How to lose your business without really trying
A danger period for many established wholly or substantially owner-operated businesses is the time when a principal of a business departs, whether because of retirement, new horizons, disagreements, illness or death. The value and even viability of a business can be reduced or eliminated if the business fails to make a successful transition to a new ownership structure. The likelihood of a successful transition increases dramatically if a properly funded agreement as to this transition can be put in place ahead of time.
What is a Funded Business Succession Agreement?
A Funded Business Succession Agreement is a document that deals with the immediate or future succession of business ownership. The agreement is typically between the business principals and their interposed entities which own the equity of the business.
Funded agreements usually take two forms. Firstly, agreements dealing with an involuntary departure of a business principal following events including death, total & permanent disability and trauma (insurable trigger events). The insurable trigger events are most commonly (but not necessarily) wholly or largely funded by life insurance. For tax reasons, options are used and insurances are held on a self-insurance basis. Non-insurable trigger events include voluntary departure, poor performance, breach of director duties, insolvency, acts of scandal and others.
Secondly, an insurance trust deed – which has all the attributes of the first but which additionally provides for payments to third parties to be funded and made. This ensures a complete financial severance as regards the exiting proprietor. Properly drafted and structured, no tax will be payable on the insurance proceeds.
Other insurances can be taken out by the business itself on revenue or capital account depending on the nature of the cover required. Proper advice from your lawyer and insurance broker is well advised.
Consider this real life example
John, Michael and Adrian are the principals of an established and successful construction business. John, who has a wife and three young children, is tragically killed in a motor vehicle accident.
Contrary to the advice given by their advisors at the time the business commenced, the principals do not have a Funded Business Succession Agreement with supporting life insurance policies in place. At the time, they didn’t think the cost was warranted.
For the years prior to John’s death, the construction business had been applying most of its profits towards funding the expansion of its operations and whilst the business is very successful, neither the business nor the principals have large reserves of cash.
John’s interest in the business has been valued at $1,000,000, and his widow, Jill (who is a full time mother), desperately needs this money to support herself and her three young children. John’s death could not have come at a worse time and neither the business, nor Michael and Adrian, can raise the $1,000,000 required to pay Jill the value of John’s interest in the business. Accordingly, Jill has no alternative but for John’s estate to sue the business in order to force the business to arrange for John’s estate to be paid the value of John’s interest.
The ensuing court case cost Jill all of her accumulated savings and, although she won the case and the business was ordered to pay John’s estate $1,000,000 plus costs, it resulted in the business becoming insolvent. The outcome was that the business had to be sold. After paying the liquidator’s costs and repaying loans due to the secured creditors from whom the business had borrowed money to fund its expansion, there was nothing left to pay the $1,000,000 owed to John’s estate or to pay a return to Michael and Adrian for all their years of work in the business.
In order to survive, Jill had to sell her home, move herself and her three young children in with her parents and get a full time job.
This terrible outcome could have easily been avoided if John, Michael and Adrian had taken prudent advice of their advisors at the time they formed the business, and put in place a Funded Business Succession Agreement. If this advice had been taken, when John died:
- insurance proceeds would have enabled John’s estate to have been paid the value of his interest in the business within a few weeks of his death, and Michael and Adrian would have acquired
- John’s interest in the business;
- Jill would have been able to keep her home and continue to be a full time mother to her children;
- the business would have continued to prosper and been able to achieve the long term goals of its principals notwithstanding the death of one of the principals; and
- the untimely death of John would not have resulted in the collapse of the business and the impoverishment of John’s family.
For further information about Funded Business Succession Agreements, or about Business and Estate Succession Planning Strategies, contact Leigh Adams Special Counsel at Owen Hodge Lawyers.
Leigh Adams joined Owen Hodge Lawyers as Special Counsel in November 2016. Prior to this he ran Leigh Adams Business Lawyers which was established in 1994, and which developed a reputation for providing high quality legal services at an affordable price.
Leigh practices in the area of business and commercial law with a particular interest in business contracts and business structuring (including franchising), shareholder arrangements and joint ventures, as well as tax effective business succession (the entry and exit of business partners) and estate planning. He also has a significant focus on asset protection, trusts, and personal property securities.
Leigh is a highly regarded tactical lawyer and a highly sought after speaker, frequently presenting papers to numerous industry groups (including ARITA and the Financial Planning Association of Australia) on these and related topics.
As a member of the PPSA sub-committee of the NSW Law Society Business Law Committee, Leigh assisted in drafting the personal property securities clauses for the 2015 edition of the contract for sale of business, which is used throughout New South Wales.