Believe it or not, just like many marriages, for a variety of reasons not all business partnerships last forever.
Last week we dived into The importance of proper Estate Planning and how crucial this is to protect your spouse & kids and to keep assets “in the family” when you are no longer around. We also touched on how to best pass control of business & investment structures (such as trusts & private companies) to your intended beneficiaries.
But what if you are a Business Owner and are in business with one or more person who is not your spouse? If you were to pass away, would your spouse want to be in business with your current business partner/s?…would your current business partner/s want to be in business with your spouse? My wife likes my business partners, and vice versa. But I don’t need to ask any of them to know that if I passed away…neither would be terribly excited about being in business with the other! My business partners would want to maintain control…and equally my wife would want to take the value of my equity and try to move on with her life (as crushed as she may be…although I’m sure the level of my life insurance pay out from our Super Fund might ease her pain somewhat).
For all these reasons and a variety of others, this is why Business Succession Planning is a key area for all business owners to address. But firstly…what exactly is “Business Succession Planning”?
Business Succession Planning
Business Succession Planning can mean many different things depending on the shape and size of the business. Meanings of Business Succession Planning can vary from planning to pass the business on to the next family generation, exit via a sale to key team members or a main competitor, or possibly even an IPO. But for the scope of this blog Business Succession Planning will cover two key events;
- Voluntary Exit succession planning – planning for when one business partner decides to exit the business (or it’s decided for them), and
- Involuntary Exit succession planning – planning to cover the death or incapacity of a business partner.
In this context essentially Business Succession Planning is ensuring that the Right amount of money, from the right source, is paid to the right parties at the right time, in the event of one or more business partner/s passing away (or becoming totally and permanently incapacitated) or decides to exit the business.
Voluntary Exit Succession Planning
Whilst the majority of this post will cover Involuntary Exit Succession Planning, the importance of Voluntary Exit Succession Planning should not be underestimated (as frankly it’s the more likely of the two). Any business with multiple business owners, whether in a partnership, company or unit trust should have agreements in place to handle life & business “what if situations”, including retirement of a business partner, sale of a partners’ business interest and expulsion of a partner from the business.
Just like marriage, at the start of a business with two or more partners, everyone is “in love” and it’s all happy families. But just how 48% of first marriages and 73% of second marriages end in divorce (I won’t mention the stats on 3rd marriages – but they’re not great), not all business partnerships remain amicable. People fall “out of love” including business partners. It’s part of life…and in many cases it’s inevitable and just a matter of time.
It’s been said that “if it’s in writing, there’s no fighting”. This may or may not always hold true, but either way business agreements put in place in the “honeymoon” or “in love” phase can protect each business partner along with protect the business in the event of a “divorce” of one or more business partners. Without properly structured succession plans including a thorough shareholders (or unit holders) agreement, a “business divorce”, just like a real divorce, can become expensive, time consuming, and mentally and emotionally draining for all involved…all of which can have a major negative impact on the cash flow and valuation of the business.
Some things to consider in the event of one business partner wanting to exit;
- What agreed mechanism or formula is used to value their equity in the business?
- Do the remaining business partners have right of first refusal?
- Can the exiting partner/s sell to a 3rd party?
- How will the remaining business partners fund a buy out?
- Will the buy out be a terms payment or lump sum? Via cash or borrowings?
- Do you want a “lock in” period of time so the business is not disrupted by the unexpected early exit of business partner?
- How long a notice period does an equity owner have to give before retirement or sale of their interest?
- Will there be “drag along” and “tag along” provisions…especially when the exiting partner is a major shareholder?
- Should/can a restraint of trade be placed on the exiting business partner?
- What if everyone doesn’t agree on terms…does the whole business get put up for sale on the open market?
An experienced Business Succession Planning lawyer in conjunction with your Business Adviser/Accountant are best placed to facilitate a discussion with you and your business partners in relation to “Voluntary Exit” Business Succession Planning, including what a proper shareholders agreement should cover to protect all parties.
Involuntary Exit Succession Planning
As above, Involuntary Exit Business Succession Planning is effectively planning for what happens if a business equity owner passes away or becomes permanently incapacitated (or possibly suffers a major illness).
Involuntary Exit Business Succession Planning provides the business and the business owners with Control, Cashflow and Certainty in the event of any of the above mentioned events occurring.
Many advisers incorrectly believe that Involuntary Exit Business Succession Planning is a buy/sell agreement….or business insurance. These are only part of the process. Involuntary Exit Business Succession Planning is effectively Estate Planning for business owners. There may or may not be funding required for a buy out. Either way, insurance (if applicable) is just a “funding mechanism“. The certainty for business owners (both remaining & exiting) is the key goal to reach.
