Background
Many entrepreneurs, professionals and investors have significant interests in private companies, partnerships or similar entities which often represent their most valuable asset. These interests are typically held by a single person or a small group of individuals.
Having committed years of hard work and dealt with the many stresses of being a business owner, how do you ensure that your family or dependents actually realise the value that is represented by the business should you pass away or become permanently disabled and can longer participate in the operations. This is particularly important for single shareholders, sole proprietors, or professionals where the value is at risk of totally dissipating should something happen to them.
Apart from realising the value, just as important, is the issue of being able to liquidate that value i.e. another party may acquire your interest at full value; however, if they do not have the cash available for payment (as their major asset could also be a business interest and therefore illiquid) your dependents could be severely prejudiced.
While there are a few scenarios, the same principals may be applied to each to resolve this issue. Below we will review the following 3 scenarios:
- Where there are 2 owners
- Where There are more than 2 owners
- Where there is a single owner.
Owners
Good governance determines that there should be a signed document which regulates the relationship between the parties i.e., a shareholders or partnership agreement. These agreements should include a clause as to what would happen should one of the co-owners die or become incapable of performing their duties owning to physical/health reasons.
As having another family member step into the shoes of the affected/exiting shareholder is often not the preferred option, these agreements usually provide that the exiting owner is deemed to have offered their interest in the business to the remaining shareholder on the day, or day before, a specified event such as death or permanent disability. The valuation of the business interest being offered is determined by a predetermined formula or by an independent third party.
While these agreements may ensure that a fair value is determined they usually do not consider the capacity of the acquiring/remaining owner to actually make the payment. The non-implementation of the agreement owing to an inability to make payment can lead to consequences such as:
- A person becoming an owner of the business who may not be suitable or acceptable to the remaining owner or
- The beneficiaries of the exiting owner not receiving any cash leading to them experiencing hardships.
As this obligation arises from an event such as the death or disability of one of the parties, the most efficient and cost-effective way of resolving for this situation is to support the shareholders, partnership, or other agreement with a buy-and sell agreement that is backed by life insurance policies.
In terms of this arrangement each owner takes out a life policy of the other for a value that is equivalent to their potential purchase obligation. Should an insured event occur, the life policy will pay the proceeds to the remaining owner who, in terms of the provisions of the buy and sell agreement, is obliged to use the proceeds to acquire the exiting owner’s interest.
This elegant solution not only achieves the owners’ objectives but is also unlikely to place a financial burden on the remaining owner. The buy and sell agreement may make provision for the basis of the business valuation and the quantum of life assurance may be adjusted from time to time as required.
More than 2 owners
The solution for the scenario when there are more than 2 owners is the same as above; however, this situation requires a buy and sell agreement which is a bit more complex, and each owner will have a number of life policies equivalent to the number of owner interests they could potentially be obliged to acquire. The value of each life policy will be equivalent to the potential obligation payable to the owner on which the life policy is based.
Should an insured event occur, once the obligations have been settled, the buy and sell agreement and the values of the life policies will need to be revised to reflect the new situation.
Single Owner
Should the owner die, while their business interest could be included in their deceased estate and distributed to their nominated beneficiaries, these beneficiaries may not have an interest or may not be suitable to continue with the business.
Trying to sell the business on the open market may also not be the preferred option as its full value is unlikely to be realised in a forced sale and the value of a single owner business often dissipates rapidly should they not be involved on a day-to-day basis.
Considering the solutions above, implementing a buy and sell agreement which is supported by a life policy would appear that the best option, but this requires that a potential purchaser is identified in advance of any required sale.
This conundrum is compounded as often there is not an obvious “other” party to whom the business interest may be sold to.
The options when trying to identify a purchaser who has the ability and the appetite to become the owner are usually focused on:
- A current employee.
- A third person known to the owner.
- A complementary business or significant customer that would want to expand their existing business.
- A competitor – while this may appear initially perverse, if the business is highly specialised this option could be the best to realise the value. Reciprocal buy and sell agreements between competitors in highly specialised single owner businesses are not uncommon.
