Do you have a business succession plan? Owner-operated businesses can find themselves in real danger when a principal departs, whether because of retirement, new horizons, disagreements, illness or death.
The value and even viability of a business can be reduced or eliminated if the business fails to make a successful transition to a new ownership structure. How can this be avoided?
What is a Funded Business Succession Agreement?
A Funded Business Succession Agreement is a document that deals with the immediate or future succession of business ownership. The agreement is typically between the principals and their interposed entities which own the equity of the business.
Funded agreements usually take two forms. Firstly, agreements dealing with an involuntary departure of a principal following events including death, total and permanent disability and trauma (insurable trigger events). The insurable trigger events are most commonly (but not necessarily) wholly or largely funded by life insurance. For tax reasons, options are used and insurances are held on a self-insurance basis. Non-insurable trigger events include voluntary departure, poor performance, breach of director duties, insolvency, acts of scandal and others.
Secondly, an insurance trust deed – which has all the attributes of the first but which additionally provides for payments to third parties to be funded and made. This ensures a complete financial severance as regards the exiting proprietor. Properly drafted and structured, no tax will be payable on the insurance proceeds.
Consider this real life example
John, Michael and Adrian are the principals of an established and successful construction business. Tragically, John is killed in a motor vehicle accident.
The principals do not have a Funded Business Succession Agreement with supporting life insurance policies in place.
For the years prior to John’s death, the construction business had been reinvesting its profits into expansion, so neither the business nor the principals have large reserves of cash.
John’s interest in the business has been valued at $1,000,000, and his widow Jill desperately needs this money to support herself and her three young children. Neither the business, nor Michael and Adrian, can raise the $1,000,000 required to pay Jill the value of John’s interest in the business. Accordingly, Jill has no alternative but for John’s estate to sue the business in order to force the business to arrange for John’s estate to be paid the value of John’s interest.
The ensuing court case cost Jill all of her accumulated savings and, although she won the case and the business was ordered to pay John’s estate $1,000,000 plus costs, it resulted in the business becoming insolvent. The business had to be sold. After paying the liquidator’s costs and repaying loans due to secured creditors, there was nothing left to pay the $1,000,000 owed to Jill via John’s estate or to pay a return to Michael and Adrian for all their years of work in the business.
This terrible outcome could have easily been avoided if John, Michael and Adrian had put in place a Funded Business Succession Agreement from the outset. This was meant that:
Is it time for you to develop a business succession plan?
Leigh Adams, Special Counsel, Owen Hodge Lawyers