Confusing Numbers: Singapore & Our Sovereign Wealth Funds

The following are some points about Singapore and our Sovereign Wealth Funds.  The numbers are estimates and rounded off.  They are taken from whatever is available online at the respective sites.

The official balance sheet of the government of Singapore, as at 31^st March 2015, has a total income at $150 billion, and net surplus at $111 billion.  Our cash and cash assets are at $256 billion out of our total assets of $1.366 trillion.  Temasek Holdings assets as of this date is $256 billion.  It has since been claimed at $266 billion as of the current date.  Given the cash holdings and the stated portfolio of Temasek Holdings, that would add up to $512 billion.

The outstanding Singapore government borrowing since 31^st March 2015, which is the latest I could get, is $396 billion.  It is undoubtedly larger now.  But taking that as the outstanding debt, if Singapore were a giant corporation, which is arguable, then our shareholder equity is $970 billion.

In the 20 years since 1975, our debt has risen by almost $350 billion.  And the IMF has given our operational surplus as $280 billion.  Temasek Holdings have claimed a return of 17% in that time, and 19% this year alone.  GIC itself has claimed a 5% rate of return in that same 20-year period.

If we count backwards, based on these claimed returns, how is it that as of 31^st March 2015, our total assets are only $1.366 trillion?  That would mean that in 20 years, our actual return was less than 1%.  The numbers released by the MoF and MAS on one hand, and Temasek Holdings and the GIC on the other hand, are incongruent.  And what we can get from the IMF only makes things more confusing.

Typos Can be Deadly

Typos can be deadly for companies.  All limited liability companies in the United Kingdom are required to register with a government agency called Companies House, which records financial statements and other corporate information.  This is their equivalent to Singapore's Accounting & Corporate Regulatory Authority.

In 2009, Companies House reported that Taylor & Sons Ltd., a 124-year-old engineering company, had been declared insolvent.  That was news to the management and employees of Taylor & Sons, a very much functioning company.  Almost immediately, they were plunged into crisis.  Believing the company had collapsed into bankruptcy, customers cancelled orders, contracts were declared void, and suppliers stopped offering credit.  To compound matters, the company’s managing director was on vacation, causing clients and creditors to believe he had fled the country.  Operations slammed to a halt, and Taylor & Sons found itself forced to close for real.  All 250 employees were laid off.

As it turned out, Companies House actually meant to record the closure of Taylor & Son, an entirely different company from Taylor & Sons.  The now-liquidated Taylor & Sons sued Companies House and won; the judge ruling the agency completely responsible for the collapse of the £8.8 million company.  Now, if they had some form of liability protection, they could have mitigated this immediately.

Our GDP to Public Debt Relationship with Our CPF

This is a short explanation on why the Singapore government has embarked on a growth at all cost economic strategy that has increased our GINI coefficient and diminished our social safety net.  It also gives an insight into why they are so firm on the Population White Paper.

One of the issues that should concern Singaporeans is the nature of our public debt.  The public debt, also known as government debt, national debt and sovereign debt, is the cumulative debt owed by our government.  This is distinct from the annual government deficit or surplus, which is the difference between government receipts and spending in a single year.  A deficit is the increase of debt over a particular year, and a surplus is a decrease.

Public debt is a method of financing the government operations.  Our government can also monetise its debts by creating money.  This removes the need to pay interest on the debt, but it actually reduces interest costs rather than outright cancelling the debt.  There are limits to this, otherwise it might lead to hyperinflation.  Governments borrow by issuing securities, bonds and bills.  Our public debt consists largely of Singapore Government Securities (SGS) and Special Singapore Government Securities (SSGS), which is issued to assist the payments on the Central Provident Fund.  Singapore does not borrow from international financial institutions, therefore, we have no external public debt.

Here are some points about our public debt.  Singapore has amongst the highest public debt to GDP ratio.  This is because Singapore does not borrow externally to fund its fiscal policy.  According to MOF, “The Singapore Government operates on a balanced budget policy and does not need to finance her expenditures via the issuance of Government bonds.  It has enjoyed healthy budget surpluses over terms of Government in the past decades.”

Singapore only borrows domestically, the Singapore Government does not have any external debt.  Why do we have such a large public debt?  SGS are issued to develop the domestic debt market.  There are three principal objectives of SGS issuance.  Firstly, it is to build a liquidity in order to provide a risk-free benchmark against which other private debt securities are priced off.  Secondly, to grow an active secondary market for cash transactions and derivatives.  And finally, to enable efficient risk management; and encourage both domestic and international issuers and investors, to participate in the Singapore bond market.  It has succeeded to an extent.  As at December 2011, SGS stock is valued at S$79 billion, while the stock of Treasury-Bills is valued at S$59 billion.  Being government bonds, the yield is extremely low.

