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Business Succession Planning:

Business Succession Planning

Need for Succession Plan

Need for Asset or Buy/Sell Strategy

Need for Liability or Key Person Strategy

Negotiating a Succession Plan

 

Simple Succession Plan:

Simple Succession Plan

 

Complete Succession Plan:

Complete Succession Plan

Strategy

Financial Needs

Insurance Funding

Retirement Funding

 

One Page Strategy:

One Page Strategy

Asset Needs

Liability Needs

Personal Needs

Who Pays the Premiums?

Valuing the Business

Simplifying the Valuation Issue

Equity vs. Loan Capital

 

One Policy Strategy:

One Policy Strategy

Flexibility

Dual Role of Personal Cover

Dual Role of Debt Red'n Cover

Security & Tax-Effectiveness

Cost Savings

Pre-Agreed Purchase Price

Apportionment of Premiums

Methods of Aggregation

 

Multiple Policy Approach:

Multiple Policy Approach

Super Fund Ownership

Tax Disadvantages

Cost Disadvantages

Other Disadvantages

Geared Premium Funding

Super Buy/Sell

 

One Page, Two Policy Strategy:

One Page, Two Policy Strategy

 

Other Issues:

Tax Deductibility

Inadequate Insurance Proceeds

Vendor Finance

Changing Needs

Future Growth of Equity

Trauma Buy/Sell Strategy

 

Sole Proprietors and Families:

Sole Proprietors and Families

Overview

Family Ownership

Sale Strategies

Third Party Buy/Sell Strategies

Estate Equalisation Strategies

Family Buy/Sell Strategies

Second Generation Strategies

Debt Reduction Strategies

 

 

Dual Role of Personal Cover

 

Purpose of Personal Cover

Personal Cover is designed to fund:

  • the repayment of any Personal Debts and Liabilities: and

  • the Living Expenses of the Life Insured or their Family upon the occurrence of an Insured Event.

 

Determining the Capital Amount Required to Fund Living Expenses

When the Life Insured has repaid their Personal Debts and Liabilities (either during their lifetime or out of Insurance Proceeds payable upon the occurrence of an Insured Event), the focus of their needs is the funding of Living Expenses.

It is customary to determine a capital amount, which when invested at, say, 5% per annum will fund the desired amount of Living Expenses per annum.

Thus, if a Life Insured wishes to fund Living Expenses of $50K per annum (without eroding their capital), then invested at 5% per annum, they require a capital amount of $1M.

 

Investments and Superannuation Contribute to the Capital Amount

Usually, the amount of Personal Cover will take into account the amount of any investments, superannuation and cash held by the Life Insured.

Thus, if the Life Insured has no investments, they require Personal Cover of $1M to achieve their goal.

If their investments, superannuation and cash total $400K, then they require Personal Cover of $600K to meet their target capital amount.

 

Insured Purchase Price Contributes to the Capital Amount

If the Life Insured is a Business Proprietor who also has Buy/Sell Cover, the Purchase Price of their Equity in the Business will contribute to the amount of capital that will fund their Living Expenses.

Ultimately, their Equity is one of the investments that needs to be taken into account in determining whether they have a shortfall that can be addressed by Insurance Cover.

As a result, the Personal Cover of a Business Proprietor meets their Living Expenses Need to the extent that the Insured Purchase Price is inadequate.

In effect, it is a "top up" over and above their Buy/Sell Strategy .

 

Aggregate of Purchase Price and Personal Cover

As a result, the Life Insured's family will normally receive the aggregate of:

  • the Purchase Price (or Blue) Cover; and

  • the Personal (or Green) Cover.

The aggregate of the Blue and Green Cover will fund the Living Expenses, regardless of how it is characterised in the Succession Plan or Agreement.

In a sense, under a Complete Succession Plan, the Life Insured will receive a Blue Cheque and a Green Cheque.

What matters is the aggregate of the two.

However, as the value of the Proprietor's Equity increases, the Buy/Sell Insurance will do more of the job of meeting the Living Expenses Need.

 

Increasing the Value of Your Equity

If the Personal Cover is aggregated onto the One Policy, the provision for Personal Needs performs a second function over and above the contribution to Living Expenses.

As the Pre-agreed Purchase Price increases over time, the Personal Cover can be re-allocated to the Purchase Price or Buy/Sell Cover.

Thus, as the need for Buy/Sell Cover increases, it can be satisfied by the re-allocation of the Personal Cover.

The total Cover might remain the same.

However, the "mix" or "colour" of the Cover might change.

 

Warehouse or Comfort Zone for Future Growth

The One Policy Strategy effectively acts as an Insurance Facility.

The Personal Cover acts as a "warehouse" or "comfort zone" for future growth of the Purchase Price of the Equity.

This avoids the need to obtain additional Buy/Sell Cover from the Insurance Company.

In a sense, a One Policy Strategy recognises that your "Green Cover" can be "Future Blue Cover".

 

Avoidance of Valuation Disputes

When Purchase Price (or Blue) Cover and Personal (or Green) Cover are combined on the One Policy, what matters is the aggregate of the two amounts payable to the Life Insured.

If there was some uncertainty or a difference of opinion with respect to the Price at the time of designing the Succession Plan, the One Page Strategy allows the parties to adopt a conservative Pre-agreed Purchase Price on the basis that they will increase the amount of the Personal Cover for each Life Insured.