Before we explore the 3 key steps in Involuntary Exit Business Succession Planning, let’s first cover various possible outcomes without appropriate Business Succession Planning being in place.
One Business owner dies…
- No amount of funds from anyone to any party.
- The estate owns shares with no cash at all.
- The estate is pushing for settlement.
- The remaining business partner(s) has a new partner…immediately (the spouse/family).
- The business value has decreased, and
- Everyone is stressed and in conflict.
Other outcomes (Major illness or Totally & Permanently Incapacitated);
- The sufferer is around and owns shares but no cash available.
- The sufferer is around and pushing for settlement.
- The able partner(s) has a non-productive partner.
- The business value has decreased.
The importance of Involuntary Exit Business Succession Planning
A business owners equity in their business is often their largest asset. Therefore proper planning ensures their personal wealth is protected along with the well being of the business owners family. Additionally it also protects the remaining business owners as well as the ongoing business viability.
Let’s take an IT consulting business with two equity partners; Jack & Joe, both aged 41, married with two young kids each. The business is valued at $1.2mil with profit of $400,000, debt of $750,000 and 4 non equity team members.
Jack has just passed away…what issues is his business partner Joe now faced with? In no particular order;
- Loss of a best friend & business partner,
- Lost of expertise,
- Cost of replacement,
- How is he going to pay the bills and cover the debt?
- Managing the 4 team members and covering Jack,
- Impact on other team members and their roles,
- How is income going to be generated ongoing if Jack was the main “rainmaker”?
- How will Joe deal with Jack’s family as a Partner?
- What is the impact on customers/clients?
- How can Joe afford to pay Jack’s wife/family out?
- Lenders/Personal Guarantees – the bank may call in the loans,
- Access to Cash – Creditors come knocking and Debtors disappear,
- Clients – need to tell clients. There is a potential loss of contracts & future business,
- Team members – Grief, loss of productivity. Retention, will they leave? Paying wages. Ripe for poaching, and
- Jack’s family & estate – Continued salary payments. In business with Jack’s family.
The business can get destroyed….Business Succession Planning can guarantee the value of the business.
Additional issues for Joe;
- Grief for Joe.
- Can Joe continue running the business, make a living & support his family?
- Where will the business end up eventually?
There is uncertainty all round…Business Succession Planning provides certainty.
When something goes wrong like this there are 3 disruptions;
Putting in place a proper Business Succession Plan guarantees that by doing so the Financial and Organisational aspects are taken care of…which by doing so will decrease the Emotion grief and disruption.
The are 3 Key Steps to a solid Business Succession Plan
Step 1 (Control) – Maintain the ownership with remaining business owners as well as having the funding mechanism in place to fund equity transfer costs (bank loan, cash, risk insurance).
Step 2 (Cash flow) – Protect the value of the business to ensure the business is still worth what it was worth before the event occurred. Value is protected by;
- protecting any loss of profit and loss of revenue from one of the key people not being there;
- covering the costs of hiring expertise to replace the loss of a key person; and
- clearing any debts that personal guarantees are being provided for any deceased parties.
The value of the equity is maintained by insuring the risks associated with reliance of key people and business debt is covered (key person cover).
Step 3 (Certainty) – Guaranteeing the Equity Transfer occurs the way everybody wants it to in the situation of a trigger event occurring (buy/sell agreement).
A note on business valuations for “Involuntary Exit” Business Succession Planning – This is not a Market Transaction. The valuation agreed under Step 1 isn’t necessarily the Market Value but rather a Valuation all business partners agree is fair and equitable for the time being…and then have a valuation formula/mechanism to value the business in the future – with a Valuation floor/minimum if you like. As an example let’s say your business is a relative “Start Up” and is yet to make a profit, however you and your business partners have put your “blood, sweat & tears” into building the business for the last couple of years and it clearly has massive potential for explosive profits and valuations in the future. So, what should the valuation be under “Step 1” in your Business Succession Plan? And the Answer is….whatever you want it to be – provided it’s at least at the “Market Value”. Based on financials the Accounting Valuation might only be $100,000. However based on potential growth, to be fair to each other and all your families, you and your business partners might place a $2,000,000 valuation on the business for the sake of the “Involuntary Exit” Business Succession Planning. Provided you all agree and it’s in writing, with the funding to back it up…why not.
Let’s explore these steps in more detail…
Step 1 – Funding the “buy out”…misconceptions;
- “We’ll just borrow from a bank” – are the remaining business owners in a strong position to be able to apply for a loan?
- “We’ll use working capital” – Won’t this be needed to bolster cash flow?
