Planning for what would happen to a partner’s shareholding, should they be unable to perform their role in the business, or even worse, pass away, is an incredibly important aspect of any business’s succession planning. Talking through these scenarios with business owners is important so they can understand what the consequences of such an event would be on the business.

The big issue is that if one of the partners were to suddenly become disabled or to die, their estate would want to ensure that they can easily realise their share of the business. The equity held in the business would generally be considered an important component of the capital used to live off in retirement or support the family. If that money is tied up in the business and cannot be realised easily, this could put a financial strain on the estate when unexpected events occur.

If in the event of disability, it may be that the business would continue to pay the owner, however, one would question how long that is viable. To continue to pay a business partner who is no longer able to work in the company but continues to draw money from the business and share in the profits will ultimately become unsustainable or at least undesirable.

What, if one of the business owners were to suddenly pass away? Most people would consider this unlikely, but sadly it happens and in a business with multiple owners, naturally the risk is magnified. Speaking with a prospective client recently, they explained to me the arrangement they had in place as part of their shareholder’s agreement. If one of the two owners were to exit the business suddenly as a result of disability or death, the remaining partner would have the first right of refusal to purchase the share of the company for a three-month period. After this point in time, an external party can be sought to buy into the company.

This isn’t necessarily uncommon but has its limitations. What if the remaining partner/s cannot come up with the money in those three months? Cash may not be available and borrowing capacity may be restricted. Further to that, what if an external party can’t be found to buy in? Depending on the timing, it could be quite difficult to find an appropriate buyer.

Losing a business partner could have an impact on business revenue and profitability, so an event such as this could hurt the bottom line and there is no guarantee that the entity would be in a position to continue paying the estate.

Ideally, we would simply see the partner paid out, the estate settled and the shares of the business transferring to the remaining partner/s. The person who has exited the business is, therefore, able to realise their equity to continue to provide for either themselves and/or their family.

One funding mechanism which can make this a fairly straightforward process is the use of personal insurance policies, with a legal agreement (buy/sell agreement) for the business that dictates the purpose of the insurance policies.

Typically, each owner would have life and total and permanent disability (TPD) insurance (sometimes critical illness insurance too) with a sum insured equal to their share of the company. If one of the insured events takes place, the buy/sell agreement is triggered. The business owner and insured person make a claim on their policy and proceeds are paid to either themselves or their beneficiaries. This money acts as consideration for their share of the business, and the shares transfer equally to the remaining owners.

The main advantage of using such a strategy is how straightforward and cleanly it can be executed. The obvious downside is the cost of insurance every year when it is quite possible that the insurance policies would never be required. Having said that, if the policies are ever required, then it’s just about the most cost-effective funding mechanism possible. Particularly when compared to borrowing money and being subjected to ongoing interest payments, or the opportunity cost of having to use cash reserves. Many businesses simply treat the ongoing insurance premiums as a cost of doing business.

If you are a business owner and need to discuss your own personal situation, please reach out directly to me via email HERE and I’d be happy to answer your questions.