A new take on business insurance

Financial advisers are well placed to manage business succession strategies for small-to-medium enterprise clients, writes Ted Voges.

As the financial services industry evolves toward the provision of holistic and ongoing advice, the small-to-medium enterprise (SME) market represents a valuable opportunity for advisers who understand its unique needs.

Regulation and SMEs

For years business coach and financial services guru, Dan Sullivan, has been warning against the ‘commoditisation’ of our industry. He believes that having advisers’ remuneration linked to the sale of product is a short-term business model – one which has, in fact, hindered the ‘unique processes’ required for a quality advice proposition.

This argument is particularly relevant in the light of the proposed legislation aimed squarely at commissions. These proposed reforms are forcing advisers to consider their current business models and, in particular, how they get paid for what they do.

The challenge

The first challenge facing advisers is to restructure their business to focus on fee-for-service and reduce the reliance on commissions.

The second challenge facing advisers is around broadening the scope of their advice to extend beyond the sale of a product. ‘Set and forget’ type business, which drives a high level of passive adviser income, is likely to be a thing of the past.

The opportunity

One of the best opportunities for advisers to build professional advice businesses and charge a fee-for-service is through the small-to-medium enterprise business sector.

Not only does the financial adviser become an important strategic business partner, they are very well positioned to take care of the SME’s overall long-term wealth creation, protection and distribution strategies.

This is an area well suited for charging a fee for service, especially when SME needs in this space change frequently and rapidly and therefore require constant attention and review.

Small business, big prospects

The provision of business insurance, buy/sell cover or key person cover to their SME clients has always been a hot topic for financial advisers, and is often perceived as being a complex but profitable part of the market. 

Considering there are over 1.8 million SMEs in Australia - with an estimated total value of nearly double the total market capitalisation of the Australian Securities Exchange - it is imperative that advisers grasp the unique needs of SME owners in order to provide succession solutions. 

Most importantly, advisers must appreciate and intimately understand:

• How business insurance fits within their SME clients’ overall business succession planning needs (as well as their retirement and estate planning needs); and
• The importance of explaining to clients what business insurance does rather than what it is. Too often advisers go into solution mode and use industry jargon. They tell their clients they need “buy/sell cover” or “key person insurance” without explaining, in simple terms, what the cover is meant to achieve - both personally and in the context of their greater wealth protection plans.

Why plan for succession?

Business insurance is part of an overall succession strategy for SMEs. A robust exit plan ensures the realisation of a business owner’s equity in an orderly fashion and caters for all possible circumstances. 

The majority of SMEs go into business not only to earn an income, but also to build the value of their equity. Most of these SMEs plan to realise this wealth to fund their retirement (we have all heard SMEs utter the words “my business is my super” at some stage).

Research shows that 40 per cent of all SME clients are totally reliant on the proceeds of their business sale to fund their retirement. However, 85 per cent of these owners do not have an exit plan. SMEs, therefore, generally appear to hope for the best but fail to plan for the worst.

On average, New South Wales-based business owners are around 56 years of age. Further, 68 per cent plan to retire in the next 10 years. In light of this, it is not surprising that business succession is a key advice opportunity for financial advisers.

Voluntary and forced exits

SME clients mostly exit from their businesses voluntarily, selling their interest in their business when the time is right or just before retiring. Recent studies have shown that between 40 and 50 per cent of business owners surveyed were likely to exit their business within the next five years.

However, most SMEs do not consider how they may exit their business down the track.

Shareholder or partnership agreements often only contain a ‘right of first refusal’ clause. This effectively states that if one of the shareholders wants to sell their interest in the business, they must first offer it to the other shareholders or partners.

As a result, most business owners automatically think that their succession arrangements are adequate, but fail to think what might happen if the remaining shareholders do not want to purchase their interest.

Any equity sale to an outsider (someone not already a shareholder in the business) is completely subject to whether the remaining shareholder(s) agree to accommodate them – and surely no person wants to buy into a business where the current shareholders don’t want them as a business partner. 

Even in the unlikely event that this hurdle is somehow overcome, there is a good chance that an outsider will not have the same appreciation of the value of the business as the current shareholders.

Further, it is very likely the sale price will be far less compared to an internal sale.

Current best practice is for SMEs to amend their shareholders agreements or to enter into separate exit agreements that stipulate, in detail, the potential voluntary and forced exit events that may take place.

These exit agreements should also account for how the internal sale of these shares will be funded among the business partners (often from future profits). Solicitors should be engaged to modify the shareholder agreements or draw up separate exit agreements.