Other considerations
Apart from realising the inherent value created by a business owner, consideration should also be given to other arrangements that could have financial impact in the event of a business owner’s death or disability. These include:
Shareholder Loans to the Business
As smaller businesses often struggle to raise financing from institutions the owners often commit their personal resources.
While this funding should become immediately repayable should the owner exit the business, there is no assurance that the business will have the capacity or liquidity to repay when required to do so.
This potential problem can be resolved by the business taking out a life policy on the owner advancing the loan, the proceeds of which are then used to repay the loans.
Personal liability
A business often requires financing, whether it is to start a new venture, expand on existing business opportunities or to acquire new business assets. When negotiating with a financial institution for financing, it is often required that the business owners (referred to as the ‘guarantor’) provide personal surety for the loan. This can pose a potential risk to the personal estate of that guarantor.
The guarantor can be held personally liable for the debt during their life and upon death, if:
- The business has a liquidity problem and cannot service or settle the debt, resulting in the personal estate of the guarantor being targeted.
- There is no suitable candidate to replace the guarantor upon their death.
- Alternative security is not available.
If the estate of the guarantor is targeted after death, it can have the following effects:
- The winding up of the estate can be delayed unnecessarily.
- The estate can be depleted of all liquid funds available and be left insolvent.
- The lifestyle of the dependants will be affected.
The death of a guarantor can also have a detrimental impact on the business. Should the personal estate of the deceased guarantor settle the debt, the estate can claim it back from
the business or its surviving owners. This may result in the unnecessary sale of business assets.
To resolve this potential problem the business can insure the life of the guarantor who has signed surety with a contingent liability insurance policy. The policy should ideally include a disability benefit and the amount of cover should be equal to the total outstanding debts (plus provisions for any taxes). Policy premiums are paid by the business and an agreement is entered into whereby the business undertakes to utilise the proceeds of the policy to settle the outstanding liabilities, thereby relinquishing the guarantor’s personal estate of any liability.
Business Interruption
For most business owners their business and the income that is generated by the business is their most important asset. The business owner and their family are dependent on that income; the business’ future depend on it and all the employees employed in that business are also sustained by it.
The disability of the business owner will generally have a detrimental impact on the business and will impact not only the short-term income flows but also the long-term sustainability of the business. If the business cannot maintain its business overheads it will likely face losing its clients, employees, and face potential insolvency.
The business can insure the life of that business owner by taking out a Business Overhead Protector or Business Protector policy. This policy will ensure that there is sufficient cash flow to absorb the monthly running costs of the business and to sustain the business’ salary expense obligation for a short period of time. This will afford the business owner and business the time to review the overall impact of the disability on the business and to plan effectively for the future thereof. In this instance the business will own the policy, pay the premiums, and receive the proceeds.
In addition, the business owner can also insure their own life with an Income Protector policy to replace any income lost during permanent disability. In this instance, the individual business owner will own the policy and pay the premiums and upon their permanent disability the policy will start paying them an income until the age of 70.
Benefits for the business and its employees therefore include:
- The business can continue to fund its running expenses.
- The employees will continue to receive their monthly income.
- The business’ short-term sustainability is secured.
- The employees can be assured that the untimely disability of their employer will not result in their immediate unemployment; and
- The business owner has time to plan for the business’ future. If they are only temporarily disabled, the business will continue unhindered until their recovery. Should their disability be permanent, the business can sustain itself during the winding-up process, if this is a consequence.
Benefit for the business owner
- The business owner can focus on recovery with the knowledge that the business is self-sufficient.
- The business owner is secured of an income during their disability.
- The business owners’ dependents’ standard of living will not be unnecessarily impacted on; and
- Should the business owner’s disability become permanent, they will continue to receive an income until retirement age.
Non-business-owner related issues
While the implications of the situations outlined above relate to the potential death or disability of the business owner, there are also a few interventions that a business owner may implement to make the business more robust which do not depend to the physical wellbeing of the owner.
Keyman Insurance
Effective and well-trained staff is vital to a business’ success (especially those with specialist skills or knowledge). If such an employee were to die or become disabled tomorrow, there would be a cost implication for that business?
