27 June, 2015
Transitioning Financially When a Shareholder or Director Dies
Business succession planning using insurance is the art of structuring policies to address the potential issues that may arise in the event of the passing or incapacitation of a shareholder, director or key person in a business. What are the issues that may arise? This depends on the status of the person who passes away. Businesses have executive and non-executive directors, major and minor shareholders and they may have gearing.
Consider what would happen to your business if a stockholder passes away. There are several immediate scenarios that will develop. The most obvious is to continue with the heirs as stockholders. They may be either as employees or as non-employees. This is essentially about protecting your legacy and your family.
Consequences of Uncertain Shareholdings
When a major shareholder or an important member of the management team passes away, this creates concern with the financiers, trade creditors and trade debtors. The financiers may decide to call in their investments. This will crash the price of the stock and severely affect the cashflow. This is especially certain if the financier is a bank or venture capitalist.
Trade creditors may also call in their loans. This is a preemptive move by most banks when the deceased is one of the guarantors of the loan. Or, the bank may raise the interest rate or vary other terms of the loan, including requiring more collateral. Please note that a private limited does not necessarily protect you from the debts of the business. Most loan contracts, especially with the bank stipulate that the board of directors in their entirety are personally responsible. This means, if the deceased shareholder was the one who took that loan on behalf of the company, even if you were not fully aware, and the bank decides to call in the loan, and the company cannot pay it back, they will go after you. And the bank will always go after the director with the most assets first. What this means, is that the death of another director can bankrupt you.
Also, you will find that your debtors will suddenly be difficult to collect from, especially of this is a large debt. This is due to the concerns above. If the company is declared bankrupt due to the escalating creditor issues, the debtors need not pay back any debts.
Heirs as Shareholders
The following are the factors we have to consider for the heirs of the stockholders. After all, they have no actual relationship to the business beyond financial interests. If they are not employed by the company:
1. Will they push for greater cashflow from the dividends?
2. Will they oppose long-term plans that might impact cashflow in the short term?
3. If the heirs are majority shareholders, will they remove you from management?
4. If they are minority shareholders, will they cooperate with management?
5. If the heirs are minors, can you cooperate with the guardians or trustees?
6. Would you be comfortable with your family being dependent on the business when you are deceased?
Heirs as Employees
If they are employees of the company, there are further considerations:
1. Do they have adequate management skills?
2. Do they have experience in the job?
3. Will they work with the management team?
4. Are they worth the same remuneration as the deceased?
5. What if there are more than one heir – can you afford their salaries?
6. Will they be worth the remuneration package?
Dealing with an External Buyer
Supposing the heirs, as is most likely, do not want to be part of the company. They will likely sell their shares. Even with a right for first refusal option to buy back the shares, the company may not have the reserves to do so without seriously impacting the cashflow. In such a case, it is most likely that a third party will buy the shares. These are the following points to consider:
1. What if the buyer was a business rival?
2. Even if not, can you accept any outsider buying into the company?
3. What is the likelihood that the new shareholder will have an alternative vision?
4. If they are the majority shareholder, will they remove you from management?
5. If they are the minority shareholder, will they share the vision of the management team?
6. If they push for a place in management, will they be worth the remuneration?
7. Will they push for increased dividends?
8. If you are the deceased, can you ensure that your family get a fair price for your shares, especially if they may not be familiar with the industry or the sale process?
Selling your Stake to the Heirs
These are the immediate questions raised on the most basic scenarios. Essentially, if your interests are not protected, it is easy to lose out. Even should you decide to sell your shares to the heirs due to an untenable position, you have to consider the following:
1. Can you stomach losing what you built?
2. How will the heirs fund it such that you can get a fair price?
We have not even addressed premium prices. In this case, the correct suite of life insurance policies can address the cost of the purchase at a premium forward pricing, the issues of the family income and the estate taxes.
Buying the Heirs’ Stake
Should you decide to protect your position to by the heirs’ stake, then you have several things to consider. The three most major are: price, funding, and payment schedule.
The price is determined by negotiation, and in most cases, the negotiation begins after death, either yours or another shareholder. That means, if your family is negotiating the sale price of your stake after your death, you have no input. And they might not have all the facts.
How will you fund this? You can borrow, use personal resources or take from the sinking fund if any. None of these are ideal. How soon can the funds be available? And what happens should the price of the shares vary greatly – upwards or downwards? If the purchase is funded from existing resources in the business, can the cashflow take that sort of pressure? Will it impact future earnings if it is taken from the working capital? Will it affect the credit rating of the company?
How much room do you have to manoeuvre? It is likely that the seller would like the funds upfront and will not tolerate a long payment schedule. Can you imagine paying an inflated price for shares that have dropped in the meantime?
This begins with a properly arranged and correctly worded buy and sell agreement. This is the most straightforward, cost effective method to protect the interests of all parties equitably. This is how it works:
1. A buy and sell agreement sets the price of the stake upon the death of every shareholder.
2. The price is given at a premium of the stock to ensure that the estate of the deceased is satisfied.
3. The price also satisfies the remaining shareholders by creating a price ceiling.
4. Such an agreement can also lock out undesirable buyers such a business rivals.
The next question is how to fund this? We fund it through life insurance policies on the life of the shareholders. This may be bought by the company on the shareholders, or by the individual shareholders on each other. The manner of this is important due to taxation concerns.
This being an insurance policy, it can be triggered upon the death of the shareholder, or upon his incapacitation and inability to continue with the business, depending on the type of policy and extent of coverage. Because this is tied up with the buy and sell agreement, the buy and sell agreement becomes a fully funder agreement. It has the following advantages:
1. It assures the heirs and the surviving shareholders have the financial strength to fulfill the sale of the shares.
2. It assures them also, that they will get an acceptable price that is a premium on the worth of the shares.
3. Since the company is not obliged to remit the entire sum claimed, only the sum of the buy and sell agreement, it can buy a higher value policy and use the difference to offset the cost of replacing a member of the management team.
4. This allows a quick clean break by facilitating the smooth sale of shares, eliminating one aspect of ownership uncertainty.
5. The estate of the deceased receive the funds quickly, in one lump sum.
6. It improves the credit rating of the business immediately.
7. It assure the continuation of the business and addresses transition of ownership.
8. Depending on how value of the policy and the obligation of the buy and sell agreement, this also allows the business to offset any debt should the bank or another creditor decide to call in a loan.
Essentially, by putting in place a proper buy and sell agreement coupled with the correct life insurance policies, we have addressed all these concerns, ensuring the continuation of your business.