Death, and disability, aren’t pleasant conversations to have, however both factors can affect the sustainability of your business. These hints and tips can prepare you to have that awkward conversation with your business partner.
As a business owner, either a sole operator or a joint shareholder in a business, you need to consider what will happen when you or your business partner is no longer able to fulfil functions in the business.
Your business, and the income derived from it, supports you, your partner and both your families; and such income could be drastically reduced or even wiped out if something happens to you or your business partner.
You can mitigate your risks by considering these four realistic options:
1. Liquidate the business and distribute the remaining assets
Due to a variety of factors this may be the only option available. Depending on the market and the economy, you have to accept that your business and its assets could sell for a lot less than they are intrinsically worth.
Related: Want to exit the company? Here’s your shareholder exit strategy
2. Take on your shareholder’s heirs as new associates
This situation may arise when there is more than one shareholder in a business. This option can be problematic. Heirs to the estate of the shareholder often do not know the business and often don’t even have the skills to do so. They may have no interest in joining the business and the remaining shareholders do not necessarily want them there either.
3. Sell out to the heirs
This is often a consideration in the event that the heirs have the desire and skills to match the business needs, but in the absence of some sort of agreement the negotiations in respect of the purchase price could be problematic. Furthermore, the funding of such a sale is a big consideration.
4. Buy out the heirs' share of the business
Often, this is the most practical choice. However, you still have to negotiate price and terms, and then come up with the funding for the sale. This is where a buy and sell agreement, funded adequately, can be invaluable during this difficult time.
A properly arranged and funded buy and sell agreement is a legally binding contract that spells out exactly what is to happen if one of the business's owners passes away or becomes disabled. The document itself can be as simple or complex as needed, and can provide for virtually any contingency.
However, it generally calls for the survivors to buy, and heirs to sell, the deceased owner's share in the business. Just as important, it should spell out the actual purchase price or, more commonly, provides an objective formula for determining the price when needed. Such an agreement can be between co-owners of a business or in the case of a sole operator between that sole operator and a key employee.
Related: What happens to your business when you are disabled?
Methods of funding if your cash flow is compromised
Wait and pay cash
In this option, surviving owner(s) use cash at the death of a co-owner to fund the buy and sell agreement. But, several drawbacks to this method exist:
- At death, funds may not be readily available for payment. It is possible to delay the payment, or pay it over some months, but this can’t be much longer than 12 months because the deceased shareholder’s estate must be wound up eventually and this can’t be done until the purchase price is collected in full.
- If you want to make provision through a savings plan, a savings plan accumulates funds over time and could be a good option, however what if funds are needed tomorrow? This is probably better than nothing.
- Accumulation of cash may cause an accumulated earnings tax or other tax implications depending on the situation.
Wait and borrow funds
In this option, surviving owner(s) borrow funds, usually bank loans, at the death of a co-owner to fund the buy and sell agreement. But, much like the first option, this method has drawbacks:
- Future growth may be slowed due to an increase in expenses (repayment of loan).
- Death of an owner may cause sales to decline, compounding the problem.
- Death of an owner may make it difficult to receive a loan.
- A surviving owner may have to sign for funds, exposing personal assets.
- Surviving owners pay rand for rand, plus interest, for the deceased's outstanding share of the business.
Related: Where are you keeping your business slush fund?
Use life insurance
Purchasing insurance can be a cost effective funding option for a buy and sell agreement, albeit as seen above not the only one. Using insurance as a funding vehicle will provide the following benefits:
- Immediate availability of proceeds when death occurs.
- Death benefit proceeds are generally tax-free.
- Premiums may be lower than the cost of repaying the loan interest.
Whatever option is best for you; it helps to have all the facts before making a decision.