Deciding what should happen to your business after you retire or pass away can be one of the most difficult business planning decisions you’ll have to make.
Aside from considering your personal circumstances when undertaking succession planning, you’ll also need to bear in mind how your business is structured. The issues you’ll need to take into account differ depending on whether you’re a sole trader, or operating your business as a partnership, trust or company.
If you’ve set up your business as a partnership, it’s likely that you had a relationship with your business partner prior to establishing it, and have a high level of trust in that person. While there are benefits to running your business in partnership with a friend or family member, in many cases this means it was established with only the bare minimum of official documents. Although this may not currently present any issues, it can cause headaches when you want succession to occur.
To minimise this risk, it’s important to ensure that all partnership agreements are in writing and as detailed as possible. If the worst happens and you are unable to run your business, clear agreements will make it much easier for those inheriting your business interests – at what is likely to be a highly emotional time.
One agreement which may help minimise problems is a ‘buy-sell agreement’. A buy-sell agreement usually incorporates a transfer agreement, which facilitates the transfer of assets and business interests in the event that you or your business partner suffers from illness, injury or sickness, or passes away. A buy-sell agreement typically also includes a funding agreement, which describes the source of the funds that are to be used to acquire the transferred assets or business interests, with insurance most-frequently being the primary source.
Buy-sell agreements offer a number of benefits, including:
- Certainty that your family will be promptly and fully compensated after you’re unable to continue in the business
- Equalising contributions and preventing financial erosion of the business
- Avoiding negotiation difficulties and conflict
- Ensuring fair financial outcomes for all parties, as decisions don’t need to be made at the time of succession and parties are relieved of that added pressure
- The option to provide for the repayment of loans made by an owner to the business or to provide their estate with a funding mechanism to meet any liability which may have arisen as a result of the guarantee the business owner had provided
Transfer agreements specify the circumstances which will cause business owners to transfer their interests to another party, as well as the manner in which this will be conducted. These agreements are tailored to the needs of you and your business partner, but are commonly structured to cater for changes due to three main scenarios – foreseeable events (such as retirement or voluntary exit from the business); unforeseeable insurable events (death, illness or disability); and unforeseeable uninsurable events (including bankruptcy, legal action or divorce).
Funding agreements specify the financing that’s required to effect the terms of any transfer agreement. Options for funding include:
- Debt funding – securing borrowed funds from an external source
- Equity funding – achieved by diluting an exiting business partner’s ownership by issuing new shares or units to the remaining or new owners
- Self-funding – using available surplus cash reserves
- Insurance funding – using various types of insurance coverage
While busy business owners have many competing time pressures, succession planning is one of the most effective ways to give you peace of mind and ensure you’re prepared for any unforseen event.
Next time, we’ll look at succession planning considerations for businesses set up under a trust structure.
The information contained within this article is of a general nature only and does not take into account your individual objectives, financial situation or needs. No direct or implicit recommendations are given and this should not be used as a substitute for specific professional advice. Reading this article does not establish any kind of advisor-client relationship. You should always consult a financial adviser for advice specific to your financial situation. Perpetual disclaims any liabilities whatsoever from your decisions based or influenced by this article. Any reference to readers’ actual circumstances is entirely coincidental.
