Small Business Succession Planning
Jack, Bill, and Russ dreamed of creating a restaurant chain in their hometown. Through hard work they built a thriving business. But their dream will become a nightmare if they don’t plan for what happens when they die.
Each partner has continually reinvested in the business so each of their respective shares represent their most significant financial asset. None of their heirs want to be involved in the business after their father passes away. And even if they did, the survivor owners would not feel comfortable working with the family of the deceased partner.
These dynamics pose serious issues for their estate planning and the future of their business. Suppose, for example, Jack was to pass away and leave his share to his family. Since no one in the family wants to work in the business, how would they realize value for the inherited partnership interest? Conversely, what if a family member or two become active in the business, but the other two partners don’t want to work with them, or they don’t get along?
Either scenario does not bode well. In the first instance, Jack’s family want to force the sale of the business so they can realize cash for their interest. “Fire sales” like that usually bring bargain hunters to the table, which is not in any owner’s best interests. So Bill and Russ decide they will buy out Jack’s family. But Jack’s family have an unrealistic opinion as to what a third interest in the business is worth. They also want all the money at once and will not accept installment payments. EVen if Russ and Bill agreed to their extortionate selling price, paying it all at one time would take more than their saving to pay operating expenses during slow seasons. Since the parties cannot find a middle ground, they feud and muddle along, but in just a couple of years the business folds and closes.
Let’s change the facts a bit and assume Jack’s family found an outsider to buy hisinterest in the business. Bill and Russ are afraid that this inexperienced third party will disrupt their operations and they are right. They end up in litigation as the new owner seeks to force Bill and Russ to sell out to him at a very low price, which they reject. This eventually drives the business into receivership and bankruptcy, as an outside buyer cannot be found.
Could Jack, Bill and Russ plan their estates to avoid these risks? How can they be fair to each other, and realize value for their heirs in a way that will not financially stress the surviving partners?
The most common solution a Buy-Sell Agreement (“BSA”) made while the partners are alive, healthy and getting along without issue. A well-drawn BSA can realize all the objectives mentioned in this discussion, and keep the business profitable for generations.
There are different types of BSA’s. Today I will highlight the Cross-Purchase BSA and the Structured Buy Out. In a Cross-Purchase plan,each partners takes out an insurance policy on the others. For the purposes of this example they would be valued at a third of the agreed upon value of the business. Should Jack pass away, Russ and Bill would use the proceeds from the insurance policies that they had taken out on Jack’s life to purchase his share in the business from his estate at the previously agreed upon price, in cash. There is no fighting over the purchase price or the payment terms. The buy-out price is paid from the insurance policies which the partners have paid for a little at a time over the years so it does not financially stress the business or Bill and Russ.
They also agreed to re-value the business from time to time, to make sure the price is fair and adjust the life insurance. But if the insurance is not enough (or if there is no insurance ) then there is a structured buy-out. That’s where the parties agree in advance to accept installment payments of the purchase price over an extended period of time, to the extent it is not covered by life insurance. Specialized provisions can be added to make sure that events after the sale of the deceased partner’s interest are not unfair to the selling partner’s estate.
Estate planning for cosely held businesses can be frought with issues, but good planning makes it fair. Failure to plan could doom a business. Contact a skilled and experienced estate planning lawyer for your options.