Why Do Business Owners Avoid Succession Planning?
58% of small business owners do not have a succession plan. This widespread lack of business succession planning can lead to major obstacles for small business owners. Without a plan, the loss of a partner can leave your business at increased risk of closure or takeover. The common myths of succession planning give business owners a sense that they can or should be dealing with this topic sometime in the future. However, It would be beneficial for your business to have a detailed and up-to-date plan at all times starting now.
Below we have highlighted some common myths to be aware of.
Myth #1: My Business partners and I cannot afford at this time to fund or commit to any type of agreement; Therefore, we need to wait.
If your company has any value or future value to protect, then the cost of insuring each or some partner’s value could be only hundreds of dollars to cover millions of equity buyout. Term insurance may be very inexpensive to assure million of capital arrives at the time most needed. Concepts such as ESOPs etc. may not be expensive to plan for now for future needs.
Myth #2. Agreements designed for buyouts due to death or disability are the same as “living” buyouts and valuation events.
Not at all. The lifetime buyout terms of mergers, retiree benefits, and any other future exit strategies are not negatively affected by DBO agreements. Living buyouts will come from negotiations, other agreements or plans, and many other future circumstances. The terms of a good buy-sell agreement are only triggered by the death or disability of an owner. It is critical that business owners understand that entering a DBO buy-sell agreement will not limit your other exit or liquidity events.
Myth #3: Agreements cannot be changed or removed once created.
False! Agreements may be changed or removed if it is agreed upon by all parties prior to a triggering event. In fact, it is important to continually update the agreement since an outdated or ambiguous agreement may result in a costly future dispute.
Myth #4: Family businesses do not need to consider these types of agreements.
Wrong. Many families should most definitely have buy-sell agreements in place. It can be a useful tool in estate planning and inheritance equalization. Additionally, it can be instrumental in avoiding family tensions amongst siblings. Done in coordination with estate planning these agreements may save substantial estate and income taxes.
Myth #5: Partners often agree about entering into a DBO buy/sell.
Not so, often, one or more partners may not be on board with entering and funding an agreement. It is extremely common to have differing understandings or agendas amongst partners. Theoretically all partners should have the same interests by having such an agreement. If there is a breakdown in moving forward with a buy/sell agreement, then there should be even more reason to work though these differences NOW. Without an agreement in place, a triggering event such as a death or disability could put your business and beneficiaries in serious trouble with messy and costly legal repercussions. All party should understand that.
Popular Succession Planning Strategies to Consider
- Buy-Sell Agreement
Buy-sell agreements are a common exit strategy for business owners looking to transfer their businesses to partners, family members, or executives in the event of a premature death. While not the only option for funding a buy-sell agreement, life insurance is a popular choice because it can pay a lump sum when the owner (insured) dies prematurely or may potentially accumulate cash value to fund the purchase of the business from the owner in the event of a lifetime buyout. A buy-sell agreement allows business owners to know up front who can buy in to the business and how the process will work. Having this agreement in place gives owners the opportunities to talk about possible scenarios rather than forcing owners into expensive litigation down the line.
Here’s How it Works:
- Step 1: The business owner works with legal, tax, and financial advisors to select the type of buy-sell agreement, and agrees to sell his or her share in the business to a participating individual or group such as family member(s), partner(s), or employee(s) for an agreed upon amount when a triggering event occurs (ex: owner’s death, disability, retirement, etc).
- Step 2: The purchaser, surviving partners or corporate, of the business buys a life insurance policy on the life of the business owner and pays the premiums
- Step 3: If a triggering event takes place, the purchaser of the business uses either the tax-free death benefit or tax free distributions from the available cash value to buy the business owners interest.
Without a buy-sell agreement in place, you may find yourself in some unfavorable situations
down the line in the event of an unforeseen circumstance. For example, how would you feel if
your partner’s widow’s new attorney helped run the business? Would you mind having your beneficiary’s dependent on getting their fair value based on the success and goodwill of the surviving partners? Having a formal agreement can define a formal roadmap in the event of a death or disability.
2. Estate Tax Liquidity Using an Entity Redemption
The companies of many successful business owners make up a substantial share of their overall net worth. Estate taxes may make it difficult or impossible for the business owner’s estate to keep the business in the family or to negotiate an equitable split of estate assets. A plan that creates estate tax liquidity using an entity redemption can help with business continuity and liquidity without resorting to complex irrevocable life insurance trusts or gifting schemes.
Here’s How it Works:
- Step 1: The business partners with legal, tax, and financial advisors, and agrees to purchase all or part of the owner’s interest at death (buy-sell agreement).
- Step 2: The business buys a life insurance policy on the owner’s life. The business is the policy owner and beneficiary and pays all premiums.
- Step 3: The death benefit is typically equal to the liquidity needed by the estate to pay any estate taxes or to equalize the inheritance of non-business heirs.
- Step 4: If there is a binding buy-sell agreement in place, the death benefit may not increase the value of the business upon the insured’s death, and thus may not indirectly increase the insured’s taxable estate.
- Step 5: The business owner’s estate uses the proceeds from the stock sale to pay any estate taxes and/or to equalize the inheritance of non-business heirs.
- Employee Stock Ownership Plan
An employee stock ownership plan (ESOP) funded with life insurance provides a business owner with a clear succession plan while rewarding employees with direct ownership of the company. It is an option for a business owner who doesn’t necessarily have an internal or external successor available but would like to make the business employee-owned to keep it in the community and keep existing employees in their jobs.
