YOU NEED A PLAN, STAN
MISTAKE # 22
Neglecting to do appropriate planning for the death of key people in a privately held business or farm
IT’S A BIG MISTAKE when Mary and Beth, sisters and proud owners of Marybeth Widgets, put their heads in the sand about what happens when one of them dies. Privately held businesses are a “hot button issue” in estate planning, and from our discussions with a number of professionals, we gleaned that the controversy they can cause sometimes has less to do with the dollars at stake and more to do with interpersonal (often the all-in-the-family sort) dynamics and a healthy dose of emotion.
When we talk about privately held businesses, we are including partnerships, corporations and family farms, which can all generate conflict if enough attention isn’t paid to planning for the death of the main people in charge.
There are four main mistakes made regarding privately held businesses and what happens when the key person dies:
• Communication: people don’t talk about succession issues, much less the death issue. Ironically the worst offenders for not talking about these delicate topics are close friends and family members who are in business together.
• Documentation: if they do talk, they don’t get their discussions and agreements reviewed or properly documented by professionals.
• Funding: shareholder agreements, if they are in place, can be useless if the cash to actually carry out the terms of the agreement is not available. For example, if the agreement directs the corporation or a surviving shareholder to buy the deceased shareholder’s interest, the corporation or the shareholder, as applicable, must have the funds on hand or available through insurance in order to actually implement the deal.
• Updating: once completed, the agreements often become stale-dated and when the need for them arises, they do not achieve their intended purpose.
communication
One senior lawyer whom we contacted about this topic has an impressive track record of working with wealthy families as they sort their way through succession and estate planning. We expected to hear back from him about all sorts of technical details and the latest planning tips and strategies. Instead, his email note a week later said that since receiving our questions he hadn’t been able to get off his mind a recent situation involving bitter estate litigation that had been commenced by those of the deceased’s children who had not received an interest in the family business from their parents’ estate.
The lawyer noted that these children had actually received more from the estate than their siblings but “they were excluded from the family business they had grown up in. I believe that if the parent had informed all the children of his choice during his life and explained his reasons, it might have ended differently, or at least led to a more equitable distribution of the estate.”
But, you may be thinking, how can you have these conversations? Like the patriarch in our colleague’s case, you may want to duck the difficult topics to do with your business, farm or partnership as long as possible—it may feel easier just to keep the peace. There could be a better way; although we tend to think about mediation as a process that people enter after a dispute starts, it can also be effectively used to hammer out a solution before illness or death makes the topic front and centre at the worst possible time.
Mediation involves all the parties creating a long list of options and solutions and then working together to combine them into a viable solution. Often parties have interests and concerns that others in the process may not have even been aware of, such as children who you assume want the business may in fact not be at all interested and the children who do want to be involved may be the ones that come up with the best ideas for how to compensate their siblings who will not receive a share of the business.
The point is not that mediation is required for you and your family or business partners to have difficult conversations, only that it is an option. And it is an option you should consider carefully if you and your family or business partners are caught in a difficult limbo between knowing something needs to be done and drawing up the agreement. There is not much point in retaining a professional to draft a terrific shareholders’ agreement that you know will only cause grief. You somehow, some way, need to find a way to discuss the matter openly and productively before it can be committed to paper.
documentation
Once you and your family or other business partners have agreed to a plan in principle, the next step is to document the plan in whatever fashion is appropriate for your situation. This documentation will definitely include a will, and if there is more than one shareholder or partner in the business, a buy-sell agreement is required to direct what happens if a shareholder dies or is otherwise forced to leave the business, or chooses to leave the business.
The buy-sell agreement will cover questions such as:
• the events that will cause a buyout (such as death, disability, retirement, an owner leaving the business);
• the people who will be eligible to buy the departing or deceased shareholder’s interest; and
• the price that will be paid for the interest in the company or the method by which the price will be calculated.
funding
When entrepreneurs have extra cash they tend to do the entrepreneurial thing, such as buy more land, build more buildings, renovate and upgrade. While this is clearly the way that businesses grow, this approach also means that when the buy-sell agreement is triggered by the death, disability or departure of a key person, neither the business nor the surviving owners have the cash to carry out the terms of the agreement. In other words, the buy-sell agreement is unfunded and is basically just a piece of paper.
This is where insurance comes in and it is something that you will want to think about and obtain early. A practical point to consider that was brought to our attention by an insurance executive is the issue of healthy shareholders with a normal weight who have to contend with a shareholder who is an obese smoker. Awkward! What would be impolite social conversation becomes an important and necessary business discussion in light of the importance of the key-person insurance and the disparity in premium costs between normal and high-risk insurance.
updating
It’s essential to keep the documentation for the succession of your business or farm lined up with the insurance policy. Consider this situation: Two shareholders entered into a buy-sell agreement with $500,000 in life insurance on each life, payable to the operating company. The agreement provided that the spouse of the first deceased shareholder would sell her shares to the company and the company would buy back these shares at the value they were worth immediately before the death.
Over time, the business began to wind down, with the owners taking the value out of the operating company where the insurance was held. As fifteen years went by, the specific terms of the buy-sell agreement slipped everyone’s mind, although if asked the shareholders would likely have agreed that the spouse of the first to die was to be paid at least half of the insurance.
However, at the first death, the value of the company—now a shell—was nominal and so, according to the agreement’s terms, only a nominal amount was paid to the spouse of the deceased shareholder for her late husband’s shares. Accordingly, almost all of the insurance proceeds ultimately went to the surviving and now sole shareholder. While all of this was within the written terms of the agreement, those terms had become seriously outdated over time as the business evolved from being an active company to merely a holding company.
points to take away
• The first and maybe most important step is to communicate with everyone involved. Avoid assumptions about who wants what. Get professional assistance in order to facilitate the discussions if you need to. Procrastinating in addressing the issues of passing on a privately held business, including the capabilities of your children, will not work over the long term.
• The value of a farm or business is often not available in cash, so consider how the buy-sell agreement will be funded or the terms of the will carried out to achieve the desired fair result. Investigate and secure any required life insurance early in the game.
• Keep your will, the buy-sell agreement and any related insurance up to date; even a few years is a long time in the life of a privately held business, and things change, especially the value of a business.