SSGS, on the other hand, are non-tradable bonds specifically issued to address the investment needs of the CPF.  CPF monies are invested in these special securities, fully guaranteed by the Government.  These securities earn the CPF Board a coupon rate pegged to CPF interest rates that members receive.  As at December 2011, SSGS stock is valued at S$216 billion.  In the 3^rd quarter of 2014, the amount of outstanding SGS bills and bonds, which account for 52% of total government bonds, was S$101 billion.  It was up 1.0% quarter on quarter, but declined 20.9% year-on-year.  New issuance of SGS bonds fell 26.9% quarter on quarter, and 66.5% year-on-year in the 3^rd quarter of 2014.  These numbers do not include the SSGS.  Singapore’s public debt was 106.7% of GDP in 2014, 104.7% of GDP the year before.

What Singaporeans must be cognisant of is the fact that public debt is an indirect debt upon us as taxpayers.  A broader definition of our public debt includes all government liabilities, including future payments, and payments for goods and services contracted but not yet paid.  This includes the money that is supposed to be paid into our CPF as a guaranteed interest.

In general, it can be said that Singapore practices Keynesian economics, where there is a tolerance for high levels of public debt to pay for public investment, which can then be paid back from tax revenues.  Our high public debt is not in itself a concern as long as we can generate GDP growth.  And that is why the Singapore government has embarked on this economic policy.  They need that growth to sustain the high public debt.

To understand the nature of our of public debt and analysing its risk, we need to estimate the projected value of our public assets being constructed, in future tax terms or direct revenues.  This is especially difficult for Singapore because a lot of our assets are held through Temasek Holdings, and they are not transparent.  As such, it is a challenge to determine whether much of our public debt is being used to finance consumption.

Because of the CPF, the government has implicit debt, which is the promise by a government of future payments from the state at a fixed rate on all deposits into the CPF.  A major problem with these implicit public insurance liabilities is that it is hard to cost accurately.  The amounts of future payments depends on so many factors.

Firstly, claims are unpredictable.  Population projections predict that when the current generation retires, the working population is insufficient to fund future payments.  Our total fertility rate as per the Population White Paper is 1.19.  We need a TFI of about 2.1 to adequately replace the population.  One way that the Singapore government is going around it is by drastically increasing the population.  And secondly, there is no maturity limit for payments of this nature.  As long as there are CPF accounts, and as long as the owners of these accounts live, the interest has to be paid.

Now, if the population by which revenues are raised to sustain these payments has a much lower TFI, the population will shrink without another form of growth.  And that means, the government will have increasing difficulty keeping up with payments and allowing withdrawals.  And that could also be a reason why the withdrawal age and the minimum sum is going up: they might not have the money to pay up on withdrawals.

In summary, these are relatively quick fixes to problems that have developed over the last few decades.  On hindsight, Lee Kuan Yew’s stop at two policy worked far too well, and we are now having to pay an expensive price to reverse this.  It either means we all have to work at having larger families, or we have to accept the reality of increased immigration.

Some Implications of the Trans-Pacific Partnership (TPP) on Singapore

The Trans-Pacific Partnership (TPP) is a proposed trade agreement between Singapore and several nations across the Pacific Rim.  It is a comprehensive agreement concerning many aspects of economic policy.  The TPP seeks to lower trade barriers such as tariffs, enforce common standards for labour law, avoid double taxation, establish a common intellectual property framework, and organise a common investor-state dispute resolution mechanism.  The TPP is an expansion of the Trans-Pacific Strategic Economic Partnership Agreement (TPSEP or P4) signed by Brunei, Chile, Singapore, and New Zealand in 2006.  From 2008, 8 additional countries joined for a broader agreement: Australia, Canada, Japan, Malaysia, Mexico, Peru, the United States, and Vietnam.

The original goal of wrapping up negotiations was in 2012.  However, agriculture, intellectual property, and services and investments were some of the contentions that are still being negotiated.  The latest round of negotiations was schedule to take place in July 2015.  That has been delayed due to events in member countries.  After the Election victory, the PAP are in a stronger position domestically to push ahead with the TPP.  And with no significant Opposition presence in Parliament, they can rush through the reading of the bill as they have always done.  To date, there have already been 19 rounds of negotiations.

The negotiations have been conducted in secrecy and the text of the treaty has not been made public.  This means that by the time domestic opposition can build, the treaty would likely have been ratified in most member countries.  WikiLeaks has published several leaked documents pertaining to the TPP since 2013.  Controversial clauses in drafts leaked to the public do not give us much confidence that it is actually to our best interests.

