Paul was the senior partner and a major shareholder with three others in an expanding accounting practice with a total equity value of $2.8M and business loans and overdraft of $0.8M. The facilities are the subject of Personal Guarantees by the partners. Paul and his wife Alison had both previously been married and between them were raising and caring for 4 dependant children. They had some personal insurance to protect the outstanding mortgage/debt and to provide some funds for the family in the event of Paul’s demise.
The partnership had no formal business succession agreement in place. The Partners had discussed many times over the years the importance of doing this, but never got around to actually doing it.
Paul was killed in a motor vehicle accident with a current Will leaving everything to Alison. This included his share of the business.
Alison found herself effectively with a majority interest with the remaining 3 partners. The Practice continues to operate. Alison however, doesn’t want involvement in the business but wants the equity/goodwill in cash. She will gladly give up her shareholding for this, although she is considering holding the asset if the price is not fair, as she needs the money for her family.
The problem of course is that the desired outcome for Alison and especially the remaining partners cannot be resolved easily. The practice is now in survival mode with Paul’s clients to contact and assure that they will be looked after by the practice even though many would only deal with Paul. Current matters Paul was handling have to be reallocated, staff will need to be reassured and possibly reorganized. During this Alison is grieving and devastated, and is effectively now the major owner of the practice, with an unacceptable degree of control.
With no agreement on the value of Paul’s shares, arguments as to the valuation may arise. Verbal undertakings by Paul to his fellow partners that “I will look after you when I sell down” are undocumented and worthless. Additional costs will be incurred to determine an amicable result. Arbitration may be needed and what will be the value now that Paul who was the senior partner and a key person, is no longer around? The remaining Partners will have to borrow funds to buy Alison’s equity, find a buyer or leave Alison as a shareholder.
Alison’s need for a substantial payout is not what the partners want to hear as they need to address the management of the business at this point in time.
Further, the bank has raised gentle concerns about the impact on the business. They have indicated they want additional security from all remaining shareholders (including Alison) or will consider calling in the debt. Death or disability of a guarantor to a business loan/overdraft is often listed in the loan guarantee clauses on security as a “default event” that permits the lending institution to request new or additional security. Paul’s partners are already heavily geared and may struggle to meet the bank’s requirements. The bank is also looking at Alison’s proceeds from Paul’s self owned life insurance to secure the business debt rather than Alison extinguishing the home loan and providing a nest egg for her and the children. Alison is not only facing the tragedy of loosing Paul but at the same time suffering further financial hardship with the real possibility of having to sell the family home just to survive. The bank also has security over the home.
This sounds like a real nightmare for all concerned – sadly it is also real. The situation above could have been avoided.
Estimated Insurance costs had the partners proceeded with Business Succession insurance;
- Equity Cover in total $8,460 for all 3 partners per year,
- Loan/Debt cover in total $2,880 for all 3 partners,
- Keyperson cover loss of revenue on Paul’s life for $900K cost is $4,495 per year.
Succession Agreements are designed to allow the outgoing Partner to sell and the continuing Partners to buy the outgoing Partner’s equity in the business. Most importantly it allows for the orderly management of the transition when the outgoing Partner leaves the practice. It also avoids the financial stress if that plan is accelerated because of an unexpected death, disablement or critical illness. The above situation would have been very different with a proper plan in place. Alison would have received the agreed value of Paul’s equity via life insurance. No dispute over the value would arise. The other insurances would have been kept for the family. The bank would have little concern as the “Keyperson” policy on Paul would have reduced the debt. The remaining partners incur little financial pain and own the share of the practice as Paul intended.
The question to ask business owners is consider your own business arrangements. Are you one of the few who have formally addressed succession planning? Many people avoid the topic. It is considered as a negative, complicated and expensive discussion that is difficult to get started. It needs to be dealt with in a structured and sensitive manner by an independent and experienced professional or risks falling flat.
The role of the accountant/banker/adviser is to ensure that the business is valued, the method of value documented and to look at related tax issues. The Solicitor will prepare agreements for all parties to join in that will give certainty that there will be a smooth exchange of equity and control. The Risk Adviser is usually the “facilitator” of the process, providing advice as to what funding mechanisms can be put in place to meet unplanned events, cost comparisons and the type of business insurance contract to evaluate.
Expertise is also required in placing insurance and insuring underwriting is managed for competitive costs. It is not simply about an insurance policy. The combination of insurance funding or vendor funding payouts is really a cost/benefit analysis that is decided by the parties.