What it means
A private business with two or three owners has a problem hiding in plain sight: nobody has decided what happens to a departing owner's shares. Without an agreement, a stake can pass to a spouse, an adult child or a creditor who has no interest in or aptitude for running the business.
A cross-purchase agreement settles the question in advance by committing each surviving owner to buy a defined share of the departing stake at an agreed price. Funding is the practical heart of the arrangement.
Most owners cannot write a seven-figure cheque at short notice, so each buys a life insurance policy on each of the others and uses the payout to fund the purchase. That converts an unaffordable obligation into a manageable annual premium.
The structure differs from an entity-purchase or stock redemption agreement, where the company itself buys back the shares. In a cross-purchase the buyers are the individuals, which normally gives survivors a higher tax cost base in the shares they acquire.
The trade-off is administration, because the number of policies grows quickly as owners are added. The number of policies required is n x (n - 1), where n is the number of owners.
Two owners need two policies, three owners need six, and five owners need twenty, which is why larger groups often use a trusteed cross-purchase or switch to an entity-purchase design instead. The agreement also needs a stated valuation method, whether a fixed formula, a multiple of earnings or a periodic independent appraisal.
Review the agreement every two or three years without fail. A stale valuation clause is the single most common source of dispute, and insurance cover should be re-checked at the same time so it still matches what the shares are genuinely worth.
In practice
Real-world examples.
Example
Two dentists own a practice equally and value it at $2,400,000. Each buys a $1,200,000 policy on the other, so that if either dies the survivor can buy the whole practice outright and the family receives cash instead of half a business they cannot operate.
Example
Three siblings inherit a haulage company in equal shares and put a cross-purchase agreement in place with a valuation set at four times average EBITDA over the previous three years. When one sibling wants to emigrate, the same agreement governs the voluntary exit, with the price paid in twelve quarterly instalments rather than from insurance.
Example
A four-partner engineering consultancy finds that twelve separate policies have become unwieldy as partners age and premiums diverge. The partners move to a trusteed arrangement where a single trustee holds four policies and administers the buyout, keeping the tax treatment of a cross-purchase with far less paperwork.
Formula
Calculation
Cover each owner needs on each co-owner = (business value x that co-owner's ownership share) / number of remaining owners
Take a design agency with three equal owners and an agreed value of $9,000,000. Each stake is worth $9,000,000 / 3 = $3,000,000. If one owner dies, the other two split that stake, so each buys $3,000,000 / 2 = $1,500,000 of shares.
Each owner therefore holds a $1,500,000 policy on each of the other two. The number of policies is 3 x (3 - 1) = 6, with total face value of 6 x $1,500,000 = $9,000,000. At $4,000 per policy per year, the group pays 6 x $4,000 = $24,000 in premiums, or $24,000 / 3 = $8,000 per owner.
When an owner dies, each survivor collects $1,500,000 and hands it to the estate for half the deceased owner's shares. The two survivors move from one third each to one half each, so each now owns $9,000,000 / 2 = $4,500,000 of a business they still control, and the estate receives $3,000,000 in cash rather than an unsellable minority stake.Case study
Seen in the real world.
Ridgeway Fabrication is an illustrative, invented example of a metalworking firm owned equally by three founders and valued at $9,000,000. They signed a cross-purchase agreement in their fifth year and funded it with six life policies of $1,500,000 each, at a combined cost of $24,000 a year.
Eleven years later, one founder died unexpectedly. The insurers paid within a few weeks, the two survivors bought his shares from the estate for $1,500,000 each, and his family received $3,000,000 in cash. The business kept trading with no ownership dispute and no bank borrowing.
The illustrative complication was the valuation clause. The agreement fixed the price at the value certified at the last annual review, which had been skipped for two years while everyone was busy. The company had grown, so the family argued the shares were worth more than the agreed figure, and the parties eventually settled on a top-up payment. The lesson is that the funding rarely fails, but the valuation often does.
Watch out
Common mistakes.
- Signing the agreement and never funding it. A promise to buy shares is worthless if none of the surviving owners can actually raise the money, so the insurance or a funded sinking arrangement is not optional.
- Letting the valuation go stale. A price set five years ago will usually be wrong by a wide margin, and a wrong price is how family relationships and business partnerships come apart at the worst possible moment.
- Covering only death. Disability, divorce, bankruptcy, retirement and simple falling-out are far more likely than death for owners in their forties, and a good agreement addresses each of them.
Questions
People also ask.
How many policies does a cross-purchase need?
The formula is n x (n - 1), so three owners need six policies and five owners need twenty, which is the main practical reason larger groups prefer a trusteed or entity-purchase structure.
Is a cross-purchase better than a company redemption?
It usually gives survivors a higher cost base in the acquired shares, which reduces tax on a later sale, but the entity version is simpler when there are more than three owners.
Who should own the policies?
Each owner personally owns the policies on the others in a classic cross-purchase, though a trustee can hold them on everyone's behalf to cut down the number of contracts.
From the founder's library
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