So what are the main points being negotiation?  There is nothing on the official sites of the Singapore government.  However, on the website of the Office of the United States Trade Representative has a list of chapters there.  Of interest to us are the chapters on competition, cross-border services, customs, e-commerce, financial services, government procurement, intellectual property, investment, labour, legal issues, market access for goods, rules of origin, technical barriers to trade, telecommunications, temporary entry, and trade remedies.  The USTR further that the contents of the TPP seek to promote comprehensive market access, facilitate the development of production and supply chains among TPP members, create regulatory coherence and promote “comprehensive and robust market liberalisation”, amongst other things.

One of the most controversial agreements is the Investor-State Dispute Settlement (ISDS).  Based on the draft agreement from WikiLeaks, the treaty essentially elevates a corporation to equal status with the sovereign state in enforcing sections of the treaty.  This means foreign investors in a company can sue the member state governments for any sort of infringement.  This presents a major problem since governments, even the newly elected governments that were not yet in office at the ratification of the TPP are constrained from enacting domestic laws and regulations that might contravene the treaty.  This puts the interests of companies over the interests of citizens.  This provision is at the expense of our sovereignty.  A more aggressive interpretation means that corporations and foreign interests can force the repeal of laws that contravene the free flow of trade and persons.  To put this in a way Singaporeans can understand, this means that the Singapore government cannot limit, for example, the flow of foreign workers and enact laws to protect Singapore jobseekers.

This treaty allows corporations to challenge domestic legislation of public interest.  On the 26^th March 2015, WikiLeaks released the TPP’s Investment Chapter.  According to the documents released, under this treaty, global corporations have the power to sue governments in international tribunals and obtain taxpayer compensation for loss of expected future profits due to government actions.  That means, if a future government of Singapore were to enact a legislation protecting, say, the interest of Singapore PMETs and require companies to hire a certain percentage of them, a corporation based here can sue the government for loss of profits, and they will win.  The tribunal will decide damages and that money will come from our taxes.  That is not ideal.

Joseph Eugene Stiglitz, the Nobel prize-winning economist said, based on leaked drafts, it “serves the interests of the wealthiest.”  Organised labour groups in the U.S., New Zealand, Australia, and Canada have come out against it.  Economic policy think tanks oppose it, including the Economic Policy Institute and the Center for Economic and Policy Research, arguing that it could result in further job losses and declining wages.  Other renowned economists against it include Avram Noam Chomsky, Paul Robin Krugman, and Robert Bernard Reich.

What does it mean for Singaporeans in a nutshell?  It is a mechanism to depress wages, while manipulating currency through massive movement of bank instruments.  In the long term, in its default state, this will shrink the middle class and create an entrenched lower class over the long term.  It will significantly affect our GINI coefficient, meaning that the gap between the wealthy elite and the rest of us will widen, and eventually become insurmountable.  It is not a recipe for a stable economy.  In summary, in the hope of future profits brought about by increased trade, we have made a calculated bet.  The only people who will benefit greatly from the TPP are major corporation in the banking, pharmaceutical and technology sectors.  Of course, now that the US has declined to sign it, under a Trump presidency, it can be argued that the TPP will be modified.  This does not mean, in future, a government having the same policy philosophy would not attempt a similar deal.

CECA between Singapore & India: Why Our PMETs are Losing Their Jobs

On the 29^th June 2009, Singapore concluded the Comprehensive Economic Cooperation Agreement with India.  This strategic agreement would become a concern for ordinary Singaporeans.  The primary area of concern pertains to the articles on the movement of natural persons.  This agreement will open a flood of Indian PMETs into the Singapore market, squeezing Singaporeans out of 127 specific occupations mentioned in the agreement, mainly in areas of middle management, and cause a direct adverse impact for Singaporean PMETs.

This agreement also allows intra-corporate transferees.  What this means is that a company can open an office in India and Singapore, and taking advantage of this loophole, parachute professionals, technicians and managers into Singapore since they are guaranteed an approval of short term stay.  And this is just one such agreement.

However, in light of the backlash due to the increased numbers of foreign workers, the Singapore government has been put in an unpleasant position of backpedalling from a binding agreement.  The government made changes to its Employment Pass Framework law to reduce the inflow of foreign workers significantly.  There were too many PMETs out of work.

Understandably, the Indian government was displeased.  Indians did not get the preferential treatment incorporated into the CECA between them.  There is a possibility that India might take up the issue with the World Trade Organization’s dispute settlement body.  The Indian government rightfully considers this a violation of the CECA.  There are about 200,000 non-resident Indians in Singapore working, and there is a possibility that some of them would lose their jobs.

