business succession

Maintain Value- Why we recommend Business Succession Agreements

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Where a business is run by multiple owners, it is important to secure the ongoing viability of the business in the event that one of the owners passes away or suffers from a critical injury, disability or illness. A Business Succession Agreement is a useful tool to ensure the seamless transfer of ownership over the company in one of these unfortunate events.

The importance of a Business Succession Agreement is best explained through a hypothetical scenario. Let’s say that two owners named Cathie and Barney carried on a business supplying building materials to government builders. When Barney died, Cathie offered to purchase Barney’s shares in the company from his estate. However, Barney’s Will left everything equally between his two teenage sons, Bill and Bob. Unfortunately, the boys fancied themselves as business owners. Rather than selling the shares, the boys insisted on taking an active role in the business. After a year of indecision, arguing and stagnant growth, the business failed.

The failure of the business could have been avoided if Barney and Cathie had executed a Business Succession Agreement which transferred Barney’s interest in the company to Cathie as the continuing owner.   

Essentially, a Business Succession Agreement is a legally binding document which stipulates what happens to each owner’s respective interest in the company should they pass away or lose the ability to continue running the business. Typically, this involves allowing the continuing owners to buy the outgoing owner’s shares in the company. This gives the remaining owners certainty that their rights to continue on in the business while also ensuring fair value for the family of the outgoing owner whose interest has come to an end.

This Agreement also ensures that third parties do not have an unacceptable level of control or influence over the business, the estate cannot demand an unreasonable amount for the interest in the business, loans are not called in without proper funding, and the continuing business owners can protect the asset that they have worked hard to build up. 

The Agreement functions through a grant of an option in favour of the continuing owners to purchase the outgoing owner’s interest. At the same time, there is a grant of an option for the outgoing owner or their executor to require the continuing owners to purchase the interest in the business on set terms. The Agreement will also set out the mechanisms by which these options can be exercised and the time periods within which a valuation of the interest must occur and payment of that interest.

To fund these buy and sell obligations, the Agreement may impose obligations on the parties to maintain policies of insurance to provide all or part of the funds to purchase the outgoing owner’s interest in the business.

Ultimately, a Business Succession Agreement is only part of an overall strategy that must be formulated. It is imperative that the other documents that form part of the legal framework under which a business operates are reviewed carefully.  Therefore, Trust Deeds, Company Constitutions, Loan Agreements and other arrangements must be reviewed and, where appropriate, updated. It is our pleasure to assist our clients and their advisors in achieving these goals. Should you be interested in arranging a Business Succession Agreement, please contact Tony direct on (07) 3317 4312.

Real Value of Due Diligence and Independent Advice.

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The enemy within

It never ceases to amaze me how people can be so trusting when entering into a business transaction with someone they don’t know very well.

As part of small business management, it is usual when acquiring an asset that the director exercises a reasonable level of due diligence before committing to the transaction. Certainly, a high level of scrutiny is given to the purchase of such items as plant and equipment or stock. One can only wonder why a director would leap into a financial or structural change without the same degree of scepticism.

Recently, I encountered another example of a business that had been created with a potential significant time bomb lodged in the structure.

My clients were skilled construction individuals who had created a unique method of surface material application and decided to start their own business.

Lacking the acumen, advice and funding, they accidentally discussed the matter with an unknown third party, who decided to offer them start up finance. A company was duly formed and, on the advice of the accountant for the third party, a change in the constitution occurred.

This was a significant moment in the life and destiny of the business. The accountant made it clear that he was acting only in the interests of the third party investor, but for some inexplicable reason, this did not trigger a warning to the other two to seek independent advice.

As a result, a special class of shares was issued to the third party and highly restrictive voting powers imposed upon the two original shareholders. In fact, the third party forced a change to the constitution to the extent that, at any time, the third party could appoint himself as a director.

The two working directors, who had taken the majority of the business risk, were left having no real control over the company, could not seek out further or alternative funding and certainly could not complain about the management style of the third party.

Regardless of their predicament, they set about working hard in the business seven days a week; taking risky contracts with difficult time lines; employed and managed the staff; juggled cash flow; and somehow managed to repay the third party the principal and interest on time. To make matters worse, from the outset, the spouse of the third party shareholder had a registered first charge over all the assets and undertaking of the company pending receipt of the final payment of principal and interest.

