Consider what happens the morning after one of two owners of a Brampton machine shop dies suddenly. The surviving partner needs to keep the customers calm and meet payroll. The widow needs income and has no idea what her late husband’s half is worth. Each of them may be perfectly reasonable, and they may still end up in a serious dispute, because neither has any idea who is entitled to do what. A properly drafted buy-sell clause answers that question before anyone is grieving or angry.
A buy-sell clause is a set of terms, usually inside a shareholder agreement, that says when an owner’s interest must or may be sold, who buys it, how the price is determined, and how it gets paid for. The idea is simple. The drafting is where many agreements fail, and they usually fail in a way nobody notices until the clause is finally needed.
What follows is general information about Ontario business arrangements. It is not legal, tax, or insurance advice. A buy-sell clause can have major tax results, and it should be designed together with your accountant and, where insurance is involved, your insurance adviser.
Decide What Should Set It Off
A trigger is an event that activates the clause. The usual list covers death, long-term disability, retirement, voluntary departure, termination of employment, personal bankruptcy, marriage breakdown, serious breach of the agreement, and a deadlock among owners. Each one needs its own thinking, because they are very different events.
For every trigger, ask three questions:
- Is it mandatory or optional? On death, many owners want a binding obligation: the estate must sell and the survivors must buy. On retirement, an option may be more suitable, since a forced purchase could arrive when the company can least afford it.
- Who holds the right? The company, the other owners, or either of them, and in what order?
- Is the same price fair in every case? Someone who leaves to join a competitor may not deserve the same price as the family of an owner who has died.
Definitions deserve attention. “Disability” is a good example. If the clause says “unable to perform duties,” a dispute is almost guaranteed. A better version sets out a period, such as a stated number of consecutive days or a total within a year, and identifies who decides, perhaps an independent physician or the insurer under a named policy. Aligning that definition with any disability buy-out policy avoids a situation in which the agreement says the owner is disabled and the insurer says otherwise.
Who Is the Buyer?
There are two basic structures, and each one has consequences.
Redemption by the corporation. The company buys the departing owner’s shares and cancels them. This is administratively simple when owners do not have much personal cash. It is constrained, though, by the solvency tests in Ontario’s Business Corporations Act: a company cannot purchase its own shares if there are reasonable grounds to believe it would be unable to pay its debts as they come due, or if its assets would fall below certain levels. A clause that promises a redemption the company is legally unable to complete needs a fallback, such as payment in instalments as solvency allows. For tax purposes, part of the price may be treated as a deemed dividend.
Purchase by the other owners. The remaining owners personally, or through their holding companies, buy the shares. This usually produces a capital gain for the seller instead of a deemed dividend, and that gain may in the right circumstances be eligible for the lifetime capital gains exemption. It also leaves the buyers paying with after-tax dollars. Where there are three or more owners, the clause should state how shares are divided among the buyers and what happens if one of them does not want to buy or cannot.
A hybrid is common. The clause might let the parties select the method at the time, based on advice, or it might set out a default with flexibility. Rigid wording written without tax advice can cost a family a good deal more than a small amount of drafting would have.
Price Is the Clause Most Likely to Start a Fight
Most buy-sell disputes come down to price. Each of the usual methods has a weakness.
A fixed amount, updated annually. Owners sign a certificate of value each year. It is inexpensive and clear, and in many companies it is updated once and then forgotten. A clause using a stale number can produce a shocking result, so consider a backup: if the last certificate is more than a set period old, the price is determined by valuation instead.
A formula. A multiple of earnings or a percentage of book value is easy to apply but can age badly. Book value may seriously understate a profitable service business with few hard assets. An earnings multiple can be distorted by one strange year or by how owners pay themselves. Be precise about adjustments, such as owner compensation, one-time items, and the time period used.
An independent valuation. Often the fairest method, this can also be the slowest and most expensive. Name the qualifications required, such as a Chartered Business Valuator, how that person is selected, who pays, and whether the decision is final. Specify the valuation date. The value at the date of death and the value six months later might be quite different if the deceased owner was the main rainmaker.
Discounts. Say expressly whether a minority discount applies. Without clear wording, a 25 per cent holder might receive 25 per cent of the company’s value, or something less, and both sides can argue for their reading.
A lower “bad leaver” price, for someone who breaches the agreement or is dismissed for cause, can make sense, but it should be defensible. Courts have tools for relieving against penalties and forfeitures in some circumstances, and an extreme discount invites a challenge. It also has to work with employment law, because “cause” in an employment setting is a demanding test that an agreement may need to define carefully.
