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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

 

 

 

 

Inadequate Insurance Proceeds

 

Sometimes, it isn't possible for all of the Proprietors of a Business to obtain the amount of Buy/Sell Insurance they require.

This could happen because of health or premium cost.

Examples of situations when this might happen are:

  • they might only be able to afford part of the Cover they require;

  • they might not be able to obtain any of the Cover they require;

  • they might be able to obtain Death Cover, but not TPD or Trauma Cover; or

  • the Pre-agreed Purchase Price might exceed the maximum amount of Cover that is available for a particular Insured Event (such as TPD or Trauma).

 

Implications for Succession Plan

This doesn't mean that a Succession Plan is impossible in these situations.

It simply makes it necessary for the Succession Plan and Agreement to deal with the terms of payment of any shortfall.

In a sense, the Agreement can take over, if the Insurance Cover is inadequate.

All IGS Agreements are intended to act as a Complete Succession Agreement in these situations.

 

Only Part of Required Cover Available at Time of Commencement

In some cases, the available Insurance Proceeds might fund only part of the Pre-Agreed Purchase Price.

For example, if the Insurance Company increases or "loads" the Premium for health reasons, the Life Insured might be able to afford only part of the required Sum Insured.

Legal Strategy

In these cases, the Agreement can make provision for the payment of any shortfall by way of Bank Loan, Instalments and/or Vendor Finance.

 

No New Cover Available at Time of Commencement

If the Life Insured is uninsurable, the Life Insured might:

  • have no available Cover; or

  • might have to use a pre-existing Insurance Policy for their Succession Plan.

Legal Strategy

If no Cover is available at all, the Agreement can specify the terms of payment of the whole Purchase Price (e.g., by way of Bank Loan, Instalments and/or Vendor Finance).

If some Cover is available, the Agreement can specify how the shortfall will be paid.

 

No Additional Cover Available at Time of Review or Variation

Sometimes, the parties might be able to obtain adequate Buy/Sell Cover when they sign their Initial Agreement, but are unable to obtain additional Cover when they review the value of their Business in the future.

Legal Strategy

This makes it necessary for the Variation Agreement to address the terms of payment of the shortfall.

The shortfall might have to be addressed by Instalments or Vendor Finance Provisions.

 

Insertion of Options in Agreement

In any case where the Proprietor is only Partly Insured or Uninsured with respect to a particular Event, the Agreement can specify:

  • how the particular Event will be dealt with; and

  • how the Purchase Price will be paid.

The Agreement can provide that the Purchase Price be paid by way of Bank Loan, Instalments and/or Vendor Finance.

 

How Will the Particular Event Be Dealt With?

If a Proprietor can only obtain part of the required Cover (or cannot obtain any Cover for a particular Event), then the Agreement can deal with each Partly-Insured or Uninsured Event in two alternative ways:

  • it can create an Un-funded Option to Purchase (or Call Option) exercisable by the Continuing Proprietors; or

  • it can create both Put and Call Options pursuant to which one party or other can force a Sale to occur in accordance with pre-agreed Vendor Finance Provisions.

A Call Option would only result in a Sale, if the Purchasers exercised their Option to Purchase.

A Put and Call Option structure effectively makes the Sale happen one way or another, because it assumes that at least one party would want the Sale to occur and would exercise their Option.

Click here to read more about Options to Purchase and Put and Call Options in relation to Retirement Strategies.

Partly Insured Events

If an Event is only Partly-Insured, then the Agreement need only deal with the funding of the shortfall in the Purchase Price.

Assuming that the amount of the shortfall is relatively easy to fund, then it is more likely that Put and Call Options would be used for these Events.

This would give certainty to both parties.

Un-insured Events

If an Event is Un-insured, then the Agreement must deal with the funding of the whole of the Purchase Price.

It is more likely that an Option to Purchase (or Call Option) would be used for these Events, unless a Funding Mechanism can be pre-agreed.

Un-funded Trauma Event

Trauma Buy/Sell Strategies are problematical, even where Cover is available.

This is because there is a possibility that the Proprietor might recover from the Trauma Condition and therefore might not wish to sell their Equity.

Click here to read about Trauma Buy/Sell Strategies where Cover is available.

IGS is reluctant to document a Call Option in the case of an Un-funded Trauma Event.

However, if the Proprietor believes that they cannot continue to work and therefore wishes to sell their Equity, then the situation is analogous to a Retirement.

In this case, it would be appropriate to use a Call Option (which is exercisable by the Purchasers).

However, the Call Option would be triggered by the Retirement of the Proprietor, not the occurrence of the Trauma Condition itself.

Thus, the Sale would be triggered by the voluntary Retirement of the Proprietor.

