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Business Succession Planning:

Business Succession Planning

Need for Succession Plan

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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

 

 

 

 

 

 

 

 

 

Future Growth of Equity

 

Most Businesses expect to grow in value over time.

This means that the value of each Proprietor's Equity will grow as well.

If they have Buy/Sell Cover that will fund the Purchase Price of their Equity upon the occurrence of an Insured Event, then they will need to review the amount of Cover from time to time.

By analogy, if you have insured any of the Debts of the Business, the repayment of the Debts over time means that:

  • there will be less Debt that needs to be insured; and

  • the Net Value of the Business will increase.

Again, you might need to increase your Buy/Sell Cover.

In addition, once your children have been educated and become financially independent, then your need for Personal Cover might decrease.

The One Page, One Policy Strategy makes it easier to deal with your needs as they change over time.

Example

Click here to see a typical change in the needs of a Proprietor over a five year period.

 

“Multiple Policy Approach”

Traditionally, Advisers have written one Policy for each separate need, often resulting in four or five different Policies for each person, often in the name of different owners (the traditional " Multiple Policy Approach").

If the cover was written on separate Policies:

  • as the Debt reduces, the Debt Reduction Cover should be reduced, to avoid any risk that it might be treated as Key Person Revenue Cover (and taxed upon the payment of a claim);

  • as the Purchase Price increases, the Buy/Sell Cover should be increased; and

  • as Personal Needs reduce, the Personal Cover should be reduced.

These steps involve the administrative burden of dealings with the Insurance Company.

In addition, the increase might require new underwriting and medical tests, which can take up valuable management time.

If the Life Insured cannot satisfy the Insurer’s requirements, an increase might not even be possible.

 

“One Policy Strategy”

In contrast, the One Policy Strategy is designed to place all of the cover under the one roof.

Once it is under the roof, you might find that you have the right total Sum Insured for the indefinite future.

All that needs to be changed is the "mix" or allocation of the cover.

It is not necessary to deal with the Insurance Company or do medical tests in the future, unless additional cover is required over and above the original total Sum Insured.

Thus, changes become a management issue, not an Insurance Company issue.

Rather than changing your Policies, the One Page, One Policy Strategy simply requires a change of the Schedules to your Business Insurance Trust Agreement.

Similarly, the beneficial ownership of some Personal Cover might be moved from the Super Fund to the Life Insured as the value of the Super Fund starts to exceed the Reasonable Benefits Limits (this might not be relevant after 1 July, 2007).

 

Dual Role of Personal Cover

If Personal Cover is aggregated onto the One Policy, it will fund the Living Expenses of the Life Insured or their family upon the occurrence of an Insured Event (in combination with the Insurance Proceeds attributable to the Purchase Price of their Equity).

However, the provision for Personal Needs performs a second function: as the Pre-agreed Purchase Price increases over time, the Personal Cover can be re-allocated to the Purchase Price.

The Life Insured's family will normally receive the aggregate of the Purchase Price and the Personal Cover, so the aggregate will be received by the family, regardless of how it is characterised in the Agreement.

When the Personal Cover is re-allocated to the Purchase Price, it effectively acts as a "comfort zone" or "warehouse" for future growth of the Purchase Price of the Equity.

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

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

 

Increasing Both the Amount and the Value of the 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 no longer needs thie Cover for 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 follows:

  • $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.

This Sum Insured would allow the Life Insured to increase the amount of their Buy/Sell Cover from $400K to $1M over time, without requiring additional Cover.

In other words, the Life Insured already has enough Cover to meet their future needs.

 

What if You Have No Need for 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

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.

Future Sale Price Provision

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.

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.

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.

 

"Forward Underwriting" or "Future Insurability"

The One Policy Strategy uses Personal Cover that the Life Insured otherwise requires to act as a warehouse or comfort zone for future Buy/Sell Cover.

In the above example, the Buy/Sell Cover could be increased from $400K to $1.2M (250% of the original amount) just by re-purposing the original Sum Insured.

This provides some level of comfort that Cover will be available to meet future needs for Buy/Sell Cover.

Another, equally important strategy is a "Forward Underwriting" or "Future Insurability" Option.

Most Insurance Companies offer a "Forward Underwriting" or "Future Insurability" Option that enables the Policy Owner to increase the Sum Insured in the case of certain pre-defined events like an increase in the value of the Equity in the Business.

For example, the Option might allow the Life Insured to treble the Buy/Sell Cover from $400K to $1.2M or from $1M to $3M.

These Options normally require the Life Insured to satisfy greater medical and underwriting requirements at the time the Policy is first taken out.