Where the Money Comes From
A buy-sell clause without funding is merely a promise. Several sources can be used alone or together.
Life insurance. This is the classic solution for a death trigger, because the money shows up exactly when it is needed. Policies may be owned by the corporation or by the owners on each other’s lives. When a private corporation receives life insurance proceeds, a capital dividend account credit can arise, which may let funds be paid out tax-free to shareholders in some structures. Those rules are technical, and they have been the subject of careful planning for a long time, so have the arrangement reviewed. Keep three things aligned: the agreement, the policy ownership, and the beneficiary designation. An insurance policy that names a spouse personally when the agreement assumes the company will receive the money can cause a real problem.
Disability buy-out insurance. This is less common and tends to have long waiting periods and specific definitions. Ask about it anyway, and make the agreement’s timing fit the policy.
Instalments from the buyer. Most buyouts without insurance are paid over time. A hypothetical clause might call for 20 per cent at closing and the balance over four years with interest. The seller then becomes a creditor of a business they no longer control, and that risk should be addressed. Common protections include a promissory note, a general security agreement, a share pledge, personal guarantees, limits on dividends and owner pay until the note is paid, and acceleration if a payment is missed.
Bank financing. Possible, but a lender will review the company’s cash flow and security position after the buyout, and it may require existing owners to give guarantees. An early conversation with your bank about how it would treat a shareholder buyout can reveal limits in your existing loan covenants too. A clause in the bank documents may even prohibit a redemption or a change of control without consent.
Review the funding at least every few years. A hypothetical company worth $400,000 when its $200,000 policies were bought may be worth $2 million a decade later, which would leave the survivor owing $800,000 with no insurance to pay it.
Coordinating With the Rest of Your Life
The clause should be read together with several other documents, and this is where experienced advisers often catch problems.
Wills. On death, a person is generally deemed for income tax purposes to have disposed of capital property at fair market value, subject to rollover rules for a spouse. If the agreement forces a sale at a formula price lower than fair market value, the estate could face tax on a value it never receives. Non-arm’s length sales raise similar questions. Your will should also give the estate trustee authority to complete the sale, and it should not leave the shares to someone in a way that conflicts with the agreement.
Family law. Under Ontario’s Family Law Act, a married owner’s shares can factor into an equalization calculation on separation. A marriage contract may address this. A buy-sell trigger on marriage breakdown should be drafted with a family lawyer’s input, since it may affect how a court views value and could raise fairness concerns.
Non-competes. A seller’s covenant not to compete can be a major part of what the buyer is paying for. Ontario’s ban on employee non-competes has limited exceptions, and it is not always obvious how it applies to an owner-employee who sells on a trigger. A covenant in an exit context should be specifically reviewed.
Financing and leases. Check whether your lender, landlord, or franchisor needs to consent to a change in ownership. A clause that works perfectly among the owners can still breach a commercial lease.
Shotguns Are One Tool, Not the Whole Answer
A shotgun clause, where one owner names a price and the other chooses to buy or sell at that price, often gets included as a deadlock remedy. It does nothing for death or disability, and it works best where the owners have similar finances and equal knowledge of the business. If one partner runs the company and the other is a passive investor, or if one has easy access to credit and the other does not, the mechanism may favour the stronger party. Protective features include a blackout period after signing, a longer time to arrange financing, and a bar on use during another pending trigger. Also address what happens if the responding owner fails to close: usually, the other side may buy at a stated discount or on stated terms.
Make the Closing Mechanics Boring
Deals often fall apart on details. A good clause spells out the closing date and place, delivery of share certificates or transfers, resignation as director and officer, release of the seller’s personal guarantees, or an indemnity if a lender refuses to release them, repayment of shareholder loans, return of company property, and a power of attorney to complete the transfer if a party refuses to sign.
That guarantee point matters more than most people expect. A departing owner who has sold out but is still personally on the hook for the bank loan and the lease has taken on a real risk with no control. Ask for a release as a closing condition where possible, and set out what happens when a lender says no.
Test It Before You Need It
Before signing, take a blunt approach. Pick each trigger and walk through it with real numbers. If you died tomorrow, what would your family receive, when, and from whom? Could the survivor afford that today? What would the tax result be? If the answers are vague, the clause is not finished.
Then set a reminder to review it, perhaps every two or three years, and whenever the company’s value changes significantly, an owner’s family situation changes, or a child enters the business. Our business formation and organization page outlines how these agreements fit into a company’s founding documents, and if a sale is already in view the purchase and sale of businesses page explains the wider transaction. To have an existing agreement read against your current situation, you can contact the firm.