Tuesday, March 2, 2010

The Mechanics of a Buy and Sell Agreement

A buy and sell agreement is a legally binding contract which on the death or disability of a partner forces the remaining partners to buy the deceased / disabled partner’s interest and forces the deceased’s estate / disabled partner to sell the interest at a predetermined price (or method of determining the price).

Life assurance is merely a way to finance the buy and sell transaction. The partners may finance the transaction in other ways, for instance with their own capital or incurred debt. However as stated before, life assurance is generally the most cost0effective and practical way to do so.

It is very important that a buy and sell agreement is structured correctly.

• Each partner must take out cover on the lives of the other partner. The owner(s) of a policy is therefore someone other than the life assured.

• The proceeds of the policy must be utilized to purchase a share in the business and/or a claim against the business (for instance a credit loan account)

• No partner must pay any premiums of a policy on his own life.

A wrongly structured buy and sell agreement will result in estate duty being levied on the proceeds. For example, where each partner owns a policy on his own life with the other partner as a beneficiary, the proceeds will attract estate duty. There will also be uncertainty in such a case, as each partner can change his/her beneficiary nominations without the other partner knowing.

As the buy and sell agreement provides for a predermined price at which each partner’s interest will be bought, the first step is to place a value on the business. This is usually the domain of accountants, where factors such as the business’s profits and the value of assets are taken into account.

There are however certain factors not found in the financial statements of the business which can affect its value, for instance:

• How dependant is the business on the unique skills of the owners?

• How strong is the brand / what is the value of the goodwill attached to the business?

• Does the business have a sustainable competitive advantage?

• How are other companies in the same industry performing?

• How sensitive is the company to economic changes?
Each business is unique and each Buy and Sell agreement should therefore be structured around each business’s needs.

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