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 four dependent 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 his Will leaving everything to Alison. This included his share of the business.
Alison found herself with a majority interest in the business, with the remaining 3 partners. The practice continues to operate. Alison, however, didn't wish to have ongoing involvement in the business but wanted the equity/goodwill in cash. She was happy to give up her shareholding for this but was considering holding onto the asset if she didn't believe the price was fair, because she needed the money for her family.
The problem of course was that the desired outcome for Alison and especially the remaining partners could not be resolved easily. At the time, the practice was in 'survival mode' contacting Paul’s clients to assure them that they will be looked after by the practice, even though many previously would only deal with Paul. The matters that Paul had been handling had to be reallocated, staff needed to be reassured and potentially reorganised. During this time Alison was grieving and devastated and was effectively the major owner of the practice with an unacceptable degree of control.
With no prior agreement on the value of Paul’s shares, arguments as to the valuation had the potential to 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 could be incurred to determine an amicable result. For example, arbitration may be needed and there was a question of what would be the value of the business be now that Paul, who was the senior partner and a key person, is no longer around? The remaining Partners would 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 wanted to hear as they addressed the management of the business at this critical time.
Further, the bank had raised gentle concerns about the impact on the business. It had indicated it wanted additional security from all remaining shareholders (including Alison) or it would 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 were already heavily geared and may have struggled to meet the bank’s requirements. The bank was 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 was not only facing the tragedy of losing Paul but at the same time suffering further financial hardship with the real possibility of having to sell the family home to survive financially. The bank also had security over the home.
This may sound 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 three partners per year,
- Loan/Debt cover in total $2,880 for all three 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 to 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 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.