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Traditionally most advisers see a business succession plan as buy/sell life insurance policies that fund the purchase of a proprietor’s share of their business if they died or became disabled.
At PRP we see Business Succession Planning as a package of commercial strategies that enable you to exit a business, whether or not insurance is available at a reasonable cost. Our role is to act as the project manager who helps create a deal that will apply to each proprietor on their departure.
Other people on the team to properly address these commercial strategies are:
The key to good protection is the right amount of money, for the right person, at the right time.
This is often called “buy/sell insurance”.
The purpose of the insurance is to ensure that:
The role of the Agreement is to:
A traditional Buy/Sell Agreement should not be a very complicated agreement. It normally deals only with the purchase price and no other requirements of a succession plan. It normally has no impact on the level of premium payable for the insurance. However, a succession plan needs to address issues other than the sale of equity.
The proprietors might have given personal guarantees or second mortgages over personal assets (such as their homes) as security for these facilities.
Many clients think these securities die when they die or when they sell their equity.
Unfortunately, they don’t. Instead, they trigger a re-consideration of the facility by the bank or creditor. At the same time, the executor of your estate wants to obtain a release of the security, so that it can distribute the estate to the beneficiaries.
The bank can effectively turn around to the Continuing Proprietors and say, “We are being asked to release a security, we want replacement security from you”.
If the Continuing Proprietors can’t provide adequate security, the estate might continue to be responsible for liabilities of the Business.
This means that the purchase price of the equity and any other assets might be available to the bank. If there was a default, the bank would prefer to access the cash sale proceeds sitting in a bank account (rather than have to sell a house or other personal asset).
This problem can be avoided by insuring part or all of the debt.
If there are three directors and we reduce the company debt by one-third, the Continuing Proprietors can justifiably say, “three people used to be responsible for 100% of the debt, now two are responsible for two-thirds of the debt”. This should help obtain a release of the security.
In summary, a succession plan should help a proprietor to leave both the asset and the liability sides of the ledger.
Most business people have residual personal needs over and above their asset need.
For example, if their goal was to fund a living expenses budget of $50,000 per annum for their family, they might need a lump sum of $1 million (assuming a five percent interest rate).
If their purchase price was $400,000, they would need a top-up of $600,000. If it was $300,000, they would need a top-up of $700,000.
There is, therefore, an “inverse” relationship between the purchase price and the personal cover. They both feed into the same pot. As one goes up, the other one can potentially go down.
The one page succession plan can now be a one page summary of a business person’s needs and succession plan.
It represents a worst-case scenario that enables them to obtain an estimate of the premium cost of the strategy.
If the estimate is not acceptable, they can then use the summary to prioritise what risks they will insure and what risks they will assume or self-insure.
It is common for business people to have four or five different insurance policies. After a few years, they have no idea what they have, who owns it, whether it is the right amount, or who will get it. They are no longer in control of their succession plan.
A business person’s needs change over the course of their life or career.
In the personal sphere:
Their need for personal insurance, therefore, goes down.
At the same time, business debt should be going down.
Over time, you would also expect that the value of the business would go up.
In summary, two of our needs tend to go down, while one goes up.
If we combine all three needs on one policy, we might have the right total for the indefinite future. Only the mix will need to change.
Let’s assume that the cover was written on separate policies.
Firstly, as the debt is reduced, the debt reduction cover should be reduced, to avoid any risk that it might be treated as key person revenue cover (and taxed upon the payment of a claim).
This involves administration and contact with the insurance company.
Secondly, as the purchase price increases, the buy/sell policy should be increased.
This involves not only administration, but new underwriting and medical tests. Thus, the cover might not be available, if the life insured cannot satisfy the requirements.
In contrast, the single policy strategy is designed to place all of the cover under the one roof. Once it is under the roof, it is not necessary to deal with the insurance company, unless additional cover is required over and above the total sum insured.
Thus, changes are a management issue, not an insurance company issue.
The agreement is a buy/sell agreement. However, it is also an engine that drives the one page, one policy succession plan. It ensures that each component of the cover is paid to the correct recipient securely and tax-effectively (with ATO approval).
However, unlike a traditional buy/sell agreement, it also results in substantial cost savings and flexibility for a long-term succession plan.