It is easy to think of these agreements as business pre-nuptial agreements that deal with business break-ups, in a very similar way that a marriage pre-nup deals with marriage breakdown. After all, businesses fail roughly at the same rate as marriages.

Involuntary exits from the business

Beyond focusing on an orderly exit from their business through voluntary succession, the realisation of a business owner’s equity through involuntary succession creates probably the most angst for SMEs (as often a lifetime of effort is severely compromised).

Serious disability or sudden death often has grave implications for SME clients’ ability to successfully extract the value of their equity. This is mainly because, unlike voluntary succession, they are not capable of supervising or partaking in the negotiations.

Even in multiple-owner operations where the business will probably continue in their absence, the value of the deceased or disabled partner’s equity in the business will almost certainly be compromised.

This is because the revenue of the business is bound to suffer as a result of their absence as business valuations for ‘going concerns’ are almost always based on the profits.

Therefore, if profits suffer, the value of the shares will suffer.

This, coupled with the uncertainties for the remaining owners around the deceased or disabled owner’s share in the business, means that planning for involuntary succession is just as vital as planning for voluntary succession. 

Which exposures and why insurance?

From any SME’s perspective, insurance can provide a very cost-effective funding solution for addressing the consequences of involuntary succession, especially when compared to the alternatives available (additional debt funding or vendor finance, selling surplus assets or selling a stake in the business).

Most of the time, such alternatives are not accessible or their cost is prohibitive.

For instance, the bank’s appetite for providing further funding at the moment a key person suddenly exits the business may be limited, and even if the funding could be obtained, the first year interest expense on the additional debt could often fund multiple years’ worth of premiums for a similar level of cover.

Furthermore, exhausting the business’ borrowing capacity to fund an equity buy-out may significantly limit the business’ future growth prospects if any further debt was needed to finance the expansion.

A summary of the various types of business insurance solutions is set out below.

When advisers discuss an SME’s involuntary succession needs, it is important to address all three exposures as they relate to very different personal outcomes. Emphasis should be placed on what each of the components does for SMEs personally, rather than what they are called.

Buy/sell cover 

 Funding the buy-out of a deceased or disabled partner or shareholder:

• Creates certainty for the departing owner around obtaining a pre-agreed price for their equity in the business. It means their estate and dependants will receive fair compensation for their lifetime of effort invested in the business;
• The transfer of the shares is handled through a separate legal agreement with trigger events that coincide with insurable events. These agreements are drawn up by solicitors;
• Remaining shareholders retain control of their business and avoid having to increase their personal or business’ debt levels to fund a buy-out; and
• It is much cheaper than funding the buy-out through borrowings (even if it is possible to obtain bank funding at such a crucial stage considering the business has just lost one of its key people).

Key person capital purpose cover

To ensure all business debt is repaid upon the death or disablement of a partner or shareholder:

• Often the bank has secured the business debt with personal guarantees over the personal assets of the owners. Ordinarily, these guarantees will only be released once the entire debt is repaid, thus ensuring that the debt does not outlive the borrower(s) (which makes practical sense);
• It is common for loan agreements to state that the death or long-term disability of a key person in the business will be a trigger for the repayment of the entire loan;
• Until the guarantees are released, the deceased partner’s estate cannot be finalised, and hence surviving family members cannot access their inheritance;  and
• Often the buy-out value of the equity in the buy/sell agreement is negotiated on the value of the business without debt. Therefore, ensuring that the debt is repaid supports the buy-out value of the equity.

Key person revenue cover

To mitigate the impact of a key person’s death or disablement on the profitability and productivity of the business:

• In addition to some key employees, most business owners are key people and their sudden departure will surely impact on the bottom line;
• Valuations of businesses operating as ‘going concerns’ are mostly based on a multiple of the ongoing profits the business is predicted to generate in future; and
• This cover indirectly protects the equity of the remaining business owner(s) by replacing lost revenue and funding the additional costs of obtaining a replacement if necessary. This keeps the bottom line, and hence the valuation of the business, intact.

Of course, there is a further raft of issues around the implementation of the above concepts which need to be addressed, including the sharing of the funding costs between business owners, ownership of the various policies and tax considerations around the premiums and the proceeds of policies.

Conclusion

Succession planning is not an event, but rather a process. With their overall end-to-end wealth creation, protection and distribution focus, advisers are well placed to become the project managers of an overall business succession strategy for SME clients.

This strategy will create certainty for business owners around the realisation and protection of their equity in their business - often their largest asset and the main source of funding for their retirement - rather than leaving it to chance in an uncertain world.

Ted Voges is the forensic services manager at OnePath.