However, because these requirements have been satisfied, the Insurance Company relaxes the medical underwriting requirements in the case of future variations, up to the level specified in the Option.

This means that, if the Policy Owner requires more Cover in the future, they might not have to satisfy the normal medical and other underwriting requirements.

The main requirement will be to satisfy financial underwriting requirements that prove that the value of the Business has increased.

The relaxation of the medical underwriting requirements means that the Policy Owner might be able to obtain an increase in the Sum Insured, even though the health of the Life Insured has deteriorated since the Policy was taken out.

Cost of Forward Underwriting Option

There is normally a cost associated with a Forward Underwriting Option.

The Insurance Company does not normally charge a Premium for Cover that has not been used yet.

Thus, if the Sum Insured now is $1M but the Facility allows the Sum Insured to be increased to $3M, the Insurance Company will only charge a Premium for the Sum Insured of $1M.

However, because of the Option, the Insurance Company will charge a higher rate of Premium for the $1M Cover that is actually utilised at the time.

The additional cost varies between Insurance Companies, but is usually between 8% and 15% of the premium that would otherwise be paid.

When the Sum Insured is increased, the Insurance Company will charge the higher Premium on the increased Sum Insured.

In the example of the Life Insured with Buy/Sell Cover of $400K and Personal Cover of $600K, the Life Insured would pay a premium for each of the two Policies totalling $1M.

However, in addition, they would have to pay the cost of the Forward Underwriting Option with respect to the Buy/Sell Cover of $400K.

Thus, it is possible that the total cost of the Cover would be greater than it would otherwise have been.

Paying for Cover That You Might Never Need

You must pay the additional premium for a Forward Underwriting Option, whether or not you ever exercise the Option and take out the additional cover.

If you make a claim under a Policy with a Forward Underwriting Option, you will only receive the Sum Insured that you have been paying a premium for.

The One Page, One Policy Strategy recognises that you have other Cover that you have taken out.

It simply allows you to repurpose this Cover as your needs change.

If a claim occurred, you would be paid all of the Sum Insured that you had paid for.

It recognises that you will have and receive some Buy/Sell Cover as well as Personal Cover.

It focuses on the aggregate of the two needs.

Administrative Burden

If the Buy/Sell Cover was increased from $400K to $600K, then initially the total amount of Cover would be $1.2M (i.e., $600K Buy/Sell Cover and $600K Personal Cover).

At this point, the Life Insured would have to determine whether they needed an aggregate Sum Insured of $1.2M or $1M.

If they only required a total of $1M between the two Policies, they would presumably reduce the Personal Cover to $400K.

Thus, the failure to aggregate the Cover onto One Policy seems to involve both a higher premium and a greater adminstrative burden within the framework of the $1M total need.

Valuation Requirments and Disputes

Most Options depend on the application of a pre-agreed valuation formula to the financial statements of the Business at the time of a review.

This could require the Business to obtain a formal valuation initially and at the time of a review.

The anticipated cost should be taken into account in assessing the value of an Option.

Often, the Life Insured wishes to exercise their Option when they are aware that their health has deteriorated.

While the Option is designed to benefit the Life Insured in this very situation, it is a commercial reality that much greater focus will be placed on the valuation exercise when it is known that the risk has increased and a claim is that much more likely to occur in the foreseeable future.

"Use It or Lose It"

Historically, many Forward Underwriting Options have required the Policy Owner to exercise the option at least once within any three year period.

If the option wasn't exercised, it would be lost forever.

Lives Insured and Advisers should carefully check the terms of any Option.

Increases in the Value or Amount of Equity

Historically, Options have been drafted so that they apply to increases in the value of the original amount of Equity.

They do not necessarily extend to the value of:

  • additional Equity that has been acquired during the life of the Policy (e.g., when another Proprietor retires); or

  • Equity in new Business Entities that are established or acquired during the life of the Policy.

Lives Insured and Advisers should carefully check the terms of any Option.

Higher Value and Higher Growth Businesses

The One Page, One Policy Strategy is often adequate for medium-sized Businesses that experience incremental growth.

It would not be adequate where the the anticipated growth of the Business exceeded the aggregate of the current Buy/Sell and Personal Cover that would otherwise be required.

Similarly, it would not be adequate where the total Sum Insured was $1M and the $400K Equity had grown to $1.2M or higher within a relatively short period of time.

Thus, subject to the above issues, it is always important to consider the use of a Forward Underwriting Option.

 

Copyright: Ian Gray Solicitor

 

 

Adviser Tip

A Complete Succession Plan is not just about Death, it's not just about Insurance and it's not just about selling your Equity.

See more Adviser Tips

 

 

 

 

 

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