According to Chapter 9: Movement of Natural Persons, under Article 9.5: Long-Term Temporary Entry, the paragraph on Professionals, it states clearly “Each Party shall grant temporary entry and stay for up to one year or the duration of contract, whichever is less, to a natural person seeking to engage in a business activity as a professional, or to perform training functions related to a particular profession, including conducting seminars, if the professional otherwise complies with immigration measures applicable to temporary entry, on presentation by the natural person concerned of:

(a) Proof of nationality of the other Party;

(b) Documentation demonstrating that he or she will be so engaged and describing the purpose of entry, including the letter of contract from the party engaging the services of the natural person in the host Party; and

(c) Documentation demonstrating the attainment of the relevant minimum educational requirements or alternative credentials.”

The “professional” here refers to anyone employed in an occupation listed in Annex 9A, List of 127 Professionals.  These are all jobs that Singaporeans find themselves locked out of.  As per this agreement, Singapore is legally bound to allow the free flow of Indian nationals under the list of “professionals” into Singapore without any border controls.  It is specifically written that we may not enact legislation that “requires labour market testing, economic needs testing or other procedures of similar effects as a condition for temporary entry”.  Any such law enacted to protect Singaporeans would be a violation of the agreement.  The agreement also allows Indian nationals who come to Singapore to work to bring in their spouses or dependents, and the Singapore government is required to grant these accompanying spouses or dependents the right to work as managers, executives or specialists.

It is no coincidence that the “other work passes” category experienced a growth rate of about 22% in 2012 and in 2013.  By the middle of 2014, this had grown 30%; that is, in 6 months.  In response to the Singapore electorate’s disgruntlement, in 2013, the Singapore government introduced the Fair Employment Consideration framework.  This is to supposedly ask for employers to consider Singaporeans for employment first.  Most employers paid lip service and the framework is a failure since here is no real check and no teeth in legal enforcement.  It is this framework that made the Indian government consider bringing the issue to the WTO.

In May 2010, CECA was up for a second review.  However, it was held up because of two main issues.  The first is that the Indian government wanted more Indian banks to operate here.  And they are unlikely to hire Singapore management personnel.  And secondly, it wanted Singapore to continue to allow the free flow of Indian professionals into Singapore.

In 2012, Prof. Tommy Koh Thong Bee said, “The truth is that we pay these workers such low wages not primarily because their productivity is inherently low, but largely because they are competing against an unlimited supply of cheap foreign workers.  Because cheap workers are so plentiful, they tend to be employed unproductively.  In the Nordic countries, unskilled workers are relatively scarce and thus deployed more productively, with higher skills, mechanisation, and better organisation.”  He further added, “What is the solution?  The solution is for the State to reduce the supply of cheap foreign workers or introduce a minimum wage or to target specific industries, such as the hospitality industry, for wage enhancement.”

Singapore is India’s 10^th largest trade partner globally, the 2^nd largest in ASEAN, accounting for 25.9% of India’s overall trade with ASEAN in 2013-14.  India was Singapore’s 12^th largest trade partner globally in 2014.  Bilateral trade expanded after the conclusion of CECA from US$6.65 billion in 2004-05 to US$25.2 billion in 2011-12.  It declined to US$19.27 billion in 2013-14.  Bilateral trade stood at US$17.1 billion in 2014-15.  India’s imports from Singapore were US$7.1 billion, and exports from India to Singapore were US$10 billion.  These numbers are from the Indian government.  In 2003-04, just before the signing of the CECA, bilateral trade between India and Singapore was US$4.2 billion.  Singapore is the 2^nd largest source of FDI, at US$32.2 billion from April 2000 to March 2015.  This is 13% of total FDI inflow.  Singapore was the largest source of FDI into India for 2013-14, with US$5.98 billion.  This accounted for about 25% of FDI inflows in the year.  Our FDI grew about 15 times.  The trade surplus favours India.

Clearly, the people who are in business, who run the corporation and the companies, have profited greatly from the CECA.  In terms of pure business, it was an excellent deal.  It also allows us to diversify away from dependence on the performance of the China markets.  From a nation building perspective, however, it is not ideal.  The CECA was not well thought out.  Evidently, the people who sign these deals and plan our trade policies have little contact with the ground.  The needs of Singaporeans do not factor greatly in this.