- “We’ll sell business assets” – Aren’t they needed to earn income? How will the money be taken out of the business? Tax considerations?
- “We’ll sell personal assets” – This could alienate family further for the sake of the business.
- “We’ll pay off the Estate in instalments” – When does ownership transfer?…straight away. So therefore the deceased family/estate will be entitled to the relevant share of any profits straight away. The deceased family/estate has ownership, and is receiving profits (if any) plus receiving instalments for the “buy out”. The business has to be around long enough for the surviving business partner(s) to fund the instalments.
What about the Cost of Alternatives (versus Life Insurance as Funding)?
- “We’ll just borrow from a Bank” – $ for $ for the full amount needed plus interest costs.
- “We’ll use working capital” – Investment or lost business opportunity cost.
- “We’ll sell business assets” – Investment or lost business opportunity cost.
- “We’ll sell personal assets” – Capital Gains Tax and opportunity cost.
Are any of these guaranteed like wealth protection (life cover) insurance is? Wealth protection insurance premiums cost cents in the dollar versus $ for $ for the above alternatives.
Step 2 – Cash flow & maintain the business value;
This step is all about ensuring that each partners share of the value of the equity in the business is as much as it was before the business partner died (or become TPD’d).
Upon loss of a Business partner / key person, a number of things may contribute to the erosion of the value of the business;
- Loss of contracts – leading to a drop in revenue.
- Recall of loans by lenders, concerned about the viability of the business. This will erode working capital and/or personal assets.
- Damage to reputation – which translates into loss of goodwill.
- The sufferer / or family of business partner, may need to be paid a salary – although they are not generating revenue?
So what’s the solution?…Key Person cover;
- Life/TPD & Trauma, and
- Business Expenses cover.
Typically, in sufficient amounts to cover business debts as well as provide the cash flow to hire in replacement expertise (at a minimum), as well as ideally also cater for temporary loss of earnings.
Step 3 – Providing Certainty
Solution: A Buy/Sell Agreement – A legal contract which binds;
- The deceased business partners family/estate to sell the shares/units to the remaining business owner/s, and
- The remaining business owner/s to buy the shares/units of the business from the deceased business partners family/estate.
- The Buy/Sell Agreement should also set the formula around how the business valuation at the time of “Involuntary Exit” should be set.
- The “Valuation Mechanism” as well as the “Funding Mechanism” should be reviewed on a yearly basis just to ensure it all makes sense and all business partners remain on the same page. If the Funding Mechanism is Life/TPD Insurance then the level of insurance should be increased as the business valuation grows…otherwise the remaining business partners are likely to face a funding shortfall in the event of another business partner suffering an Involuntary Exit from the business.
An experienced Financial Adviser (in conjunction with the adviser coordinating your Business Adviser/Accountant and your Lawyer) is best placed to lead the advice in relation to “Involuntary Exit” Business Succession Planning including specific advice for Steps 1 & 2. The adviser will work with your solicitor to ensure that the Buy/Sell Agreement in Step 3 is implemented according to the overall Business Succession Planning Strategy.
All 3 steps are required for a rock solid Business Succession Plan;
- Funding for buy out,
- Maintain the value of the business,
- Legal contracts guaranteeing share/ownership transfer.
If any one of these 3 are missing, the family, the business or remaining partners are all at risk. For example, if there is a Buy/Sell Agreement in place without Life insurance as the funding mechanism, then the remaining business partners will be contractually obligated to come up with the cash (either via borrowings, business cash flow, or selling business or personal assets) in order to buy out the deceased business partners’ family.
If you are an equity owner in a business with one or more other business partners (who are not your spouse), resolve to collectively seek advice and guidance in relation to implementing a rock solid Business Succession Planning strategy – covering both Involuntary & Voluntary Exits. Combine this with thorough personal Estate Planning from The importance of proper Estate Planning and you are well on the way to protecting all your assets and having the peace of mind knowing these assets will pass to the rightful beneficiaries in a protected & tax effective manner.
Remember, “If it’s in writing, there is no fighting” (well usually)…provided the funding is there (under Steps 1 & 2) to make it all happen.
Matthew Morrison is the Director of Wealth Advisory at The Practice, a Personal Wealth Advisory & Business Advisory firm based in Parkville, Melbourne. Matt along with The Practice team are committed to and passionate about developing & implementing wealth creation strategies for clients to enable them to Fuel their Family’s Future (while protecting them along the journey).
Matt and The Practice team can be contacted via http://thepractice.com.au or (03) 8888 4000.
Disclaimer – the above views and ideas are general advice only and are purely the opinions of the author. It’s important that you seek professional advice tailored to your needs before taking action regarding your financial future.