the insured becomes disabled and can no longer work. Allows business partners to execute a buyout when an owner becomes disabled.

Buy-Sell Agreement Insurance Ownership Structures

In addition to the type of life insurance policy, business partners must also determine the ideal ownership structure for their buy-sell insurance policies.

Cross-Ownership

Each owner personally purchases a life insurance policy on the lives of the other individual owners. Beneficiaries are the other partners. Survival insurance ensures continuity.

Entity Ownership

The business entity purchases a policy for each owner. The company receives a payout upon an owner’s death and uses proceeds to buy shares from their estate.

Trust Ownership

A trust set up by the owners purchases life insurance for the partners. Acts as an intermediary, avoiding corporate or personal ownership.

Factors like the number of owners, creditor protection needs, and continuity goals help determine optimal insurance ownership structure.

Buy-Sell Disability Insurance

In addition to life insurance, businesses can also purchase disability buy-sell insurance. This provides coverage specifically for owner disability, which may be a triggering event requiring a buyout.

Disability buy-sell insurance provides a tax-free lump sum, monthly installments, or combination benefit upon the total disability of an insured owner. This payout allows the entity or owners to purchase the departing owner’s shares.

The policy remains in force until the earliest retirement age, permanent policy discontinuance, a disabling event, or leaving the business for any reason.

Disability buy-sell insurance is more expensive than life insurance since incidence rates are higher. Individual disability policies for owners provide added protection.

Key Considerations for Business Owners

Those entering buy-sell agreements should carefully assess the following:

• Ensure the terms align with your succession goals. Outline contingencies if certain owners remain.
• Coordinate the agreement with your will and estate plan. Confirm your executor understands their obligations.
• Review and update the agreement regularly. Valuations, ownership structures, and insurance needs change.
• Consult qualified legal and tax experts to ensure optimal structuring and adherence to regulations.
• Educate your heirs on their rights and obligations under the agreement. Avoid potential disputes.
• Use experienced insurance advisors to tailor policies and ownership to your specific buy-sell needs.

With input from competent advisors, buy-sell agreements can provide robust continuity plans for your business.

Conclusion: Safeguarding Business Transitions with Buy-Sell Agreements

A buy-sell agreement funded with life insurance provides a strategic advantage for business owners seeking continuity. The unexpected loss of an owner can cripple companies lacking a clear transition framework.

These legally binding contracts predefine the terms for ownership transfers when triggering events occur. Integrating life insurance further ensures liquidity to execute the buyout smoothly.

While complex in nature, buy-sell agreements offer substantial benefits for existing and surviving owners. They minimize disruptions, avoid conflicts, establish fair valuations, limit successor involvement, and provide certainty during ownership changes.

Business owners would be prudent to secure competent legal, tax and insurance help in tailoring buy-sell agreements to their specific continuity needs. The investment made when times are stable pays dividends during periods of turbulence.

With sound guidance, companies can implement funded buy-sell agreements that provide strategic advantage and continuity through future ownership transitions.

Frequently Asked Questions (FAQs)