Importance of Buy-Sell Agreement for Partnership Business (Part #1)

Entering a Business without thinking about the proper Exit Planning will cause a lot of problem.

• Business interested inherited by heirs might not be the best choice, it is because the heirs might not be interested or conflict might arise due to different vision or direction among the heirs and surviving business partners

• Difficulty in selling the business interest because there were no outside markets for Sdn Bhd and without pre-arranges funding from the surviving business partners. More often, this will cause “haggling” process for the sale where the seller (heirs of the deceased business owner) will be demanding for a higher value & the buyer (surviving business owner) wants a lower value.

This ultimately will lead to conflict among the heirs and surviving business partners that will affect business credibility and employee confidence thus lead to discontinuation or dissolution of a profitable business.

Therefore, a Business Value Protection (BVP) agreement or I like to call it “Premarital Agreement between business owners” is the key to minimize these problems. The purpose behind this planning is to protect the value of the business so as to ensure fair and agreed price for the outgoing business owner or his family. A complete set of agreements will consist of 4 items: Buy-Sell or Cross Option Agreement, Power of Attorney, Trust Deed & Funding (Life Insurance or Cash)

In this issue, I’ll share more in detail on the general structure of this “Premarital Agreement” and what would be the funding options for a business owner to buy-out the other business owner. The diagram below explains on the overall general structure.

Diagram A: General Structure of a Business Value Protection Trust

Let me give you an example, where Ismail, Chong and Ramesh are shareholders in ICR Design Services Sdn. Bhd. which provides designs and construction services for offices. The business is thriving and last year, the company had a net profit of RM5 million. Ismail is a 40% shareholder, whereas both Chong and Ramesh own 30% each. All of them are married and have children. All of them agree that their family members should not be involved in the business. This is because their wives are working elsewhere with their own careers and their children are all under the age of 18. Ismail is 40 years old, Chong is 35 years old and Ramesh is 38 years old. All of them at this moment, are healthy and do not have any pre-existing medical condition that would prevent them from being insured by a life insurance company.

When they first started out 5 years ago, exit planning was the least in their priority because at that time, their business was still relatively small and all their energy is focused towards building their business. All their hard work paid off, their business are growing and thriving. They are keen to explore on the exit planning because they come to realize that any unforeseen events might happen as they have clients or vendors who suddenly passed away due to heart failure or accidents at a very young age. And they realize that they need to make time to seriously arrange for a exit strategy because it makes it very easy for them to sell their shares to the others without having to discuss on the pricing and the purchasers would not be financially drained to pay for the purchase.

To start, Ismail, Chong and Ramesh would need to agree on the value of the business. The purpose of the valuation is to establish a method for determining a purchase price for the ownership interest and avoids costly disputes over its values. There are two commonly used ways to value the business

1. Engage an accountant to conduct a valuation or agree on the formula to be used to value the business in the future

2. Have an agreed price which is subjected to be reviewed periodically (for example: every 3 years)

Once the valuation method is sorted out between them, the next critical issue would need to be determined – funding to purchase in the future. Unless Ismail, Chong and Ramesh have a huge cash reserve of their own, it would be difficult for them to buyout the shares when one of them exits. In my opinion the easiest way to fund such a purchase is by way of life insurance policy. (except for Keyman insurance).

Next is how will Ismail, Chong and Ramesh be able to pay for the insurance premiums? Part or all of the premiums may be paid through the dividends received as shareholder and/or director’s fees. It is very important to highlight to Money Compass reader that the company itself cannot be paying the premiums (whether it is categorized as deductible or non-deductible expenses) as it would contravene section 67 of the Companies Act 1965. For Sdn Bhd, the company is not allowed to buy back its own shares or directly or indirectly providing financial assistance to the shareholders to purchase the shares of another shareholder.

There are 3 scenarios that I’ll be sharing

Scenario  #1: All owners are insurable

Scenario  #2: Some owners who are not insurable

Scenario  #3: Some owners who are in active in the business

Scenario  #1: All owners are insurable (See Diagram 1)

Regardless of the type of life insurance (except for Keyman insurance), each of the eligible shareholders shall be insured. If all of the shareholders are insurable, there are two methods in approaching this

Method #1: 1st party method is to be used. This means Ismail will insure himself (and he is the policy owner-life assured) whereas both Chong and Ramesh pays for the premium of Ismail’s policy. The same method is used for Chong and Ramesh’s policies.

Method #2: 3rd party method where Ismail will insure and pays for the premium on the life of Chong and Ramesh. This is commonly known as cross purchase. However, this method may give rise to issues of insurable interest (to prevent a policy owner to gamble on lives of others commonly known as moral hazard) and multiple policies requirement.

Generally the 1st party method of insurance is the choice recommended

If Ismail, Chong and Ramesh are insurable, the funding structure is as illustrated in the diagram below. Once the policies are enforced, each of them shall assign the policies to the Trustee.

Diagram 1: Funding Options if all business owners are insurable

Scenario  #2: Some owners who are not insurable (Diagram 2)

If Ismail or anyone of them is not insurable due to health reasons, the ownership of the policies will be different. The diagram explains how to structure the insurance ownership when one of the shareholders is not insurable, which uses a 3rd party method. Alternatively, Chong and Ramesh could start a sinking fund right now or pay all of it by cash when the time comes to buy-out Ismail’s shares.

Diagram 2: Funding Options if some business owners are not insurable

Scenario  #3: Some owners who are in active in the business (See Diagram 3)

When one of the shareholders is not active in the business and that shareholder has no intention to purchase the shares of the others, then the funding structure would be different as shown in the diagram below. Let’s assume Ramesh is merely a shareholder who invests but he is not active in the business. He is also not a Director of the company.

Diagram 3: Funding Options if some business owner are inactive

Each policy owned by Ismail, Chong and Ramesh is to be assigned to the Trustee. This would enable the Trustee to claim and to receive the insurance proceeds when an unfortunate event such as death or disability or critical illness befalls one of the shareholders. The advantage of incorporating the Trust into Business Value Protection Trust is to ensure that the proceeds are received by an independent party as well as to distribute the proceeds to the outgoing shareholder or his family avoiding the need to apply for Probate, in the event of death. The Trust would be most advantageous when a shareholder dies because it contains instructions to the Trustee how to distribute the proceeds as there is no need to distribute all the proceeds to the beneficiaries at one time but a structured distribution can be designed. This prevents the beneficiaries misspending the funds.

Once the funding is sorted out, we shall then put in place together with the other components of  which is the buy-sell or cross option agreement, power of attorney and trust deeds.