Business Needs

Running a small to medium sized business is a risky business. The unexpected death or disablement of a business owner can potentially destabilise the ongoing viability of the business.

There are three basic types of business protection needs that typically apply to businesses, these are:

• Asset protection;
• Revenue protection; and
• Ownership Protection.

Asset and Revenue Protection

When business owners are asked about what their most important business assets are, they invariably think of physical assets. However it is the intellectual capital provided by key people in the business, who employ these assets to generate business profits.

These key people are the most important assets of the business and what effect does their death or disablement have on the long term success of the business?

Without the security provided by a key person then the business may face many issues including:

• Lenders are not prepared to extend credit and call up loans or personal guarantees
• Customers and suppliers lose confidence in the future direction and trading capacity of the business
• Is there a logical successor?
• Is there a drop in revenue due to loss of a key person?

There are many scenarios that may result in the required sale of assets which generally have been put up as collateral security and are still required to generate income.

It is not commonly recognised that the death of a guarantor in most cases triggers an automatic default in most business loan agreements – entitling the financial institution to call in the loan facility and proceed against a guarantor’s assets should it decide.

Ownership Protection

The next key area revolves around succession planning and protecting the ownership of the business. Here are some questions to be posed?

• What if one of the owners of business dies?
• Does that share go to the surviving spouse/ heirs?
• Do the other shareholders want the surviving spouse/ heirs to retain a share in the business?
• Does the surviving spouse/ heirs want to be involved in the business?
• If there is net debt in the business does the spouse/ heirs inherit debt by transfer of the shares?
• The questions are endless.

Although we do not like to think about it the chance of a death or disablement among owners is surprisingly high. Following is a table of the probability of at least one owner (where all owners are aged 35) dying or becoming total and permanently disabled before reaching age 65.

Source: Australian Life Tables, 1995-97, MLC’s Class 1 Occupation TPD Experience.

A proprietary company generally continues unaffected by the death of a shareholder. While a shareholder’s death may leave the company’s legal structure intact, the same cannot be said for the operational structure of the business. In this case an active interest may now become an inactive interest and these tend to be fundamentally opposed.

The active interest, represented by the continuing shareholders would now more likely be concerned about ongoing business development. Since they derive income largely from salary and allowances for work done, they could view dividends of secondary importance. The inactive interest represented by the surviving spouse and heirs may be more concerned about the need for present income through dividends.

The continuing shareholders of a proprietary company are presented with a major problem following the death of a shareholder. Without a pre-arranged right to purchase a deceased shareholder’s equity and the right amount of cash, the continuing shareholders face potential conflict with the deceased shareholder’s spouse or heirs whose participation in the business may or may not be welcome. Some future spouses and heirs may not be known at this time.

Should the current shareholders of the business believe that it would be in the best interests of both parties for the surviving (or non-disabled) shareholder to obtain full ownership of the business on death or total disablement of a partner then what is required is:

• A buy-sell agreement granting the continuing owners the option to buy a deceased or disabled owner’s interest in the business; and
• The right amount of cash, at the right time to buy the out-going owner’s interest.

If the continuing owners exercise the option to buy, the deceased owner’s spouse or heirs or the out-going owner must sell their interest for a price determined in the agreement.

This would normally be the market value calculated annually by your accountant, valuer or other qualified people you nominate.

Normally the current owners of the business would like to ensure that any surviving spouses and heirs are adequately compensated and looked after in any agreement so as not to suffer hardships as the result of any untimely death or disablement. There also needs to be recognition to owners for all the time spent in growing the business. Often business owners sacrifice short term reward i.e. wages and benefits for the long term rewards that often arrive in the future.

Business Succession Funding

The problem for the continuing owners can be how to fund the purchase of another owners share. This can be done through:

• Realising business assets;
• Realising personal assets, though these may be encumbered and not readily relisable;
• Borrowing cash;
• Paying off over a period;
• Insuring the risk.

The first three methods involve divesting of assets or borrowing further money, which the business or individuals may not be able to afford. Paying off over a period is not necessarily in the interests of the surviving spouse or heirs and may involve an obligation to pay principal and interest from the other shareholders.

Business protection insurance provides a cost effective option to provide the required purchase price in the event of an owner’s death, TPD or diagnosis of a critical illness. It is cost effective in that it can provide the purchase price at only a fraction of alternative funding options, which at a minimum would be 100 cents in the dollar for every dollar of purchase price.

Plan for Changes in Business Ownership With a Buy-Sell Agreement

Your shareholder agreement isn’t complete unless it governs what happens when a shareholder leaves the business.

Many business owners overlook a critical element of their shareholders agreement that can save them both money and angst: buy-sell provisions. When you create buy-sell, or buyout, provisions for your shareholders agreement, you and other shareholders can prepare for events that have been the downfall of more than a few businesses – namely, the death, divorce, bankruptcy, or retirement of one of the owners.

What Is a Buy-Sell Agreement?

A buy-sell agreement is a binding contract between shareholders about the future ownership of the business. A buy-sell agreement is made up of several clauses in your written shareholder agreement (or it can be a separate agreement that stands on its own) that control the following business decisions:

• who can buy a departing partner’s share of the business (this may include outsiders or be limited to other shareholders);
•  what events will trigger a buyout (see the list below); and
• what price will be paid to acquire the outgoing owners share?

What Events Should You Cover Under a Buy-Sell Agreement?

