According to Statistics Canada, an average of about 97,000 new businesses are created in this country every year. If you are a partner in one of these SMEs, it’s possible that you and your co-owners have not yet had time to sign a shareholder agreement, and a buy-sell agreement in particular.

Here’s why you should do that sooner rather than later.

What is a shareholder agreement?

A shareholder agreement is a legally binding agreement between individuals who are partners in a business. This agreement may address a number of objectives such as: settling in advance certain administrative, operational and financial matters that might become sources of conflict in the future; preventing a majority shareholder from harming one or more minority shareholders through certain actions or decisions; preventing third parties from becoming shareholders against the will of the other partners; and ensuring a market for the shares.

It is generally agreed that the best time to sign a shareholder agreement is when all of the partners are getting along, ideally when the business is just starting out. Rather than assuming that things will stay the same forever, it might be wise to ask “What if...?”, and to formalize what should happen in every situation.

What is a buy-sell agreement?

A buy-sell agreement is a central component of the shareholder agreement. It specifies all the terms and conditions under which a partner may dispose of his or her shares – for example, to whom they may be offered and how the fair market value would be assessed. The buy-sell agreement may be a clause within the shareholder agreement or, in its absence, may stand alone.

Such an agreement could be essential for the ongoing survival of the business. Without it, a shareholder may sell his or her stake to a third party without the approval of the other partners, who might find themselves in a situation where this third party is making decisions about the company. On the other hand, if there is no established buy-sell mechanism, the partners might end up stuck with a co-owner they would rather get rid of.

But here’s a point that might surprise you: in a large majority of cases, buy-sell agreements include a clause requiring the partners to take out life insurance.

Why?

The role of life insurance in a buy-sell agreement

Let’s say that Paul is in a flourishing business partnership with Jennifer, who is not his spouse. After several years, the fair market value of the business has grown to around two million dollars. Unfortunately, Paul dies. His estate inherits his shares in the company, and under the buy-sell agreement Paul signed with Jennifer, it must sell them to her. Under the same agreement, Jennifer is obliged to buy them.

But here’s the thing: where will Jennifer find a million dollars in cash to buy back the shares from the estate? Life insurance could provide a lump sum that would enable her to buy back the shares and continue growing the business. Otherwise, she might have to deplete her own savings, take on substantial debt and/or spread her payments over a long period. In the worst-case scenario, she might not be able to go ahead with the buyback at all, which could put the business at risk.

The following diagram outlines how life insurance can be useful in the context of a buy-sell agreement.  

A number of possible strategies

A buy-sell agreement may be complicated, involve many clauses and, depending on how it’s formulated, have significant tax implications. Among other things, depending on the clauses used, it may or may not provide eligibility for the basic capital gains deduction after the partner’s death. This is why it should be drawn up with the help of professionals who specialize in this area. Note that in addition to the partners, the business itself may be the holder and/or beneficiary of the life insurance policy, which opens the door to different tax treatments. Some agreements also provide for the purchase of critical illness or disability insurance.

So, where to begin? Talk to your advisor. He or she will be able to help you get started.