As business grows, it’s quite common for closely-held business owners to channel the profits to be reinvested into their business to fund growth. Hence, a significant part of their total asset portfolio is invested in the business. So much so that often business owners see their value in the business as their “default CPF” (Singapore Retirement System) which they assume will be available on retirement.
Personally, there is a likely risk involved in this strategy as that investment is vulnerable to “break up”, whether for a voluntary reason, i.e. retirement, or for an involuntary reason, i.e. upon their untimely death or their disability to continue in running the business due to contracting a critical illness and long-term injury.
When there is no business succession plan in place, the business break up can cause confusion, conflicts and potentially put significantly assets at risk. All business relationship will inevitably come to an end. And this is definitely the last thing what business owners are looking for.
So what is business succession planning about?
Briefly, business succession involves planning for the smooth transfer and succession of the business interests of business owners for both voluntaryand involuntary situation, as mentioned. It is advisable to work with your financial planner who has the ability to identify the possibilities and plan for the desired outcome. Putting legal agreements and funding in place before they are needed is simply good planning to protect what can often be a very large investment and a significant portion of the total assets.
There are two legal agreements available to cater for these departure possibilities. An Exit Agreement covers the issues surrounding a voluntary departure, e.g. retirement, while a Buy/Sell Agreement covers off involuntary departures caused by death, total and permanent disablement or critical illness.
When a partner voluntarily leaves, the Exit Agreement stipulates terms such as the valuation method, perhaps a discount to that because of the early departure and the payment terms e.g. the agreed amount is paid down over three years. With Exit Agreement this payment is funded by the remaining partner, and is often structured so that it is equivalent to the extra profit retained.
However, when someone’s departure is caused by death or disablement, the funding is usually via insurance. This is where the financial planner has a vital role to play, and to put protection in place for those involuntary exits.
- What would happen to the business if one of the partners could never work again?
- How long would they be prepared to support each other if one of them became critically ill?
- Would they be happy to work with their partner’s spouse if their partner could no longer work in the business?
These are the common issues that business owners would ponder and funding a Buy/Sell agreement would be an excellent foresight.
What is the Buy/Sell Agreement?
The Buy/Sell Agreement is a devise used commonly for purposes of business succession to provide smooth transfer of business interests to the surviving business partners upon a “trigger” event. The agreement will state the terms and conditions for the sales and purchase of business interests upon the trigger event of a co-owner’s death, disability, retirement, withdrawal from the business or other events.
The main objective of such an agreement is to ensure that the business continues with good standing and the outgoing owner’s beneficiaries receive the fair market price for the sale or the transferred of the business interest.
How does the Buy/Sell agreement work?
In most cases, the Buy/Sell agreement comes into effect on the payment of an insurance claim for death, total and permanent disablement (TPD) or critical illness to one of the owners. And the agreement would enforce the transfer of their share to the other co-owners or surviving partners.
To illustrate my point: Joe and Henry have a buy/sell agreement that stipulates if one of them dies or becomes TPD, the other receives their share of the business. In this instance, Joe dies and the buy/sell agreement is triggered by the payment of the insurance proceeds. Joe’s life policy is paid out to his estate, and Henry in turn receives Harry’s 50% share of the business, at no cost!
Now it may sound odd that Henry receives the shares for no cost, but keep in mind that both parties are in equal position when the agreement is drawn up. It could happen to either one of them. The critical element is the insurance proceeds. This helps ensure the ‘departing’ partner and his or her family receives an amount equal to the value of the business, as desired and planned.
Imagine if there is no agreement or no insurance arrangement in the first place.
How to fund the agreement?
Self-ownership is one preferred option for a number of reasons. If a partner dies, his estate receives the insurance proceeds, tax free. With a Buy/Sell agreement in place, his share in the business then transfers to the remaining partner(s). Such an instance becomes a timely investment – money is available when it is needed most. It is straight forward approach and simple to understand, so it’s easy for business owners to act.
Next, with a properly drafted Buy/Sell agreement it is also possible to combine an individual’s different insurance needs into the one policy e.g. business funding, debts owed to the business, family needs, etc. Under these self-owned policy would reduce the cost for the client.
Self-owned policies also reduce the risk of a bankruptcy or insolvency soaking up the insurance. With cross-owned or company owned policies there is always a risk that if the other partner is bankrupt or the business is insolvent at the time, the proceeds would be directed straight to creditors and the estate or partner could miss out.
Having a trust is another option although this needs to be treated with caution. This is where a special purpose trust is established to own the insurance policies, with the trustee’s only duty being to pass on assets to the appropriate beneficiaries. These are sometimes used where there are a large number of partners, and there is a chance that over time, one or more will depart and other will join. Rather than having to amend the buy/sell agreement every time a change in ownership occurs, these changes are managed via a register attached to the Trust, where the change in owners and policies can be noted. It also reduces the cost as an individual’s different needs, as mentioned above, can be combines into one policy, reducing policy fees.
The Trust need to be properly drafted with the business purpose in mind to ensure that the trustee performs no other duty other than pass on the insurance proceeds to the appropriate beneficiaries. Other issues to be considered include the potential annual fees associated with a third party acting as a trustee and possibly taking a percentage of the proceeds.
What if the insurance funding is prohibited?
Sometimes, financial planner can’t get insurance for one of the partners or the loading is prohibitive due to health reasons. This is where an Exit Agreement has an additional role to play.
Let’s say there are three partners – Anne, Bob and Chris. They can all get life cover but Bob can’t get TPD cover. The life cover can be implemented for all three partners, to be supported with a buy/sell agreement to ensure the shares are transferred in the event if one of them dying. A TPD payment can also be included as trigger event however it will obviously not be applicable in the event of Bob suffering a total and permanent disablement. In this instance, the Exit Agreement can be used to cover Bob suffering a total and permanent disablement. If Bob can no longer work due to stroke as an example, Anne and Chris can force him to transfer his shares to them and he in turn will need to receive a payment from them. Obviously that won’t be funded by insurance but terms payments and possibly a discount to a value can be written into the contract to make it easier for the remaining partners.
While this might not be as ideal as insurance funding, it does provide the other business owners with some comfort that should Bob suffer a total and permanent disablement that they have an agreement in place to deal with it.
It’s critical that business partners implement business succession plans to protect what often represents a large proportion of their total wealth. More often than not a large number of businesses might not have such plans in place.
So, business owners would engaged financial planner who needs to understand their business to facilitate this business succession planning, to provide a funding solution via insurance in the event of the death, total and permanent disablement or critical illness of the partners.
Without proper planning, business owners are not guaranteed of their effort they have put in.
Lastly, to the business owners, what do you really want to happen to your business due to your retirement or early demise?