Your buy-sell agreement will instruct and remind all shareholders how you have agreed to handle the sale or buyback of an ownership interest when one shareholder’s circumstances change. Typically, some of the events that trigger a buy out of a shareholders interest under a buy-sell agreement are:

• the disability, death, or incapacity of a shareholder;
• an attractive offer from an outsider to purchase a shareholders interest in the company;
• a divorce settlement in which a partner’s ex-spouse stands to receive an ownership interest in the company; 
•  the foreclosure of a debt secured by an ownership interest; or
• the personal bankruptcy of an owner.

Just looking at this list, it should be obvious that if you don’t anticipate and plan for circumstances like these, you’re risking serious personal and business discord.

Options for Cover?

Each shareholder may effect an appropriate policy for the amount of cover required (including coverage for benefits required on their own life – death, total and permanent disablement benefits and medical trauma).

They may then establish a legally binding Cross Purchase agreement that covers the shareholders and their beneficiaries/family members. By doing so, the agreement will establish the rights and obligations for the transfer of the deceased’s/disabled share of the business to the surviving shareholders.  Beneficiaries/Family members will receive payment of proceeds from the insurance policy in consideration for the transfer of business ownership to the surviving shareholders.

By establishing this type of agreement, each shareholder has a guaranteed right to purchase for a fair price the equity of another if certain agreed events occur. The family of the deceased/disabled will have a guaranteed market and will receive a fair price for their share of the business; each party has the right and funding to protect their position.

If shareholders decide to leave the company, buy / sell agreements can be dissolved while having the option to maintain the policies for individual personal protection requirements.

What else should the business consider?

One of the other issues that businesses should consider is what happens to the salary payments of respective owners in the event of long term illness or not being able to work for an extended period. Does the company bear the burden of such payments? For how long?

In many businesses they have binding requirements that working shareholders have Income Protection insurance. This means that in the event that one owner is unable to work for an extended period they will not be drawing a salary from the business and affecting its overall performance. Rather the owners each pay the premiums for income protection and this provides their income if they are unable to work due to sickness or injury. Owner’s salaries can be adjusted to take into account the cost of receiving such cover.

Income protection is even more critical from a personal perspective as future income will dictate the quality of life for each person and their family going forward.

Estate Planning

Estate planning is all about giving you proper control of your assets, making sure that the right amount of money and assets go to the right person(s) at the right time. It is about wealth succession.  Estate planning is complex and requires the expertise offered by a solicitor and accountant in conjunction with the guidance of a financial planner.

Wills

It is important to ensure that you do not die intestate (i.e. without leaving a valid will) or with a will that does not meet your current situation or satisfy your current estate requirements. It is vital to maintain a register of estate information such as the location of your will, house deeds and investment certificates and documents.  It should also include a list of all your separate investments and specific bequests, and be kept in an appropriately safe position where the executor can easily gain possession.

A properly executed will ensures that after your death:

• Assets will be invested or distributed according to your wishes.  This is the function of the executor/s.  You should choose an executor who is unlikely to pre-decease you, who is readily available and if possible, is someone in tune with your wishes.  It is quite common to have more than one executor appointed.
• Funds are held in trust for beneficiaries.  It is possible some funds may be held for some time in trust for beneficiaries who have not yet reached the age you nominate for them to receive the bequest.
• Taxation can be reduced wherever possible.  This is another consideration to bear in mind when you are endeavouring to ensure that your desired degree of equity amongst beneficiaries is achieved. Depending on the timing of an estate settlement, and the taxation situation of individual beneficiaries, CGT can have a substantial impact on those who receive and later sell assets from a deceased estate.

Powers of Attorney

A Power of Attorney is a formal legal document in which an individual (the Donor) appoints another individual, individuals or a company (the Attorney) to act on their behalf. A Power of Attorney is sometimes referred to as a ‘Living Will’ as it gives the Attorney complete authority to act on the donor’s behalf in any business decision or transaction that the Donor would normally undertake themselves.

Powers of Attorney have extremely broad scope and careful consideration should be given to which individual, individuals or company is chosen to act as the Attorney. The Attorney can effectively make legal, financial and personal decisions on an individual’s behalf and as such a significant level of trust and comfort is required by the Donor in making the appointment.

There are generally three types of Powers of Attorney depending on the State or Territory law prevailing:

• General Power of Attorney

Normally used in a limited capacity.  For example the donor may wish the Attorney to conduct a specific transaction such as the purchase of a property or the donor may be going overseas for a prolonged period and wishes the Attorney to mange their affairs in their absence. However if the Donor becomes mentally incapable of managing their own affairs the General Power of Attorney becomes null and void.

• Enduring Power of Attorney

An Enduring Power of Attorney continues to have force and effect even if the Donor loses mental capacity. This means that should the donor lose their capacity due to accident, stroke or a degenerative disease, the Attorney can step in and manage the Donor’s affairs on their behalf.

• Enduring Power of Attorney – Medical Treatment

This type allows the Donor to authorise an Attorney to make decisions regarding medical treatment. Typically it is prepared where the Donor wants to express a preference in relation to the administration of a particular medical treatment, for example no blood transfusions or DNR instructions (do not resuscitate).

Testamentary Trusts

The term trust describes the situation where a trustee looks after the assets on behalf of the beneficiaries. The trustee may be one of the beneficiaries but in many cases it may be a professional advisor like an accountant or solicitor. Testamentary simply means that the trust has been established as a consequence of a will. They can be an effective tool to make distributions to beneficiaries. They can be as simple as leaving a set amount of money to a member of the immediate family or to a charitable organisation or as complex as appointing a guardian as well as primary and secondary beneficiaries. Discretionary trusts enable beneficiaries to enjoy assets and receive income payments without actually owning the assets. This lack of ownership can have particular benefits in relation to; bankruptcy, pension entitlements, family law proceedings and income splitting.