As outlined in the first article in this series, Seven Gaping Holes in Your Clients' Business Continuity Plans, most business continuity plans that rely solely on buy-sell agreements are riddled with holes. We continue our series with a more in-depth discussion of the first, and most common, problem: few buy-sell agreements—the tool that most owners use to plan for business continuity—include provisions to remedy the challenge that businesses will face after the death or departure of an owner.
The typical buy-sell agreement only addresses the transfer of ownership and usually only at the death of an owner. For example, if a bank pulls a company’s financing because the surviving owner does not have enough assets to satisfy the personal guarantees made by the now-deceased owner, the business may not be able to continue.
That’s just part of the problem. What happens if the deceased owner was the COO or the company’s top or only rainmaker? In our next article we’ll look at the impact the loss of the departed owner’s “personal capital” has on a business, but today let’s focus on the loss of financial capital.
The Case of the Missing Personal Guarantee
One of BEI’s Exit Planning members first met Joel Canfield soon after Frank Sobel, Joel’s 51%-co-owner, died. Joel told her that, as a key employee, he had purchased 49% of Sobel Construction, Inc. (SCI) over several years. He was President and ran the business, allowing Frank to retire. Our member learned that SCI undertook one or two large construction projects each year—projects that required a performance bond and a line of credit.
As founder and majority owner, Frank had personally guaranteed the performance bonds and his personal assets served as collateral for the LOC. After Frank’s death, Joel was willing to provide his personal guaranty, but with his nominal personal assets he couldn’t satisfy the bank’s outside collateral and guaranty requirements. Without bank financing, SCI could not continue to do business.
Neither lifetime transfers nor transfers at death provide the departing owner or his estate with financial security if the successor owner is an unacceptable substitute to lenders. Nor will ownership transfers under these conditions allow the successor to continue the business.
Frank and Joel had not considered that. Frank’s advisors had addressed the business succession issue: his attorney had drafted the agreement and his insurance advisor purchased the insurance to fully fund a transfer of ownership at Frank’s death. Joel was able to pay Frank’s family for his 51% share of the ownership. Still, the co-owners had not ever considered that, without capital (unavailable without Frank’s guarantees and collateral), the business could not survive. Unfortunately for all involved, neither had their advisors.
In this, SCI’s buy-sell agreement was not at all unusual; without access to capital many companies simply cannot continue. Think of your clients: if their businesses have permanent debt, long-term leases, or lines of credit, are one owner’s personal guarantees necessary to obtain and maintain them?
Exit Planning Answers
How can you prevent the demise of your clients’ perfectly capable businesses?
- Ask the right questions. Determine whether personal guarantees and collateral exist.
- Make sure the financier-owner does not give up control without receiving:
- Full payment (a death-designed buy-sell does this) and
- A full release from all of the existing and contingent debt and obligations of the business.
Few owners, even in family business, should entertain remaining contingently liable for company debt after they have transferred (whether during lifetime or at death) their ownership. Skilled Exit Planners understand how to manage this control/risk issue.
- Get written assurance from your clients’ lenders that, with an adequate amount of insurance on the financier-owner’s life (or a specific amount replacement capital provided by the new owner), they will allow the removal of the financier-owner’s guarantees/collateral.
- If insurance on the financier-owner is not available, consider revising the buy-sell agreement to suspend the transfer of ownership until the designated successor can provide, to the lender’s satisfaction, the required guarantees/collateral.
Exit Planners know, through experience, that when contingent liabilities remain, the financial security of departing shareholders is far from certain. Instead, they keep their clients in control of ownership until those contingent liabilities are managed. They also know that a buy-sell agreement may properly provide for a funded transfer of ownership, but it does nothing to ensure that the business can continue.
In our next article we’ll discuss a second aspect of this challenge: What happens if Joel, the co-owner who managed the business and brought in most of its customers, dies first?