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Financial planning is perhaps the most important part of planning that you should do in your lifetime, not just for yourself but for your family and your loved ones.

Business Succession:
Is business protection your biggest worry?

If the person is an owner or co-owner of a business which constitutes a large part of the person's wealth, there is yet another major risk that needs to be addressed at the personal level. This is the risk of the value of his/her investment going down.

Normally, an investment can go down in value if there is deterioration in the value of the constituent assets of the business or if its earnings capability is no longer sustainable. Discussion on such factors however is outside the subject here, which is on business succession planning.

Business succession planning is about planning for the continued protection of a business and those invested in the business during times of uncertainty such as when there is a business disruption. It is like having a valuable but fragile thing in the car boot which needs protective wrapping.

Business disruption can be brought about when something bad happens to key personnel, key facilities or key co-owners. When there is business disruption, even an investment in a profitable business can go down in value.

Most businesses, particularly small and medium-sized enterprises (SMEs), would depend on one or two key personnel. The prolonged absence of such personnel would pose a major risk since this adversely affects the business in a material way, perhaps because they control the business intimately or they bring in the bulk of the sales. Absence could be due to death, injury, retirement or resignation.

Well run companies do a series of preventive and mitigating measures for such risks. They have retention programmes designed to retain key personnel. These could be attractive performance incentives and share option schemes. Succession plans would be put in place so that there is always a successor to each key person and a pool of talents to draw on just in case. In addition, there is usually key-man insurance taken that serves to cushion the business for any adverse financial effect due to loss of life.

In the case of key facilities, disruption could be caused by unexpected events, such as a fire or a flood that damages important infrastructure or even virus attacks that cause system failures or data loss. To protect against such risks, an insurance programme should be in place and reviewed regularly. The insurance programme would include preventive measures such as enforcement of good fire safety practices. It should be noted that preventive measures are often overlooked although they usually cost a lot less than insurance premiums to implement. Consequential loss insurance can also be taken to provide compensation for loss of profits while the business is temporarily crippled.

In addition, business disruption can be minimised when there is a business continuity plan in place. This is when resources that include back up data and essential or mirror facilities are set up/ear-marked offsite, together with preset procedures and identified personnel, for the purpose of quick resumption of business.

Disruption can also be in terms of financial disruption and this can happen when a key guarantor dies, triggering a recall of a credit facility that the business depends on. The best way to protect against such a disaster would be to insure the life of the guarantor so that the insurance proceeds go to the business to partially or wholly replace the credit facility. The focus for the discussion here is really on business value protection.

Business value protection involves planning for the smooth succession of business and transfer of ownership from a person to the co-owners upon his retirement, death, illness or disability, even divorce, and when there is a deadlock in decision making.

Why is an exit strategy so important for a stake in a business?

Because for businessmen, their investment in a business that they are active in usually represents the most valuable part of their estate. Value is lost if there is no avenue for a smooth transition of ownership and/or management. Take the case of two partners who have been working well together in building a successful business. The major partner dies unexpectedly and there is no prior arrangement or succession plan. The wife who inherits the stake takes over as partner in the running of the business. Because she does not understand the business well, partnership disputes become frequent. Soon, the business deteriorates and the value of the partnership equity goes down.

Or take the case of two close friends, one holding a majority shareholding and the other a minority, in a highly profitable private limited company they had built together. Again, there is no prior arrangement as to ownership transfer. The minority shareholder dies unexpectedly and his family inherits the shareholding. While the company is profitable, the minority stake is not readily saleable because the majority shareholder has the pre-emptive right (right of first refusal) and few outsiders would be prepared to purchase and get locked into a minority position. And if the major shareholder controls the board and decides not to pay any dividend, the value of the company is of little meaning to the beneficiaries of the deceased. In such circumstances, the major shareholder is in a position to suppress the share value of the minority stake before he agrees to purchase.