Losing a key person could mean increased costs for recruiting and upskilling of a replacement, a slowdown in turnover and stricter terms from suppliers. In addition, this loss could lead to difficulties in raising finances, having to pay back loans, delays in finding a successor and time lost during the settling in period.
Key person protection is an arrangement where a business insures the life of a key employee (or director) for the purpose of compensating the business for the loss of income it would suffer in the event of that employee’s death or disability. The benefits received upon the death or disability of the key person can then be used to absorb disruptions to the business, protect credit facilities and provide funds to recruit and train a replacement.
Asset Replacement Provision
Many businesses use expensive machinery, equipment, or motor vehicles to generate or assist in the generation of income. The fixed cost of these assets is either financed by shareholder capital or through bank loans. Where finance is obtained, the institution shall generally require security from the business and/or its shareholders or directors. Therefore, it is good business practice to make provision for the future maintenance or replacement of the assets: either to fund the actual purchase or to be used as security for a loan.
If no provisions are made, the business will have to go back to its shareholder(s) or bank to refinance the purchase of a new asset – thereby putting additional weight on the balance sheet and creditworthiness of the business. Provision for future asset acquisition or maintenance should always form part of the business’s holistic financial planning to ensure unnecessary financial pressure is prevented.
This situation is addressed by the business starting an investment (an endowment policy, sinking fund policy or an investment in unit trusts, etc.) to build up capital to assist with the repurchasing and/or refinancing of assets. The business may choose to invest sufficient amounts to cover all its assets in one investment or may prefer a combination of investments.
Funding options
- Where the assets are financed with a loan, the tax saving due to the tax-deductible interest can be used to fund the investment.
- In addition, any depreciation that is claimed as a tax deduction can have a positive impact on the cash flow position of the business, which saving can be used to fund the investment.
- Any surplus income available on the balance sheet or retained profit can be used as a funding option for the investment.
The advantages implementing this strategy include:
- Good corporate governance and risk management, by making adequate provisions.
- The growth of alternative assets within the business will enhance the balance sheet of the business, thus increasing its value to shareholders.
- The replacement of long-term liabilities on the balance sheet with fixed assets will improve the business’ gearing ratios and therefore improve its creditworthiness.
- The investment can serve as a ‘parking bay’ for retained income which can fund future dividend declaration or other expansion needs of the business.
Preferred Compensation Scheme
One of the most valuable assets of any business is its employees, especially those with the relevant knowledge, skills, and experience. The continued success of a business is to retain its good employees.
A high staff turnover is a costly business risk as it results in loss of productivity, intellectual property, employment costs and training costs. Therefore, it is important for a business to retain and motivate its employees.
The business can implement a preferred compensation scheme. This is an incentive scheme for valuable employees. The purpose of the scheme is to motivate and retain good employees. It rewards key employees with tax-free bonuses every five years and eliminates the cost of staff turnover and reduced productivity.
Benefits to the employer
- This is a unique way to retain employees securing the service of key employees for at least five years.
- The total amount paid by the employer is tax deductible, as it is part of the remuneration of the employee; and
- Should the employee not remain in the service of the employer for the specific time, the employer is assured of a cash benefit as compensation.
Benefits to the employee
- The employee receives a tax-free benefit for long service.
- The security of the benefit is provided by the service agreement.
- This is a forced saving, making provision for future needs easier to the employee.
- This does not affect any tax benefit due to any other retirement funds.
Implementation
This document provides a high-level overview of certain issues that should be considered and addressed by business owners.
A critical aspect of these interventions is ensuring that they are correctly implemented. In many cases very specific agreements e.g. the buy and sell agreement, are required to ensure that the intended outcomes are achieved.
The structure and terms of the life policies that support these agreements are also required to be very specific and need to align with the agreements.
It is strongly recommended that the advice of professionals is sought to ensure the correct implementation of some of these options.
Conclusion
Just as every individual should have a personal financial plan, a business owner should have a financial plan for their business which goes beyond the budget and operations and considers the risks outlined above.
A well-considered plan that is correctly implemented will not only provide the business owner with peace of mind but will also ensure that their dependents or the business itself are not negatively impacted by events beyond their control.
A lifetime of hard endeavour could be lost in a moment or the benefit fully realised through a bit of careful planning.