In simple terms, Succession Planning is establishing who will inherit or purchase an owner’s equity in the business when that owner exits the business.
This ‘exit’ may be intentional (retirement from the business), unintentional (death or permanent disablement), or forced (default, divorce etc.). To ensure that your succession plans are actually carried out it is vital that the owners obtain a ‘Business Will’, otherwise known as a ‘Buy/Sell Agreement’. The Buy/Sell agreement determines who will inherit the shares or equity of a business when an owner departs. This forms an important part of the overall ‘business plan’ and, along with the funding arrangements, is vital for a business where there are two or more families involved, as they ensure that:
- the control of the business remains with those who the proprietors choose;
- assets of the business do not have to be sold to pay out a proprietor’s estate;
- the remaining proprietors and the deceased’s family are all treated fairly;
- debts are cleared where appropriate;
- families are not left with capital gains tax liabilities;
- the business remains viable in the eyes of its creditors, suppliers and clients.
The agreement by itself will not offer much assistance to you if you do not address the funding arrangements, in other words, if your business partner dies and you want to maintain control over the business then exactly how are you going to buy his/her share of the business? Perhaps you have plenty of cash at hand or perhaps you can borrow the money. Often the best alternative is insurance.
Life, Trauma and TPD insurance taken out on the lives of each business owner is the perfect solution to fund the buyout of a partner’s equity, plus cover things like loan repayments and any capital gains tax that may be incurred by the deceased’s estate. The Principals agree that the proceeds of the policies will be used to buy the departed Principal’s interest in the business from his/her estate. The estate receives fair compensation and the remaining Principals keep full control of the business.
We have found that combining a ‘common sense agreement’ with fair compensation takes the emotion out of the decision making process when an exit occurs.
Deciding on the level of funds required depends on:
- The value of the business at the time;
- What the Capital Gains Tax implications would be;
- The amount of debt that would need to be cleared;
- Will there be a loss in profits?
- Will a successor need to be recruited and trained?
- Will the business lose important connections, contracts, goodwill or expertise?
As explained, an ‘Exit’ for succession planning purposes is when a proprietor leaves the business due to death, illness, (early) retirement or default (e.g. bankruptcy, criminal charges etc.). Insurance will obviously only fund exits on death and disablement so alternate funding arrangements will still need to be made if your business partner just decides to get up and leave.
Before deciding what the exit strategies will be, you should ask yourself:
- “If one of my partners exits, what affect will it have on the business?”
- “Would I be happy to work with my ex-partner’s spouse?”
- “What will be the situation if that spouse then re-marries?”
- “Am I happy to work with my ex-partner’s children?”
- “What’s fair for me and my family?”
- “What’s fair for my partners and their families?”
As you can see there are a lot of issues that need to be sorted out. All of the Principals will need to show a degree of flexibility, as what one may think is a fair outcome, the others may not!
For example, we have addressed situations in the past where one Principal wanted his child to come into the business but the others did not. They felt uncomfortable with the fact that they would have to ‘carry’ their newly acquired partner – besides, the business was built around their relationship with the father, not the child. The interesting point behind this case was that even though that principal wanted his child to ‘fill his shoes’, he was adamant that he could not, and would not work with the children of any of the other Principals. Now is that fair?
When addressing the succession planning needs for a business, we need to look at the situation as it currently stands. Firstly, do the individuals, discretionary/unit trusts, or separate companies own the assets of the Company? Are there beneficiaries who will still be entitled to a distribution of profits regardless of whether or not a principal is working?
Most Proprietors would prefer to cut ties with a departed proprietor’s family especially if that family is not adding any value to the business. If there is currently no agreement in place to cover an exit, you may find yourselves in a very precarious situation.
Problems we have witnessed from companies in similar situations have been:
- Spouses and/or children have come into the business without the same levels of skill and expertise as the departed principal. Often though, they still expect the same level of remuneration and control as the departed principal.
- Assets have been passed on in accordance with State Intestacy Legislation when a Principal dies without a will/up-to-date will.