Not so long ago we saw “Peter” in our office – a referral from one of our clients.
Peter had been operating a small, successful business with his business partner James. Shortly before we saw Peter, James had passed away from cancer. As is common with many Australians, James left everything to his wife Wendy via his Will which meant that Wendy inherited James’ interest in the business.
Wendy had never been involved with the business. Not only did Wendy not want to have anything to do with the business, she told Peter that she would camp on his doorstep until he purchased James’ share of the business from her.
In the meantime she expected & demanded James’ usual wage. She needed money to support herself & the children, & Peter was happy to support his mate’s family (for a short period of time anyway). He would have also been happy to pay her half of the value of the business if:
- He knew what the business was actually worth;
- Wendy then agreed with the value; &
- Peter could find the money to pay her.
Adding a little salt to the wound.
To compound the problem the bank wanted additional security for the business overdraft.
Was Wendy willing to be a co-guarantor for the business overdraft? Probably not.
It is not well known but in many business loan agreements with lending institutions, the death or disability of a guarantor or co-surety to a business is an event of default.
This means that if any person who is a party to a bank’s security dies, becomes disabled or suffers a traumatic event, the bank is able to seek repayment of the loan or re-negotiate the loan facility.
Peter was frantic. His life’s work would probably have to be flogged off at a fire sale &, rather than focusing on what he was good at & passionate about, he was embroiled in a bitter dispute with a grieving (but spiteful) widow.
What is the answer?
Peter & James, together with their Financial Planner/Risk Adviser, Accountant & Lawyer could have prepared a Business Succession Plan.
A Business Succession Plan is a bit like a business Will – essentially it is an agreement between business partners that deals with a principal:
- becoming disabled;
- being convicted of a criminal offence;
- becoming bankrupt, &;
- taking unauthorised absences from the business.
Wendy could then have required Peter to purchase her share of the business for a predetermined price. Alternatively, Peter could have required Wendy to sell her share of the business for the same predetermined price.
How can you afford to pay the purchase price?
Even with a carefully drafted Business Succession agreement in your hands to ensure the transfer of a business interest upon death, all of your problems are not solved just yet. The remaining partners need money to buy out the deceased’s family.
A number of funding mechanisms are available. The simplest & often most successful funding option is a combination of life insurance, trauma insurance, & total & permanent disability insurance policies.
Key Person Insurance, as distinct from insurance for a Business Succession Plan, can also solve the default issue on the business loan.
Obviously insurance will only provide funds for exits from a business caused by insurable events (e.g. death). Exits for events such as retirement from the business will require other consideration &, once again, it is vital that these are agreed on & documented whilst everyone is still civil to each other.
What about tax?
Yes you have to be very careful to structure your Business Succession Plan so that you avoid unnecessary tax.
- A properly prepared Business Succession Plan ensures that only nominal stamp duty is payable when an event is triggered.
- Capital Gains Tax can be triggered on the “disposal” of the business (that is when Wendy sells to Peter). There are many avenues available to you to ensure that the assets are transferred without the expense of capital gains tax provided you take the proper precautions before entering into the Business Succession Plan. Your accountant will be able to advise you in this regard.
So what was the outcome for Peter?
Fortunately Peter is still running the business however he was required to borrow a substantial amount of money to buy Wendy’s share. This meant that Peter had to use personal assets as collateral.
The whole process, including an independent business valuation, new bank loan negotiations, multiple meetings with Wendy & their respective lawyers & accountants, took just over 12 months.
The cost involved however, including time, lost productivity & stress is simply immeasurable.