Buy-Sell Agreement

A buy-sell agreement specifies what happens to a shareholder's ownership interest when a triggering event occurs. Triggering events typically include: voluntary departure (a shareholder who wants to sell their shares); death or terminal illness; permanent disability; retirement; divorce or marriage breakdown (to prevent a spouse from becoming an unintended shareholder); bankruptcy or insolvency of a shareholder; breach of the shareholder agreement; termination of employment for shareholder-employees; and loss of a professional licence, which is especially relevant for professional corporations. Without a buy-sell mechanism, a triggering event can leave the business in limbo — a deceased shareholder's estate becomes a co-owner, a divorced shareholder's spouse may acquire half the shares, or a departing shareholder can hold the remaining owners hostage by refusing to sell at a reasonable price.

The most contentious element of any buy-sell agreement is how shares will be valued when a triggering event occurs. Common approaches include: (1) Fixed price — shareholders agree on a price per share that is updated periodically (requires discipline to keep current); (2) Formula — shares are valued based on a formula tied to financial metrics such as a multiple of EBITDA, revenue, or book value; (3) Independent appraisal — one or both parties retain business valuators, and if they cannot agree, a third neutral valuator is appointed; (4) Shotgun clause — the offering party names a price per share, and the receiving party must either accept (selling at that price) or turn the table, buying the offeror's shares at the same price. Each mechanism has different implications for predictability, cost, and fairness. Most Ontario lawyers recommend against fixed prices unless they are reviewed at least annually.

Life insurance and critical illness insurance are the most common funding mechanisms for buy-sell agreements triggered by death or disability. There are two main structures used in Canada: (1) Corporation-owned insurance — the corporation holds policies on each shareholder; on death, the proceeds are received by the corporation and can be paid to the estate as a capital dividend, flowing through the capital dividend account tax-free to the shareholders; (2) Cross-purchase insurance — each shareholder holds a policy on every other shareholder and uses the proceeds to buy the deceased's shares directly. Corporate-owned insurance is more commonly used for simplicity when there are more than two shareholders. The choice of structure has meaningful tax implications that should be discussed with legal and tax advisors at the time of drafting.

Even with insurance in place, there will be cases where shares must be bought out without an insurance payout — for example, on voluntary departure or retirement. The buy-sell agreement should specify payment terms: lump sum; instalments over a defined period with interest (the Canada Revenue Agency prescribed rate is often used as a floor reference); or a combination. A promissory note secured against the shares or other assets of the corporation provides the selling shareholder with security. Instalment payments create an ongoing lender-borrower relationship between former co-owners, which can be complicated emotionally and legally. Legal counsel should ensure payment terms reflect both the corporation's cash flow capacity and the departing shareholder's financial needs.