Effectively, upon a minor or technical default, such as production of figures or reports, the spouse could have appointed a receiver at any time.

Eventually, the two original directors reached the end of the period of repayment and, due to the growth in the business and increasing complexity of financial management, they finally sought independent accounting advice. The accountant was surprised to find the change in voting rights and the registered charge had been orchestrated from the outset and gave the directors their first independent view of their position.

It came as a shock for them to understand that they could lose all that they worked for at any time and that, in fact, they at no stage really controlled the company.

No formal meetings were ever held and surprisingly, the third party sat back and let the principal and interest repayments come in without inquiring further.

The next stage of the relationship became critical. Now they had obtained this independent advice they were angry at the way that it had occurred, but understood all to well that now was not the time to incite an argument with the third party or his spouse as secured creditor.

Two crucial outcomes were sought:

  1.  To ensure that at the point that the loan was repaid in full, a release of charge would be provided in exchange; and
  2. At the same time, a change to the constitution would occur whereby the voting rights would become equal again.

You can well understand that they felt a little intimidated, calling a meeting to resolve the matter. On advice, they were open about the agenda for the meeting, the changes they were seeking and produced an independent valuation for the shares. They now realised that they were not guaranteed to free themselves of the existing shareholder with higher voting rights and that, as the company improved its financial position, so too did the value of the shares. The longer they waited to address the matter, the higher the exit price would become for the third party.

From an innocent first handshake discussion they had been outmanoeuvred carefully and had indeed helped create an enemy within.

The choices were:

  • Pay a premium on the shares; or
  • Liquidate the company and start again.

All the hard work could be undone in a matter of one moment of disagreement with the third party.

Thankfully, the share price reflected a very good capital gain for the third party and the element of risk for the future was enough to convince them to take a clean exit. The two original directors have learned a valuable lesson about business due diligence and they are addressing several other outstanding issues:

  • A formal shareholder’s agreement and a business succession plan, and
  • A review of their trading terms and conditions and the structure of their finance.

They have formal meetings which are recorded and copied to the accountant. The lesson is always the same: If it sounds too good to be true, it usually is.

ATC Digest Edition #75

Business Succession and Property

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Each business will have its unique requirements.

I assisted some clients in relation to a business succession agreement for four partners in a successful business.

At the time of formation of the original business entity, there was a simple husband and wife team. Over the years, the business grew. They were joined by their management executive and they sold shares in the company as a result.

The business expanded again and they sold a further tranche of shares to another key management person.

During the expansion phase they also had the opportunity to purchase the business real property from which the business was conducted.

As it was around the time of the last manager’s buy in, he could not afford to purchase an interest in the property as well.

So the end reality was four business owners and three property owners.

They acquired the property in a separate family discretionary trust as tenants in common in one-third shares each. A commercial lease was established between the business trading entity and the three trusts as owners of the property.

All simple so far…

The question arose as to how to deal with the property interests upon death of a principal in the business.

It is a simple matter for the one that did not buy in, as it is simply the value of his interest in the shares of the trading entity. However, when it comes to the buy/sell agreement for the three that have an interest in the property, this was a completely different matter.

The issues are

  1. Does the deceased business owner need a continuing interest in the real property
  2. Is there a greater inherent value to the property in light of the commercial lease linked to the business
  3. Should the principals be able to leave the property interest to their family in their estate as a separate matter from the business
  4. Does the buy/sell agreement take account of the goodwill attached to the business premises?

These questions were more difficult to answer than I first thought. It was always a regret of the last owner to buy in that he did not acquire an interest in the property as well. It may be that this is dealt with separately and there is no requirement to sell down the interest in the property.

In the interim, a solution was reached so that the value placed upon the business had a recognition of the business premises, pursuant to the long-term lease in place with the current owners.  A simple buy/sell agreement was prepared to allow for self insurance of the principals in the business.

Further, self-owned policies were put in place for the property ownership via the family trusts. It was an issue as to how the mortgage facility was structured and the parties are considering a variation to the agreement that governs the holding of the property. I have recommended that this be included in the buy/sell agreement, to allow the continuing owner that presently does not have a share in the property, a right of first refusal to buy that interest of the departing principal.

All sorted, for now…

ATC Digest Edition #86