Here’s How it Works:
- Step 1: The business works with legal, tax, and financial advisors to create a qualified profit sharing plan that purchases the business’ stock. (Business MUST be a C-corporation or S-corporation).
- Step 2: The company purchases life insurance policies on select key employees. The company is the owner.
- Step 3: The company contributes or sells stock to the ESOP for the benefit of the plan participants and allocates the stock to the participants’ accounts. The ESOP must comply with nondiscrimination rules. The company repurchases the stock from the ESOP in the future (the put option) and may use key person life insurance to help fund this obligation
- Step 4: The business may use cash value in the policy to purchase the ESOP shares of the deceased or retiring participants
The Dangers of Unfunded Agreements
Buy-sell agreements often requires a buyout of ownership interests upon a triggering event such as a death or disability. It should be binding and based on a formula or set value. When faced with the fact that a buyout is required, it becomes painfully obvious funding choices need to be addressed. When the triggering event occurs, the company must not scramble to determine how it will obtain the proper funds to meet the current obligation and should not have to rely on cash flow or borrowing funds. As noted below those options may make the business vulnerable to cash flow difficulties and major disruption. A better way to address this situation is with the purchase of an insurance policy. If insurance is used, it is essential to ensure that the terms of the agreement match the terms of the insurance. It is very common the insurance is not owned by the right party, or funded for the right amount, both of which can cause financial and tax issues.
What Are My Funding Options?
One of the most common mistakes in developing a buy-sell agreement is owners not properly assessing the question “how much do we need to fund the agreement?” We highly recommend consulting with a business succession expert during this process, as too often owners take shortcuts during the process and critical valuation details are overlooked, resulting in poorly funded agreements.
- Borrowing Funds- borrowing is always an option when someone owes money, however, borrowing may come with many downsides. First, will a bank lend money based on the future banking environment or if your business lost its most important asset, the partner who made the corporation what it was? If the bank decides to make the loan, will the terms or rates be reasonable from the borrower’s viewpoint? Will the business suffer from cash-flow consequences due to the demands of repaying the loan, which also may impact the credit-worthiness of the business? What will the total cost of the loan be?
- Cash- business owners have the option to fund a buy-sell agreement with cash, which has the apparent advantage of being simple and requiring no immediate outlay. This would require the business owners to keep a large after-tax cash reserve available. Cash is an unlikely solution for many business owners, since most business’s capital isn’t sitting in a cash account. It is usually tied up in the business, such as in illiquid assets or inventory. Remember the percentage of ownership applies to the cash and therefore must exclude that percentage amount from determining the buyout number.
- Installment Payments- another method of funding the buyout could be installment payments. This method is relatively simple and would require small outflow each year. However, bear in mind that this strategy has a major flaw due to its tendency to inhibit cash flow, which may cause dramatic effects if the interest purchased belongs to a majority owner. No cash flow could mean no business.
- Life Insurance- life insurance is a common and cost-effective method of funding. It is certainly the most tax efficient. Remember, most all buyout dollars come from after tax monies. That makes all other option other than Tax Free death benefit very inefficient! A death benefit equal to the value of the shares guarantees that at the triggering event, sufficient funds will be in place to execute the buyout. Whether you have paid premiums for 15 years or only 1 month, the full death benefit will pay out. That is why life insurance is the most certain and economical option to fund a buy-sell agreement.
Life Insurance Can Help Protect Your Business
Life insurance, when properly funded, can help fund your business succession plan so that your business survives the exit of an owner. In fact, more than 60% of business succession plans are funded by life insurance. A lump sum payable is provided at the insured’s death and potential cash value to help with one or more of the following scenarios:
- funding a buy-sell agreement
- paying estate taxes and business debt obligations
- protecting a surviving spouse from the financial impact of the insured’s death
- providing cash to help the business survive decreased sales due to the loss of a partner
- treating heirs equitably to minimize family acrimony
Life insurance can help reduce conflict between all parties involved and allow the business to keep running smoothly. When used to fund a buy-sell agreement, the chosen successor can also use the policy’s accumulated cash value, if design with cash build up, as a source of funding for purchase of the company at owner’s retirement.
Can You Answer These Five Business Succession Questions?
- To Whom will you transition your business
- When will you transition the business?
- How will you transition the business
- For how much will you sell the business? (if buy-sell agreement)
- How will the buyer pay for the business?
If you cannot answer all the above questions, it is extremely important to consider seeking professional guidance on devising a business succession plan. Business succession planning is a lot of work. There are a ton of things that go into planning that you might not think of during the process. If you start planning ahead of time, your business, employees, and customers will thank you later.
Exemplar’s Legal and Insurance Team Have Your Business Covered
It is uncommon that insurance professionals, attorneys, and CPAs work together in the succession planning process. Exemplar Companies has a team of lawyers that are able to assist in the design and documentation necessary while working with our in-house insurance professionals and best of breed insurance contract brokerage. We will assure the coordination of the succession and estate planning documentation with the funding choices all have your best interests in mind and are understandable by all parties involved. Complicated made simple and job done!
In part II of this blog, we will get into a more in-depth view of the pros and cons of the different types of buy-sell agreements. Additionally, we will discuss the different types of insurances available and the pros and cons. The Exemplar team will assist you in avoiding the pitfalls of the wrong documents and the wrong insurance policy choices.
Managing Director, Insurance & Financial Services, Exemplar Companies, Pbc
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