Alternatively, a combination of Put and Call Options could be used, if there was a pre-agreed Funding Mechanism for the Purchasers.

The Call Option would still be triggered by the Retirement, while the Put Option could be triggered by either the Trauma Event or the Retirement.

Presumably, the Proprietor would not exercise their Put Option, unless they wanted to retire as a result of the Trauma Event.

Thus, the Put Option would effectively be triggered by a Retirement anyway.

 

Un-funded Option to Purchase (or Call Option)

The Agreement can simply give the Purchasers an Option to Purchase the Outgoing Proprietor's Equity for a pre-agreed amount.

An Option to Purchase (or Call Option) is an Option pursuant to which the Purchasers can force the Vendor to sell their Equity in the Business.

If the Un-funded Event occurred, then because the Purchase Price is unfunded, the Purchasers would have to determine:

  • whether they want to purchase the Equity for this amount; and

  • whether they can (or want to) borrow this amount at the time the Option is triggered.

If they didn’t want to (or couldn’t) borrow the Purchase Price, they would simply let the Option to Purchase fall over and then haggle over the Price.

This is the type of provision that would be contained in a normal Proprietors Agreement.

However, it doesn't create any certainty for the Outgoing Proprietor (or their Estate).

They must wait until the Purchasers have decided whether to exercise their Option.

 

Put Options

A Put Option is an Option pursuant to which the Vendor can force the Purchasers to buy their Equity in the Business.

In effect, a "Put Option" is the reverse of a "Call Option".

IGS is reluctant to document a Put Option, unless there is a pre-agreed Funding Mechanism in place.

If a Purchaser commits to buy the Equity regardless of whether there is a Funding Mechanism in place, then effectively they are taking on a contractual obligation to pay the Purchase Price, regardless of whether they can ultimately obtain or borrow sufficient funds.

If they cannot obtain or borrow the funds, then they could be sued for breach of contract.

 

Put and Call Options

A Call Option does not necessarily result in a Sale and Purchase of the Equity.

It needs the Purchasers to exercise their Call Option.

They will only exercise their Option, if they have a satisfactory Funding Mechanism.

However, it is possible to design a more binding Succession Plan (from the Vendor's point of view), if there is a:

  • Pre-agreed Purchase Price; and

  • Pre-agreed Funding Mechanism (such as Vendor Finance).

The pre-agreement of the Price and the Funding Mechanism means that:

  • there is no uncertainty about the amount of the Price; and

  • the Purchasers have a Funding Mechanism (other than borrowing from a Bank) that takes into account their ability to pay the Price out of the cash flow of the Business over time.

This strategy takes away the uncertainty with respect to funding that is a reason for many Call Options not being exercised.

If this Strategy is acceptable to all of the parties, it is possible to structure a Succession Plan that consists of a combination of:

  • a Put Option that would be exercisable by the Vendor; and

  • a Call Option that would be exercisable by the Purchasers.

The exercise of an Option by either party would trigger a Sale for the Pre-agreed Sale Price on the pre-agreed Vendor Finance terms.

For the above reasons, if the parties want to create certainty for both the Vendor and the Purchasers, then they must effectively pre-agree a Funding Mechanism (e.g., Vendor Finance Provisions).

If a Funding Mechanism can be agreed in advance , then the Agreement can:

  • go beyond a Call Option; and

  • create Put and Call Options pursuant to which one party or other can force a Sale to occur in accordance with the Vendor Finance Provisions.

The Agreement can provide that the Purchase Price be paid by way of:

  • Bank Loan; and/or

  • Instalments or Vendor Finance.

 

Bank Loan or Finance

One option is to fund any shortfall with a loan from a Bank.

However, the parties should not lightly assume that Bank Finance would be available at the time of the Un-funded Event.

For example, Bank Finance might not be practical if the Bank was likely to question the amount of the Pre-agreed Purchase Price or the ability of the Purchasers to service the Loan at the time of the Un-funded Event.

If this is possible, then the parties should consider Vendor Finance.

Bank Loan Funds Upfront Instalment

IGS often drafts Vendor Finance Provisions that require an upfront Instalment to be paid to the Vendor.

It would normally be expected that the Purchasers could fund this Instalment out of their existing resources or by way of Bank Loan.

In these circumstances, it would be necessary to dislose the Vendor Finance arrangements to the Bank in order to obtain approval of the Bank Loan.

 

Vendor Finance Provisions

Vendor Finance is designed to allow any shortfall in the Purchase Price to be paid over time.

In effect, the Vendor finances the whole or part of the Purchase Price by agreeing to accept payment by iInstalments.

To this extent, it is like "borrowing" the Purchase Price from the Vendor and agreeing to repay it over time.

