Far too many Australian businesses are unaware of the severe financial impacts that the loss of an owner, director or key person will have on their business. Seeking professional advice on these matters along with business succession planning is imperative for all business owners to ensure that their business and livelihoods are protected.
What is business succession planning?
Business succession planning involves planning for the smooth continuation and success of a business despite personnel changes. A comprehensive business plan should cater for voluntary and involuntary personnel changes.
Business Succession Insurance
Our business succession planning advice focuses on planning for involuntary personnel changes. Our advice endeavors to maintain business profits in the event that a business owner and/or key staff member dies prematurely or is otherwise incapacitated (temporarily or permanently). One way to fund this is to use personal insurance (Life, Trauma and TPD insurance).
The key to business succession planning using insurance is to provide the right amount of money, for the right person, at the right time, with no nasty tax surprises.
Business succession insurance can be broken into three categories:
- Business revenue protection insurance.
- Business asset protection insurance
- Funding of buy/sell agreements.
Who needs business succession insurance?
Businesses that need succession insurance include:
- Non husband and wife owned businesses.
- Businesses that have business debt.
- Business relying on a key person or persons to generate revenue.
Why have business succession insurance?
The easiest way to understand why business succession insurance is necessary is through hypothetical scenarios. For example:
- What would happen to your business if you lost your key salesperson or head foreman?
- If your business partner died, do you want to be in business with their executor/estate?
- What would you do if you have provided a personal guarantee for a business loan or lease, and you become injured and can no longer contribute to the business?
- How would your family maintain their lifestyle if you died?
Business Ownership Protection Insurance
What is business ownership protection insurance?
Business ownership protection insurance aims to protect the owners of a business in the event that one of its key people suffers an unexpected event such as death, disablement or trauma.
In contrast to business asset and revenue protection insurance, business ownership protection insurance aims to protect the business by providing funds in the event that one of its key people suffers an unexpected event.
Business ownership protection involves two separate, but related components: the establishment of an exit (buy/sell) agreement and a funding arrangement.
Business ownership protection insurance provides financial resources for buy/sell and funding agreements in the event of the death or disability of a business principal.
Business ownership protection insurance can provide business owners with enough cash so that the remaining principal(s) can:
- Fund a buy/sell agreement documenting an agreed price or valuation methodology.
- Guarantee the orderly, equitable and certain transfer of ownership of the business.
- Maintain control of the business.
- Protect their entitlement to profits and the value of the business.
- Ensure all owners receive a fair value for their interest.
What is a buy/sell agreement?
A buy/sell agreement is sometimes called a ‘business will’ or a ‘critical events agreement’. It provides a framework detailing the rights of each party should an event ‘trigger’ the operation of the agreement (e.g. the death or incapacity of a principal).
A buy/sell agreement should include:
- The names of the parties to the agreement.
- The events that will ‘trigger’ the agreement.
- The valuation method to be used to value each owner’s share of the business.
- How the remaining business owners will fund the purchase of the existing business owner’s share of the business.
Other methods to fund buy/sell agreements
If you do not purchase insurance to protect against the death or incapacity of an owner of the business, there are a number of other methods to fund buy/sell agreements, including:
- Selling a share of the business. But who to?
- Obtaining additional capital from the remaining business owners or a new business partner.
- Obtaining additional funding from a lender.
- Covering any potential losses from reserves or future years’ profits.
Selling a share of the business or obtaining additional capital from existing or new business owners may be problematic for a business that has just suffered the loss of an owner, due to the perception of additional risk. Lenders may be reluctant to extend further credit for the same reason.
Therefore most buy/sell agreements are funded through life insurance products – that is life, total and permanent disability (TPD) and critical illness insurance.
Are buy/sell agreements still relevant if they are not insurance funded?
It is still advisable to have a buy/sell agreement in situations where you decide not to take out insurance or where a particular person may be uninsurable. This is because the buy/sell agreement will provide the mechanism for dealing with the business ownership on an involuntary exit. In such cases the funding of the disposal may be undertaken using the vendor finance mechanism or some other process pre-agreed by the parties. Importantly, there is a binding document with a set of rules as to how the exit is to occur.
Business Revenue Protection Insurance
The aim of business revenue protection insurance is to maintain the business in the same, or similar, situation as it was prior to the death or incapacity (temporary or permanent) of a key person.
Business revenue protection insurance is a type of key person insurance (formerly known as keyman insurance.)
Who is a key person in a business?
Most businesses have one or more key persons whose skill, knowledge, experience and/or leadership are pivotal in generating revenue.
A key person may be one or more of a number of employees or business principals. They include:
- a revenue producer, such as a salesperson
- those that are integral to the output of a business, e.g. the factory manager, office manager
- the owner of key intellectual capital
- the name behind the business (i.e. goodwill)
How does key person insurance work?
Key person insurance is generally effected by businesses owning life insurance products (life, TPD and trauma insurance) on key persons to the business. The purpose/structure/quantum of key person revenue insurance for a particular business will depend on:
- whether the key person is also a business principal
- the business’ business model/plan
- attrition of key persons in the business
- whether the key person is temporary or permanently incapacitated
- the specific skill set/expertise/leadership of the key person
What does business revenue protection insurance cover?
Business revenue protection insurance provides cash so that a business can:
- be compensated for the loss of revenue (i.e. the fixed costs of the business must still be met irrespective of reduced revenue because of the loss of a key person)
- fund the associated replacement costs of the key person (e.g. training costs, recruitment fees)
- enable bank finance repayments to continue to be met despite the reduced revenue
- protect the business owner’s profit
- maintain the value of the business as a going concern
For more detailed information on any of the topics discussed in this section please contact us today and our Senior Financial Planner will meet with you to discuss your Business Protection needs.