Thus, the inclusion of the Personal Cover on the One Policy allows the Proprietors to adopt a more holistic and relaxed piont of view with respect to the valuation process.

Case Study

Three Proprietors recently adopted a One Page, One Policy Succession Plan.

Two of them included Personal Cover in their Succession Plan.

Initially, the third did not.

The first two were comfortable that the combination of Blue and Green Cover would avoid valuation disputes with respect to their own strategies.

However, they were worried that the third Proprietor would approach the review and valuation process more pedantically, if they did not include Personal Cover in their Succession Plan.

In particular, they were worried that the third Proprietor might want to remove the Pre-agreed Purchase Price Provision and require a valuation in the event of a claim.

This would mean that the two Proprietors would have no certainty that they had funded the whole of the Purchase Price of the third Proprietor's Equity.

They were also worried about the mechanics of the review process.

If the third Proprietor wanted a higher Price at the time of review, then they would have to obtain additional Cover (which might not be possible) or the Agreement would have to incorporate Vendor Finance Provisions.

In the absence of Personal Cover (i.e., Green Cover that could act as Future Blue Cover), the third Proprietor did not have any leeway or flexibility.

Their ceiling was lower, and there was a risk that they would keep banging their head on the ceiling as the value of the Business increased.

Ultimately, it was realised that the premium cost of obtaining some additional Green Cover to act as Future Blue Cover was $400 per annum.

The risk of dispute and uncertainty was able to be removed at a cost of $400.

This amount was effectively less than the cost of one hour of professional time in the case of a dispute.

In effect, for a litigation lawyer, it was less than the cost of a "file opening fee".

 

Increasing the Amount of Your Equity

Personal Cover can also simplify how a Succession Plan is varied if one Proprietor sells their Equity to the other Proprietors.

The Outgoing Proprietor will no longer have any Equity in the Business.

However, normally, the Continuing Proprietors will now have more Equity in the Business.

The Outgoing Proprietor no longer needs their Cover for Buy/Sell or Business purposes and can reduce or cancel their Cover.

However, the Continuing Proprietors will need additional Buy/Sell Cover to fund the Sale Price of the additional Equity that they have acquired from the Outgoing Proprietor.

The additional Cover can be obtained by re-allocating the Personal Cover.

Example

There are three equal Proprietors whose one-third share of the Business is worth $400K.

One Proprietor retires and sells their Equity to the other Proprietors for a total Sale Price of $400K.

Each Continuing Proprietor now owns an Equity valued at $600K.

Their Buy/Sell Cover needs to be increased to $600K.

If their existing Cover is only $400K, they need to obtain additional Cover of $200K.

This might require medical tests, underwriting requirements and financial evidence.

In contrast, under a Complete Succession Plan, each Proprietor might have total Cover of $1M, split as folows:

  • $400K Buy/Sell Cover; and

  • $600K Personal Cover.

In order to increase their Buy/Sell Cover, they can simply change the allocation of Cover to:

  • $600K Buy/Sell Cover; and

  • $400K Personal Cover.

The re-allocation of existing Cover does not have any underwiting implications.

 

What if You Don't Need Personal Cover?

Personal Cover is normally only necessary to fund any shortfall in the Life Insured's assets (including their Pre-agreed Purchase Price) required to fund the Living Expenses of their family.

If their superannuation, investments and other assets are adequate to fund the Living Expenses, then Personal Cover might not be necessary.

However, this will reduce the amount of cover available to fund the future growth of the Purchase Price of their Equity.

 

Future Sale Price Provision

In these cases, it would be possible to obtain some additional Cover to fund the anticipated growth of the Purchase Price in, say, the next three to five years.

The Future Sale Price Provision could take into account both:

  • anticipated increases in the value of the existing amount of Equity; and

  • the value of anticpated increases in the amount of Equity (e.g., as a result of the purchase of an Outgoing Proprietor's Equity).

Example

For example, if it was projected that the Purchase Price would grow from $400K to $700K in the foreseeable future, then it would be prudent to obtain additional cover of $300K.

Pending allocation to the Pre-agreed Purchase Price, it can be "warehoused" in Personal Cover, where it would be payable tax-free to the Life Insured or their Estate.

 

Privacy Concerns about Mixing Personal Cover with Business Cover

Some Business People are reluctant to disclose their Personal Needs and Insurance arrangements to their business partners.

As a result, they might prefer to keep their Personal Cover separate from their Business Cover.

Anticipated Future Growth of Purchase Price

In these cases, it is recommended that they each obtain some additional Cover to fund the anticipated growth of the Purchase Price in, say, the next three to five years.

For example, if it was projected that the Purchase Price would grow from $400K to $700K in the foreseeable future, then it would be prudent to obtain additional cover of $300K.

This could be done with respect to all of the Proprietors, so that it does not require any Personal Needs or Strategies to be disclosed to the other Proprietors.

Again, pending allocation to the Pre-agreed Purchase Price, it can be "warehoused" in Personal Cover, where it would be payable tax-free to the Life Insured or their Estate.

 

Copyright: Ian Gray Solicitor

 

 

Adviser Tip

Your Purchase Price and your Personal Cover both contribute to the "pot" you have created to fund the total capital requirements of your family.

As your Purchase Price increases over time, your Personal Cover can come down.

If they are both on the One Policy, all you have to do is "change the mix".

See more Adviser Tips

 

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