The aim of Vendor Finance Provisions is to determine a timeframe for payment of any shortfall that is:

  • short enough from the Vendor's point of view; and

  • sufficiently long from the Purchasers' point of view to enable them to fund the Purchase Price out of the cash flow of the Business.

 

Examples of Vendor Finance Strategies

Below are examples of strategies that deal with situations where:

  • some Insurance Cover is available; and

  • no Insurance Cover is available.

 

Some Insurance Cover

If the Pre-agreed Sale Price was $400,000 and the only Insurance Cover available was for $200,000, the Vendor Finance Provisions could provide that the Purchase Price of $400,000 will be paid in:

  • one upfront payment of $200,000 (funded by the Insurance Proceeds); and

  • four annual instalments of $50,000 per annum (plus interest).

The Vendor Finance arrangements effectively fund payment of the shortfall of $200,000.

Once these arrangements are formulated (at least tentatively), the Purchasers can examine the commercial and cash flow implications of funding the shortfall out of their share of the profits of the Business.

 

No Insurance Cover

If the Pre-agreed Sale Price is $400,000 and no Insurance Cover is available, then the parties need to determine whether the Price will be funded by:

  • a combination of an upfront payment and instalments; or

  • just instalments.

Upfront Payment and Instalments

The Vendor Finance Provisions could provide that the Purchase Price of $400,000 will be paid in:

  • one upfront payment of $200,000 (funded by a Bank Loan); and

  • four annual instalments of $50,000 per annum (plus interest).

Where part of the Price is funded by a Bank Loan, the Purchasers would need to fund both:

  • the principal and interest payments owing to the Bank; and

  • the instalments and interest owing to the Vendors.

Instalments

The Vendor Finance Provisions could provide that the Purchase Price of $400,000 will be paid in:

  • four annual instalments of $100,000 per annum (plus interest); or

  • eight annual instalments of $50,000 per annum (plus interest).

 

How Many Instalments?

The number and amount of the instalments should take into account both:

  • the need of the Vendors; and

  • the cash flow of the Purchasers.

The decision will usually be a balancing act between the interests of the different parties.

However, it is a lot easier to resolve these issues when they are abstract than when someone has actually died or been forced to retire because of ill health.

After a death or retirement:

  • one party is wearing a Vendor's hat and wants to reduce the timeframe for payment; and

  • the others are wearing a Purchaser's hat and want to increase the timeframe fro payment.

 

Fact Finder

The Vendor Finance Provisions for any shortfall in the Purchase Price raise similar issues to a Retirement Strategy in which none of the Purchase Price can be funded by Insurance Proceeds.

Retirement Strategy

Please click the following link to see the Un-Funded Purchase Price Item of the Complete Succession Fact Finder that has been completed for a Retirement Strategy:

TPD Strategy

Please click the following link to see the Un-Funded Purchase Price Item of the Complete Succession Fact Finder that has been completed for a TPD Strategy which is partly funded by Insurance Cover:

 

Standard IGS Legal Fee Includes Drafting of Vendor Finance Provisions

The standard Fixed Legal Fee for all IGS Agreements entitles the Business to the drafting of Vendor Finance or other Provisions that deal with the payment of the Pre-agreed Purchase Price or any shortfall.

 

Changes Because of Underwriting Decisions

Sometimes the Life Insured will not know whether they can obtain adequate Insurance Cover until the Underwriter assesses their application.

If a Proprietor is unable to obtain the required amount of Buy/Sell Cover for the Purchase Price of their Equity, the standard Legal Fee incorporates the cost of drafting Vendor Finance Provisions.

As a result, they will still have a pre-agreed Succession Plan.

Thus, any adverse decisions made in the insurance underwriting process will not necessarily frustrate the formulation of a Complete Succession Plan for all Proprietors.

 

Use of Existing Cover if Life Insured Has Health Issues

One or more existing Self-Owned Policies can be transferred or “parked” under the roof of the Trust, if there are health issues with respect to any of the Lives Insured.

For example, a Life Insured might retain an existing Policy for part of their needs, because the premium with respect to any new cover might be more expensive.

The Life Insured's needs might therefore be met by a combination of Policies, which are effectively "pooled" by the Agreement.

If the Policy is transferred to the Trustee by the Life Insured, the Life Insured continues to be the “original beneficial owner” of the Policy for CGT purposes (so that the transfer does not have any adverse CGT implications).

 

Copyright: Ian Gray Solicitor

 

 

Adviser Tip

In the case of Retirement, a Complete Succession Plan can pre-agree the Purchase Price and specify a timeframe for payment.

If you do not have adequate insurance for an Insurable Event, your Succession Plan can specify a timeframe for payment of the shortfall.

See more Adviser Tips

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