Shadforth Insurance Specialist Kunaal Parbhoo, in the final article of his three-part series on the problem of under-insurance in Australia, discusses how an often overlooked part of business ownership is keeping the end in mind. Using life insurance to fund a business exit strategy is a popular option, he writes.
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There are a number of things that can go wrong where business ownership is concerned. A key, and often neglected, aspect of ownership is keeping the end in mind. After all every person’s ownership of a business eventually comes to an end – it’s just a matter of how and when.
Many businesses fail to plan for succession. Let’s start with some starling numbers. 37% of small businesses have heard of ’buy/sell’ cover however only 9% have it.[1] This is compounded by around a third of family businesses having no plans for transferring leadership or ownership of the business.[2]
Business succession planning is all about having a strategy in place that gives a business the best chance of survival over the long term. Central to the issue of planning is the articulation of a strategy and a set of goals or objectives. However, many businesses do not consider documenting a succession plan, which allows them to exit on their terms, and protects the business against unexpected events, as an important component of the planning process. The caveat is, that in most cases it’s as much protection, as maximising the transfer of wealth as it’s almost always an unplanned exit when a client’s wealth is at risk.
By putting a formal business succession plan in place, business owners can manage the financial impact of an unplanned exit and ensure that they or their estate receive the full value of their share of the business.
There are two types of exits that should be catered for in any well written succession plan – planned exits and unplanned exits.
The fundamental difference between planned and unplanned exits comes down to timing. Planned exits such as retirement lend itself to a degree of order, process and mutual agreement that can be implemented over time. Unplanned exits are a shock to the business and the remaining owners.
Every working Australian has a 1 in 3 chance of becoming disabled or suffering a serious illness before the age of 65.[3] Therefore, where a business is owned by two or more people, the death or permanent disablement of one owner is reasonably likely. This can have significant implications on the continuing viability of the business along with the means of extracting equity for the exiting owner or their beneficiaries.
Types of business succession agreements
There are two principal types of agreements that form the basis of a complete business succession plan – a Buy/Sell Agreement or an Equity or Shareholder Agreement.
A buy/sell agreement can be used to cover the situation where an owner dies, becomes permanently disabled or suffers a major illness and is forced to leave the business. These succession or trigger events are commonly referred to as insurable events. Buy/sell agreements are usually, but not always funded through the use of insurance policies. Conversely, an equity or shareholder agreement is generally used to cover situations where an owner retires, is dismissed, resigns, or is in dispute with the other owners of the business.
Legally drafted buy/sell agreements with a documented funding strategy can provide the following benefits.
- Peace of mind and stability for the continuing business owners so that they can buy out the departing business owner’s share of the business without putting the business or their personal finances in jeopardy.
- A mutually agreed market value sale price to the departing owner or estate and funds to complete the purchase.
- Certainty for creditors, suppliers, customers and key staff.
Fundamentally buy/sell agreements facilitate the transfer of the business to the remaining owners with minimal disruption.
It is also vital that a business succession plan has a mechanism to ensure that any funding required to compensate the departing owner will be available when required.
The funding mechanism
There are several ways for business owners to fund the transfer including selling business assets, obtaining finance, agreeing to a payment plan with the exiting owner/estate or using insurance. In many instances business owners tend to use life insurance for unplanned exits due to death, permanent disablement or illness. Life insurance is generally the most common approach as it is the cheapest, and most tax effective mechanism to provide instant liquidity on a tax-free basis at a time when the funding is needed – upon death or disablement.
Succession planning is a multidisciplinary process and there are many benefits for companies and owners who plan properly and strategically for a transition of ownership. Having robust discussions and implementing a strategy to cover both planned and unplanned exits ultimately achieves the desired outcomes for all parties involved.
Business succession arrangements form an integral part in helping business owners exit on their own terms.
Kunaal Parbhoo holds a Bachelor of Business (Banking and Finance) with Honours from Monash University. He has also completed the Advanced Diploma in Financial Services. Kunaal commenced his financial services career in the 2006 Commonwealth Bank Graduate Program (Financial Planning), where he rose to become a financial adviser. He then transitioned to a boutique financial planning practice in Melbourne where he developed his specialist knowledge in risk management solutions. Kunaal joined Shadforth Financial Group in 2016. Kunaal is passionate about ensuring clients understand the risks faced by their financial situation or business and providing advice to help protect them. Away from work Kunaal is actively involved in his community and takes great pleasure in spending time with his family. Contact Kunaal at kunaal.parbhoo@sfg.com.au
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