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Business Succession Planning: Need for Asset or Buy/Sell Strategy Need for Liability or Key Person Strategy
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One Page Strategy: Simplifying the Valuation Issue
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One Page, Two Policy Strategy:
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Sole Proprietors and Families: Third Party Buy/Sell Strategies Estate Equalisation Strategies
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Debt Reduction and Key Person Insurance (Liability or "Red" Needs)
Liability Needs The Liability Needs include requirements of the Business traditionally called Key Person Needs.
Red Needs On the One Page Risk Analysis Worksheet, these Needs are coloured Red.
Purpose of Key Person Cover The purpose of Key Person Insurance is to:
Debt Reduction Cover (External Debts)Many Businesses have external Debts owing to Banks or other Creditors. In some cases, the Creditor might require Personal Guarantees or other Securities (e.g., a mortgage over personal residential property) by way of Security for the Debt. Many people assume that, if they die and/or sell their Equity in the Business, the liability with respect to the Guarantee will die with them. Unfortunately, the liability stays alive and binds their Estate. In a sense, they cannot be confident that the Sale Proceeds of their Equity in the Business (or any other assets in their Estate) will safely pass to their Beneficiaries, unless and until they have obtained a release of the Guarantee from the Creditor. Debt Reduction Cover is designed to reduce the Debt of the Business upon the occurrence of the Insured Event. This strategy is also designed to minimise any concerns that the Bank or Creditor might have about the inability of the Business to service principal and interest payments in the absence of the Key Person. Example Assume that a four Partner Business has a Debt of $800,000. If we insure the Life Insured for a proportionate share of the Debt (say, $200,000), then at the time of Death we can say to the Creditor:
As a result, the Outgoing Proprietor will be able to both sell their Equity and extinguish their Liability. In other words, their Succession Plan will enable them to "leave both sides of the ledger". If they retain their liability under any Personal Guarantees, then the Sale Proceeds and other assets in their Estate will remain available to the Creditor to satisfy the Debt of the Business in the event of a default. Amount of Debt Reduction Cover It is common to insure a proportionate amount of the Debt with respect to each Life Insured. However, the appropriate amount depends on the views of the Creditor with respect to the relative importance of the particular Life Insured to the Credit Facility and Security arrangements.
Debt Reduction Cover (Loan Accounts) In many cases, the Proprietors of a Business lend funds to the Business to fund working capital, particularly in the early stages of the Business when it might not be able to obtain external debt. In other cases, the Proprietors might withdraw funds from the Business over and above their profit share in order to fund personal needs or liabilities. In these cases, there might be a loan owing by the Business to the Outgoing Proprietor (or vice versa) upon the occurrence of the Insured Event. A loan owing:
Just as the liability with respect to the Guarantee will remain alive, any Loans owing between the Business and the Outgoing Proprietor will remain owing and will need to be repaid either to or by the Estate. Debt Reduction Cover can be used to repay 100% of the Loan Account in these circumstances.
Key Person Income (or Revenue) Needs Often the loss of a Key Person can result in the loss of Income or Revenue, either on a temporary, once-off basis or on a more long-term basis. Alternatively, if it is expected that the Income or Revenue is not likely to suffer, it might be prudent to fund the salary cost (as well as head-hunter's or consultancy fees, relocation expenses and other on-costs) of a replacement employee for a period of, say, 12 months with Insurance Cover. This would give the Business confidence that it could weather any storm or fund the replacement employee's salary without any financial embarrassment. Some Businesses insure the salary costs for two or three years. However, normally it would be expected that the replacement employee would be earning their own way after 12 months.
Key Person Capital Needs Sometimes the loss of a Key Person means that the Business might also lose knowledge, expertise, relationships, contacts, clients, customers, suppliers, goodwill, or growth potential that a replacement employee cannot be expected to maintain. In these cases, the loss of goodwill might impact on the capital value of the Business and the value of the Proprietors' Equity in the Business. It is possible to "guesstimate" the possible loss of goodwill and insure it, so that the capital value of the Business and the Proprietors' Equity is maintained. This might also minimise the impact of any drop in value on Security arrangements with respect to External Debts. In professional firms, it might be necessary to fund the capital cost of acquisition of a replacement Partner (including their practice) in order to replace the Outgoing Proprietor and their area of expertise.
Tax Implications of Debt Reduction and Key Person Cover Please click here to read about the tax implications of this type of Cover.
Fact Finder Please click the following links to see part of the Complete Succession Fact Finder that has been completed for:
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Adviser Tip Your guarantees don't die when you do. When you leave a Business, you need to exit both the Asset and the Liability side of the ledger.
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