Buy/Sell Agreements Explained

Purpose of Buy/Sell Agreements

A buy/sell agreement is a binding contract between the owners of a business — typically the shareholders of a private company, the partners of a partnership, or the unit holders of a unit trust. It commits each owner to sell, and the remaining owners to buy, the departing owner's interest when a defined trigger event occurs.

The objectives are practical: keep the business in the hands of the people running it, provide certainty about price and timing, ensure the funds are available when needed, and remove discretion from emotionally charged decision-making.

Trigger Events

Buy/sell agreements typically respond to several events:

• Death of an owner;
• Total and permanent disability as defined for insurance purposes;
• Trauma or critical illness events capable of insurance coverage;
• Loss of capacity evidenced by appointment of an administrator;
• Voluntary exit after a notice period; and
• Default events such as bankruptcy, prolonged disengagement from the business, or material breach of obligations.

Each trigger requires its own treatment. Death and TPD events are usually funded by insurance; voluntary exit is usually funded by staged payments; default events may attract a discount on the agreed price.

Death and Incapacity

The death and incapacity provisions are the heart of the agreement. On a death or TPD event the agreement should:

• compel the deceased's executor (or the disabled owner) to sell the interest to the remaining owners;
• compel the remaining owners to buy on the agreed terms;
• determine the price by reference to the agreed valuation method;
• fund the price from insurance proceeds and from any top-up mechanism agreed; and
• deal with associated matters — loan accounts, personal guarantees, voting rights between event and completion.

For broader context on what happens to a business when an owner dies, see our companion article on what happens to a business when an owner dies.

Valuation Methods

The valuation method is one of the most contested points in the negotiation of a buy/sell agreement. The common approaches are:

• Annual agreed value. The owners agree a value each year and record it in a schedule. Simple, but the value can drift out of date.
• Formula valuation. A multiple of EBIT, EBITDA or revenue, sometimes adjusted for net debt and working capital. Predictable but inflexible.
• Independent valuation. A nominated valuer (or one appointed by the relevant professional body) values the business at the trigger date. Accurate but slow and potentially expensive.
• Hybrid approach. Annual agreed value with a fallback to independent valuation where the agreed value is more than 12 months old.

Whichever method is chosen, the agreement must say clearly who pays for the valuation, the timeframe within which it must be produced, and whether the valuation is binding or advisory.

Funding Arrangements

A buy/sell agreement without a funding plan is a recipe for litigation. Common funding sources include:

• life and TPD insurance proceeds;
• retained earnings or accumulated profits;
• vendor finance from the departing owner or their estate over a defined period;
• bank finance secured against the business; and
• equity injections from incoming owners brought in to fund the buy-out.

Insurance is the most efficient solution for death and TPD triggers. Vendor finance is common for voluntary exit and default events. Bank funding is usually a backstop.

Insurance Considerations

The mechanics of insurance ownership matter. The main ownership structures are:

• Self-ownership. Each owner takes a policy on their own life. Proceeds are paid to the estate and used to buy back the interest from the estate. Tax-efficient for life cover; TPD and trauma outcomes are more complex.
• Cross-ownership. Each owner takes policies on the other owners. Proceeds are paid to the surviving owners and used to buy the interest. CGT consequences need careful structuring.
• Company or trust ownership. Proceeds paid to an entity and used to buy back the interest. May suit larger businesses but requires careful tax planning.

The insurance policies must align precisely with the valuation method, the trigger events and the named beneficiaries in the agreement. Misalignment between the agreement and the policies is the single most common failure point.

Shareholder Disputes

A well-drafted buy/sell agreement also helps with disputes that do not involve death or incapacity. By providing a mechanism for one shareholder to be bought out, the agreement gives the remaining shareholders a way to resolve fundamental disagreements without ending the business. Shotgun clauses, Russian roulette clauses, and put/call options are different mechanisms that can be built into the same document. Each has consequences and should be designed with the specific business and the specific owners in mind.

Common Drafting Issues

• Insurance and agreement out of sync.Policy values drift below the agreed price, or ownership structures change without the agreement being updated.
• Vague trigger definitions. "Long-term illness" without a definition leaves the question to the parties at the worst possible time.
• No mechanism for valuation date. Without a fixed valuation date the parties argue about whether to use the date of death, the date of completion, or the most recent annual valuation.
• No release of guarantees. Personal guarantees given by the departing owner must be released as a condition of the buy-out.
• Loan accounts ignored. The agreement should address director loan accounts, undrawn dividends and any Division 7A loans.
• No review clause. The agreement should be reviewed at agreed intervals and on the occurrence of material events (new owners, restructuring, growth).

For broader business succession planning, see our companion articles on business succession planning and why every business owner needs an exit strategy.

Frequently Asked Questions