Business Succession Planning – What is it and Why is it Important?

Business Succession Planning sign with figurines and arrows

Business Succession Planning is essential for protecting your interest in a co-owned business and is an integral part of every business co-owner’s individual estate planning. 

Problems associated with a business co-owner suffering an untimely death or injury, as well as disputes between co-owners, both of which often lead to the financial ruin of a business, can be managed or avoided by the consideration and implementation of suitable Business Succession Planning Agreements and related insurances.  

The avoidance of these problems will ultimately protect you and your family and preserve your Estate assets. 

“Business Succession Planning” means: 

  • Planning for the sale or purchase of a co-owners’ interest in a business in the event of their death, permanent disablement, serious illness/trauma or other circumstances and funding for that sale/purchase, (See  Buy/Sell Option Agreements below), and 
  • Planning for the preservation and growth of co-owners’ equity in a business by the implementation of agreements between co-owners governing the management and decision making of the business and ability to dispose of an interest/share (See  Shareholders’ Agreements below).

Where to Start?

If you are a co-owner of a business you should at the very least consider the benefits for you and your family of having proper Business Succession Planning Agreements in place. 

What is a Buy/Sell Option Agreement? 

A Buy/Sell Option Agreement is an agreement between co-owners of a business granting each other options to buy or sell their respective interests upon the occurrence of specified Option Events. The Option Events are typically: 

  • The Death of a co-owner, 
  • The Permanent Disablement of a co-owner, 
  • Serious Illness/Trauma in connection with a co-owner such that they are no longer able to continue to work in the business, and 
  • The Retirement or Expulsion of a co-owner (although these circumstances would ordinarily be dealt with in a Shareholders’ Agreement/Partnership Agreement if one existed for the business). 

Enforceable Buy/Sell Option Agreements overcome disputes in relation to the buy out of a co-owner’s interest in a business including in relation to: 

  • Rights to buy or sell, 
  • Valuations of interests, 
  • Timing of payments, and 
  • Funding arrangements. 

Funding Agreements are frequently entered into in connection Buy/Sell Option Agreements and provide for the funding of the price for a co-owner’s share in the event that an option to buy or sell is exercised. Funding is usually provided by: 

  • The maintenance of personal insurances in respect of the co-owners, 
  • Agreements in the form of vendor finance, or 
  • A combination of each.

Why do I need a Buy/Sell Option Agreement? 

In the absence of a Buy/Sell Option Agreement disputes between co-owners or their executors/beneficiaries following the occurrence of an Option Event are common. These disputes typically relate to: 

  • Who may purchase the co-owner’s interest, 
  • Whether the affected co-owner or their Executor can insist that the continuing co-owner(s) purchase the relevant interest, 
  • Whether a deceased co-owner’s spouse/children (or other beneficiary) are entitled to keep the interest and participate in the running of business, 
  • The price to be paid for the co-owner’s interest in the business, 
  • Wow the price is to be determined in the absence of an agreement, and 
  • When and how the price is to be paid. 

Why do I need a Shareholders’ Agreement (Partnership Agreement)? 

See Amanda’s recent article, Why do you need a Shareholders Agreement?

Funding the Purchase Price under a Business Succession Plan 

When a co-owner exercises an option to buy or sell their equity in the business a liability will arise for the continuing co-owner(s) to pay an amount (“purchase price“) for the value of the outgoing co-owner’s equity in the business. Most Business Succession Plans involve the maintenance of personal insurance policies in respect of each co-owner so that a lump sum will be received under the policy to pay the purchase price when an option is exercised. 

In some cases, funding can also occur under a Vendor Finance Agreement or a combination of vendor financing and personal insurances. 

Structuring Policy Ownership for Business Succession Planning

The following options exist with respect to the structuring of ownership for personal insurances policies under a Business Succession Plan: 

Capital Gains Tax (‘CGT’) & Business Succession Planning

Generally, CGT is payable on the proceeds of a claim on an insurance policy unless an exemption is available.  Traditionally, the choice of ownership of personal insurance policies for business succession planning has been determined based on the availability of an exemption for Capital Gains Tax (‘CGT’) on the insurance proceeds. 

In Australia, the CGT laws differentiate between tax payable for Death Benefits and tax payable for Non-Death Benefits (such as Total and Permanent Disablement, Trauma and Terminal Illness Benefits). 

Risks of not making a legal Buy/Sell Option Agreement

Too often business owners use Self Ownership or Cross Ownership structures to hold polices of insurance in respect of each other without formalising their intentions pursuant to a written Buy/Sell Option Agreement.  The maintenance of insurance policies overcomes a funding problem only, however, does not address the usual problems that can arise in the absence of a written agreement.