At its core, corporate succession planning boils down to two decision categories: the expected and the unexpected. In transition planning, the business owner makes the decision to exit, whether it’s through a sale to a third party, to insiders, or through a gift to family members. It is a plan that takes into account any expected events.
In contrast, the contingency planning that we focus on here is about finding solutions to unexpected events such as death, disability, and divorce. Understanding and executing estate planning documents and sales/purchase agreements are crucial. In fact, if they are overlooked or not adequately addressed, they can have devastating effects on the continuity of a business.
Estate Plan
The key to having a solid business contingency plan is to ensure that the owner’s estate plan aligns with his goals for the business after his death. In working with business owners over the years, I have found that all too often the owners have not thought carefully about how and if their business will be passed on to their heirs and as a result have not aligned their wills and/or trust funds accordingly.
A common provision in a person’s estate plan is for the estate to be divided evenly among the heirs—usually the children. However, this is not always ideal when it comes to the disposition of an established company. Unlike traditional investments like stocks, bonds, and cash, an operating business is made up of many moving parts, including employees, payroll, customers, and day-to-day decisions that must be made to keep the business running. For these reasons, a detailed business contingency plan should be deliberately incorporated into the owner’s estate plan.
A business can be the largest asset owned by the owner, and owners may fear that it would not be “fair” if it were not divided equally among their heirs. In such cases, the owner should keep in mind that “fair” is often not the same as “equal”. For example, if an heir has worked in the business and helped it grow, it may make more sense and be fairer to let him inherit the business.
There are other ways to effectively make each heir too “holistic” in terms of the value of the estate. One is to increase the overall pool of wealth through the use of life insurance. Another option is to ensure that control of the company passes to the desired heir(s) while the company’s equity is distributed more evenly. This is done by dividing the company into controlling and non-controlling interests and ensuring that the controlling interests go to the heirs who will run the company.
Purchase/Sale Agreement
Another often-overlooked document is the purchase/sale agreement, a contract that sets out what becomes of a partner’s interest in a company if that partner dies or, for whatever reason, leaves the company . This document is usually drawn up when the company is incorporated. Unfortunately, it is then often filed and forgotten together with the other foundation documents. Three crucial parts of a purchase/sale contract are:
Triggering Event: A purchase/sale agreement should contain a detailed list of triggering events at an entity that would activate the terms of the document. The death of the owner is one of the most commonly considered events, but others – such as disability, divorce, voluntary and involuntary termination – can also have a tremendous impact on a business.
Method of Valuation: One of the most overlooked parts of the purchase/sale agreement is the method of valuing the business at a triggering event. Because the purchase/sale agreement is often entered into at the incorporation of the business and its value is small and/or difficult to determine, owners often use a lump sum dollar amount. This can make sense for young companies, but over time the value usually falls far below the actual value. As a rule, the use of an expert opinion by a third party is recommended as the evaluation method.
Financing Mechanism: Life insurance is a common method of financing a sale/purchase agreement. But as with the valuation issues, the insurance policies taken out at the time of purchase/sale are usually not enough as the business grows. The funding method should be reviewed annually to ensure it is keeping pace with the growth in shareholder value.
