Business Succession Planning
For most Partners in business together, documenting or even discussing what happens if one or more leave the business just does not get done. The subject is too easy to postpone and often awkward to come to terms with. Yet it is inevitable that a Partner will exit the business one way or another – whether it is planned or unplanned. Reasons may be retirement, disagreement, sudden death or long term disablement. Regardless, it is a topic which should be at the top of the business’ risk management agenda.
Assuming a Shareholders Agreement (or Partnership Agreement) is in place, terms limited to “first right of refusal” upon leaving or death etc. may be inadequate.
A Shareholders Agreement should explicitly cater for both planned an unplanned departure of a Partner – otherwise termed as voluntary or involuntary exit.
This occurs upon death or total and permanent disablement of a Partner. This can lead to immense problems for the business, for the surviving business owner(s) and for the personal beneficiaries of the departing Partner.
Without a formal Buy Sell Agreement in place to dictate the terms under which business assets are handled, scenarios like these are common:
- Surviving Partner(s) has to negotiate with the spouse or other beneficiaries to buy out their share of the business. Funds may not be available, the value of the business may be under contention, and beneficiaries may be forced to take whatever is on offer. (Surviving Partners may argue, for example, that the value of the business is diminished without the contribution of the Partner who has departed).
- The beneficiaries may choose to take an active role in the business, whether or not they truly want to, are qualified, or the other Partners want them involved. This may have negative consequences for the business.
Whatever the situation, it is potentially fraught with emotion, cost and dangerous distractions from running the business – and can leave everyone involved unhappy with the ultimate outcome.
Buy Sell Agreement
A Buy Sell Agreement should be in place as a contract between business Partners that sets out exactly what the rights and obligations of each Partner are in the event of the involuntary departure of a partner.
The Buy Sell Agreement should specify:
- Trigger events
- “Call Options” – the right to purchase
- “Put Options” – the right to force the purchase
- Agreed price/formulae
Funding the Buyout
Funding is usually by way of Life insurance, including Total and Permanent Disablement policies, held by each Partner. Ownership of these policies is normally held by each Partner directly. Superannuation funds may be considered in certain circumstances.
Premiums are normally payable by each Partner on their own policies. Alternatives exist and can be negotiated where substantial differences in premium are caused by age gaps or medical loadings.
Capital Gains Tax Implications
Capital Gains Tax liability is another reason why setting the agreed formula value and insurance benefit is so important. Capital Gains Tax is paid on whichever is higher at the time of the event, either the valuation of the equity or the agreed value. If the agreement is not properly prepared, a higher-than-necessary capital gains tax may be incurred.
Voluntary or forced exit
A Voluntary exit may occur as part of a planned retirement whereas a “Forced exit” may only be the only way to overcome a split between Partners to allow the business to stablise and survive.
Regardless of the business or emotional climate under these different scenarios, the presence of an Exit Agreement will be needed to ensure the most orderly solution.
An Exit Agreement will state the terms under which a departing Partner can leave.
From a fairness perspective, most business owners agree that a “penalty” should be imposed on the owner either electing or being forced to leave due to ‘irreconcilable differences’. This “penalty” usually takes the form of a discount on the value of the business as well as the payment terms.
The discount on valuation acts as a form of disincentive to the departing Partner. After all, they are potentially disrupting the business and putting the remaining Partners under pressure. Conversely, it also provides an incentive to the remaining Partner(s) to buy the shares and take on the risk on owning the whole business.
Usually the terms agreed to are such that they allow the remaining Partners to fund the buyout from the future cash flow. This acts as an incentive to the remaining Partner(s) as it helps ensure they can fund the buyout.
The continuing Partner(s) will need to resource funds over the agreed term from which the departing Partner will receive the discounted value. These funds can be obtained from their own resources or from the cash or value of the business.
Capital Gains Tax
Capital gains tax may be payable by the departing Partner and needs to be taken into account in the payment terms to ensure the tax can be paid as required.
Who plays what roles?
It is often the accountant who takes the lead in suggesting consideration of Business Succession planning. Lawyers and the insurance brokers may also suggest having these agreements in place and you will require a lawyer to be involved in the drafting process.
Insurance is an essential component. Correct advice about ownership, types and levels of cover which may consider CGT impacts are all subjects requiring quality, professional advice.
Keyman insurances, typically to erase debt or bankroll replacement expertise, owned by the business, may well be included within the overall advice at this time.
In summary, it’s prudent for business Partners to plan for their exit at the beginning.
For established businesses a review of their existing arrangements should be a high ‘risk management’ priority.
Steve Beetham, Risk Insurance Advisor
Mclean Delmo Bentleys