When a shareholder of a large, publicly-held corporation dies, there is generally no impact on the operation of the company since his/her shares normally pass to heirs. Although the heirs are now shareholders of the company, under normal circumstances, they have no ability to control the company’s destiny. By contrast, the death or withdrawal of a shareholder or partner in a small, closely-held business can be much more complicated.To protect the remaining investors in this small business entity, most Shareholders or Partnership Agreements contain what is commonly referred to as a “Buy-Sell Agreement.” A Buy-Sell Agreement is a provision under which the corporation (or the remaining shareholders or partners) is obligated to buy, or is granted an option to buy, all or part of the shares of a shareholder on the occurrence of designated events, such as the death, retirement, or disability of the shareholder.
The purchase of the shares is typically made mandatory on the shareholder’s death, since the market for the shares outside of a close corporation is usually limited. In addition, a partner or shareholder in a small business entity may not be enthused about suddenly facing a partnership with an ex-partner’s spouse or child, which could occur when the estate of the deceased partner disburses its assets to the beneficiaries, including the interest in the business.
Although a Buy-Sell Agreement is a very good idea, the sudden need to purchase a former partner’s interest or shares can be financially crippling to a small business that is not prepared. Often, the best way to prepare for this contingency is for the entity to purchase life insurance on its principals. This type of life insurance, referred to as “Buy/Sell Insurance,” is payable to the company, and should be in an amount sufficient to cover the costs of a potential buy-out.
Similarly, the voluntary withdrawal of a former partner/shareholder should be addressed in the Buy-Sell Agreement. However, this contingency should be handled with a slightly different approach. The Buy-Sell Agreement, while addressing a partner’s right to voluntarily withdraw from the company, should also seek to discourage such action, since a sudden departure of a principal in a closely-held enterprise can significantly disrupt operations. One way to accomplish that goal is for the Agreement to provide for a less favorable pay-out in the event of a partner’s withdrawal, as opposed to death.
A well drafted Buy-Sell Agreement will address each contingency of the loss of a business associate, and when coupled with Buy/Sell insur-ance, provides the best protection to a small business entity from the poten-tially disastrous results of a partner/shareholder’s death or departure.
James M. Maggio, Jr. is an associate at WJ&L, LLP practicing in the Business & Corporate and Litigation areas.