Who is stepping into your shoes?

Nothing leaves a company more vulnerable than a principal leaving without a business continuation plan: an agreement as to what will happen to their share of the business, with funding in place to facilitate this transfer.

While principals are often skilled at recognising business risks such as increased competition and the changing marketplace, they also need to recognise that personal changes could have an equally devastating impact on their livelihood.

Businesses fail to develop continuation plans for a number of reasons. Some principals wrongly believe their Will is sufficient, others avoid the issue, finding it hard to face up to the prospect of retirement, or worse.

It’s important to recognise that continuation planning can be highly emotional. Although a lucky few sell up to sail around the world, many principals leave because of trauma, ill health or death. Whatever the reason, the fact remains that every principal will leave their business eventually and that, if not planned for, this event can be catastrophic.

Structure funding and transferagreements

The key to business continuation planning is to set up an appropriately funded transfer agreement. Properly structured agreements will ensure that, if a business owner wants to leave, is ill or dies, funds are available to ensure the departing principal (or their estate) receives a fair price for their share of the business and to allow the continuing principals to retain control.

In planning for this funding, the first question is whether each principal wishes to eventually keep, sell or liquidate the business. Whatever they decide, the next question to ask is how will this option be funded.

If the business is to be kept, then funds may be needed to provide working capital to cancel debts, extinguish working personal guarantees and replace lost capital. If the business is to be liquidated, then funds may be needed to replace lost revenue or preserve the value of the business until liquidation.

If the business is sold, then it is critical the continuing principals have funds in place to provide sufficient available cash to acquire their partner’s business interests. Key to this is ascertaining and agreeing on the value of the business, or agreeing on how it will be valued at the time, on reasonable, fair and workable terms.

Plan for the shift in control

Business continuation and succession planning is very much about managing the shift in control that occurs when a principal leaves. This requires putting in place various legal arrangements to ensure a smooth transition, either from the departing principal to their agreed successor or to the continuing principals.

Without such arrangements, disputes arise over who controls a company — and these disputes rarely end well. As rival factions battle it out, the business can stall and start to lose money. Some companies simply collapse under the pressure.

For those companies that don’t survive control disputes, the main cause of their demise is the Corporations Act, which provides for the wind-up of a company under the ‘just and equitable’ rule. This rule gives courts discretionary power to wind up companies in a variety of situations, including ‘incompatibility’: a lack of harmony in a relationship and an inability to work together.

For example, in 1985 in the case ofPizem v Maleka company was wound up because of personality clashes between the continuing principal and the departing principal’s wife. The plaintiff, Mr Pizem, had enjoyed a long and cordial relationship in many commercial ventures with Mrs Malek’s husband. When Mr Malek died, Mr Pizem had agreed to integrate Mrs Malek into the business. However, he believed that he should have been the dominant partner.

By the time the case got to court, the company was foundering on the mutual dislike between the two remaining parties.

The judge’s summing up of the characteristics of the two parties indicated that neither of the parties was dishonest. However, because distrust had arisen from their private dealings, it was inevitable that one party would try to gain control of the company and neither had the power to do so.

Accordingly, the court ordered the wind up of the company, resulting in 200 lost jobs and a major write down in the value of the assets, particularly the goodwill built up. As the business ceased to be a going concern, the substantial goodwill that existed prior to Mr Malek’s death was virtually non-existent by the end of the wind-up period.

This case ended in the worst possible result: a court wind-up order resulting in bad publicity for the directors of the company and making it difficult for them to re-establish themselves in the business community.

However, even disputes that don’t end up in court can seriously destabilise a company. Ongoing distrust or disagreements over company policies and processes can be highly distracting and distressing for the remaining principals, and extremely bad for business. All this can be avoided by agreeing on and putting in place a business continuation plan.

Match estates to succession plans

It is important that principals reflect their business continuation plan in their Will. The choice of executor and the powers of the executor within a Will are crucial in preserving the business and transferring control smoothly. A carefully drafted Will, which pays attention to business continuation priorities, will prevent delays in probate and misunderstandings between beneficiaries, and the resulting inevitable loss in value of the business.

To support a business continuation plan, a Will requires an appropriate executor with appropriate powers.

In 1997, the case ofRyan v Kazacashighlighted the importance of a testator appointing an independent executor to preserve and distribute personal and business assets appropriately.

In this case, the deceased was a part owner of a company who left an informal Will in which he devised his share to his father, mother and son, and appointed his father executor. He also left a share in the company to his other partner, the plaintiff.

The plaintiff made allegations in the Supreme Court that the executor had dismissed the plaintiff and misappropriated cash from the business, and asked the court to appoint an interim administrator.

In making his ruling, the judge noted that it was unusual for the executor of a Will to be passed over, but that the exception was whether the executor was of bad character. Based on the evidence and the need to preserve business assets, his Honour granted the plaintiff’s request to pass over the executor.

In this case, had the executor not had a shareholding in the company, the situation may not have arisen.

Other common errors associated with transferring a business by a Will include improperly titled assets, where the manner in which the asset is titled takes precedence over how the asset may be described in the Will. Another problem can be improper ownership of life insurance, where the proceeds may end up going to the corporate entity rather than the beneficiary. This inflates the business’ value, and may have capital gains tax implications.

Reach mutual agreement on keyissues

A correctly structured business continuation and succession plan should meet two competing interests: those of the departing principal and their family; and those of the continuing principals and their families.

Given these competing interests, in times of crisis disputes are likely to arise that may not be easy to resolve. If all parties have considered and agreed on the terms of succession, such disputes can be avoided.

Key elements requiring all parties’ assent include: the parties to the arrangement; the events that trigger either a sale by the existing principal or purchase by the surviving principals; the price — or if this is not possible, the valuation method; and the funding solution. It is also prudent to consider taxation and compliance agreements.

Without such agreement, departing principals are unlikely to receive the price the business is worth, while continuing principals may find they lose control or cannot work with the departing principal’s beneficiaries.

Andrew Lowe is National TechnicalManager, ING.