These are just two of the many possible scenarios that can lead to loss in value of a business investment. Disruption of business can follow from the death of a co-owner because beneficiaries do not understand the business, or are too young, or not competent to take over, or do not agree with the business direction set previously or are unable to agree a value for the inherited stake. The heirs may have a problem getting funds from such an investment at a time when they need cash most because the business does not allow for cash withdrawal, or there is no ready buyer for the shares, or the surviving co-owners do not have the funds to purchase. If there is conflict with the new owners, the profitability of the business (therefore its value) will deteriorate and may even lead to break-up or liquidation.

What can be done about the problems that arise from the death of a co-owner then?

The co-owners can enter into an arrangement that involves a buy-sell agreement, insurance funding, a power of attorney and a trust deed.This arrangement is known as a BVPT (Business Value Protection Trust).

The buy-sell agreement provides that if a trigger event occurs affecting one of the co-owners (such as death or incapacity), the remaining co-owners who are parties to the agreement shall purchase his shares and pay his beneficiaries at a price that is fixed beforehand or on an agreed valuation basis. This way, there is the assurance that the ownership transition will be smooth, the business stays within the hands of people who understand the business and the beneficiaries of the deceased will receive fair compensation.

For the purposes of funding the cash required to purchase a stake in the business as provided for in the buy-sell agreement, the parties to the agreement would need to purchase life insurance on each other (known as cross-insurance), for up to an amount estimated to be equal to the envisaged purchase, such that upon the happening of a trigger event such as death or incapacity, the insurance proceeds would be used to pay for the deceased person's stake wholly or in part.

If key man insurance is used for the purpose of funding in the case of a company, there may be an issue regarding Section 67 of the Companies Act 1965 that prevents a company from providing financial assistance for the purchase of its own shares. There are also issues with regard to tax consequences. Consult specialists who are familiar with these issues.

The power of attorney (given by the business-owners as donors) is needed for the purpose of providing an independent party (usually a trustee company) with power to perform functions that are necessary to give effect to the buy-sell agreement without favouring any party thereto. Such functions would involve for example completing documentation for share transfer and taking legal action for breaches to the agreement. The trust deed is for the purpose of appointing a trustee (can be the same as the donee of the power of attorney) to administer and distribute the proceeds of the sale of shares in accordance with the terms of a trust (reflecting the wishes of an affected co-owner for the benefit of his named beneficiaries). Terms of the trust can include, for example, the distribution of proceeds to children only upon attainment of a particular age and/or the attainment of another milestone, such as an university degree, so that the benefactor can minimise the risk of inheritance being squandered away before his children are mature enough to handle finance.

If the buy-sell agreement is funded by insurance, the life insurance is either assigned to the trustee or the trustee is appointed in the nomination pursuant to Section 166 of the Insurance Act 1996, allowing the trustee to claim and receive the sale proceeds. Such proceeds are used by the trustee to settle in part or in full the purchase consideration for the subject shares in the buy-sell agreement. The transfer of the affected co-owner's stake to surviving co-owners who are parties to the buy-sell agreement, and transfer of the proceeds from the sale of the shares to the trustee, are done upon the occurrence of a specified trigger event (death, incapacity, etc.). But if the co-owner wants to ensure that the proceeds will be creditor proof, subject to time limitation under bankruptcy laws, the shares should be transferred to the trustee before the trigger event, such as at the same time as the buy-sell agreement.

In short, the steps to set up business value protection are:
  • Agree: Get the co-owners to agree and commit to such an arrangement
  • Value: Have a qualified accountant value the business or recommend the most suitable basis for valuing the business
  • Spell terms: Decide how the respective co-owners' interests in the business are to be valued, what is the funding for the buy-sell agreement, what are the trigger events, who should be appointed the independent trustee, etc.
  • Execute documents: Buy-sell agreement with co-owners, irrevocable power of attorney in favour of the trustee, and individual trust deeds to provide instructions on management and distribution of the sales proceeds

If a BVPT arrangement is contemplated, please seek the help of a trustee company who can arrange for advice from qualified lawyers experienced in legal documentation for such arrangements.

For most businessmen who own SMEs (small and medium-sized enterprises), their stake in the business can represent more than half their wealth. That is why financial planning needs to cover this aspect.

If you wish to learn more about a BVPT, contact Rockwills Trustee Berhad at 1700 81 WILL or 03-77811993