It is true that Singapore does need this agreement for market access, for creating trade and investment growth avenues, and to balance other developments in the region, including the Chinese strategy in the South China Sea.  For India, the agreement fits her political priorities regarding her interest in the broader international context, and with her need for trade and political alliances with other developing countries.  But political and economic considerations are fluid, and particularly for Singapore, it has mortgaged sort term gain for long term prosperity.  If the PAP government were planning for the next 20, then incremental convergence is likely the most prudent action.  Instead, the PAP found themselves locked in an untenable situation with a disgruntled population.  Hopefully, there will be tweaks in the policy to address these issues.

How to Calculate Your Coverage When Buying Insurance

The following are some of the formulae for a suggested needs analysis and an explanation of how they might be used.  This is a simple, and useful means to check if your coverage is sufficient.

Income Protection

This is the amount your family would need in the event of your death.  This is especially important if you are the sole breadwinner, or the principle breadwinner.  The whole idea is to have enough set aside that their standard of living is not severely affected.  Things to consider include funds set aside for the future education of your children, for the maintenance of the house and for the settlement of debts.

The Formula: (Monthly Amount Required x 12 x No. of Years) + Immediate Expenses + Outstanding Liabilities + Emergency Fund - Existing Death Coverage

The monthly amount required is the amount needed to pay the monthly bills with a little more set aside to maintain the standard of living.

The number of years refers to the time this funds need to last before someone else in the family is able to address the imbalance in the family income stream.

The immediate expenses are the expenses of a funeral, the estate expenses and the hospital bills, if any.

The outstanding liabilities include debts in the name of the deceased, or undertaken on behalf of the family.  They include housing loans, student loans, bank loan and car loans.

The emergency fund refers to the buffer amount in the family savings account that might mitigate this loss of income stream.

The existing death coverage includes any and all arrangements that would pay out upon your death into your estate.

The calculation for the accident coverage also uses this formula since the considerations are the same upon death.  If they lead to disability, then they use the formula below.

Disability Protection

This is the amount required by you to maintain your standard of living in the event of a disability, as well as the costs involved such as the acquisition of wheelchairs, walkers and such; the modifications needed to your living space to accommodate your unfortunate inadequacy; the cost of a caregiver and the immediate and ongoing treatment which may not be covered under a hospitalisation plan.

The Formula: (Monthly Account Required x 12 x No. of Years) – Existing Disability Coverage

The monthly amount required is the same as the above.

The number of years here refers to two things.  It refers to the time this funds need to last before someone else in the family is able to address the imbalance in the family income stream.  It also factors the number of years you will live with this disability.  In general, 20 years is a reasonable period to consider.

Critical Illness Protection

This amount factors two things.  It factors the amount required by you to maintain your standard of living in the event of a critical illness.  And it considers the cost of treatment.  This is important because even though you may have a hospitalisation plan, your condition may require innovative forms of treatment that may not be covered in the schedule of treatment.

The Formula: Total Lump Sum Benefit Required – Existing Lump Sum Benefit

$700,000 is a reasonable amount required in Singapore for a comprehensive treatment plan for cancer, a major killer.

Hospitalisation Expenses

This is the amount required by you for your daily expenses.  This is especially necessary for people who are daily rated such that not working would mean no earnings, and for proprietors.

The Formula: Monthly Earnings / 30 – Existing Coverage

The monthly earnings is the average earnings per month.  This is used to calculate the daily earnings.  If that is already known, then it is unnecessary.

Retirement & Savings Requirement

The retirement requirement is the amount required to maintain a reasonable standard of living upon retirement.  This is important because in Singapore, the average retirement age is between 62 to 65 years of age.  However, the life expectancy of a man is 84 years and for a woman is 88 years.  This means that the average person is expected to live more than 20 years without an adequate income.  This is also the age where medical expenses rise, as well as the attendant costs.

The Formula: Monthly Amount Needed x 12 x No. of Years – Existing Arrangement

The monthly amount needed is the amount required by you to maintain your standard of living.  A reasonable amount to start would be 80% of your last drawn salary.

The number of years is the number of years you expect to live.  We normally take it as the average life expectancy less the age of retirement.

Summary

It is important to note here that the vast majority of people are still underinsured.  We live in an age where people do understand the need for insurance.  However, people tend to underestimate their liability and their requirements.

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 pre-emptive 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 if 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 of 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 buy the heirs’ stake, then you have several things to consider.  The three most major are: price, funding, and payment schedule.

Price

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.

Funding

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?

Payment Schedule

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?

The Solution

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 as 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 funded agreement.  It has the following advantages:

1. It assures the heirs and the surviving shareholders have the financial strength to fulfil 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 assures the continuation of the business and addresses transition of ownership.

8. Depending on how the 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.