Meet Michael.
Michael is a successful entrepreneur, one of two major shareholders in a company he helped start; a company that has been going from strength to strength over the last few years. His staff are skilled, his customers rave about his business’ products and services, and he and his business partner Jeff were just about to open their second branch in Tauranga.
But that was before the accident that killed Jeff, his shares of the company defaulting to his spouse, Kate.
Kate isn’t on board with the direction that the company is taking, and as Michael’s new majority shareholder, she has significant weight in the final decisions of the business.
Michael is about to lose control of his and Jeff’s vision for the company.
READ MORE: 5 Unexpected Business Risks that Could Sink Your Company
Why did this happen?
It’s a nightmare scenario for Michael—but it isn’t exactly unknown; particularly for small businesses. If a major shareholder, such as a part-owner, dies or is permanently disabled and forced to exit the business, their shares (and their control), will head to whomever is the most legally appropriate recipient.
Without a plan in place, that can mean a spouse, a lawyer, or even a distant family member that you’ve never met before becomes your new partner. You have little choice with whom you do business with.
Without a plan in place, that can mean a spouse, a lawyer, or even a distant family member that you’ve never met before becomes your new partner.
All too often, small business owners don’t consider this as a possibility, and they end up spending a huge amount of their own money in a shareholder buyout. For many, that simply isn’t an option, and so their new partner stays.
This isn’t an ideal situation for the new partner either. In Kate’s case, she may need to stay as a shareholder in the business to ensure her and Jeff’s family continues to receive a liveable income.
What are the solutions?
Both parties in these cases generally want the same thing: for the new partner to be able to step away from the business without having to forfeit the value of their shares. There are a few solutions that can allow for this.
Effective succession planning is a good way to avoid this kind of unexpected acquisition. By planning out precisely who is going to take over the shares of the partner in the event of their death or disablement, business owners can include the potential ‘heirs’ in their plans.
This ensures that the above scenario is less likely to happen; were Kate the designated heir of Jeff, she could have been brought in earlier to keep her up to date with the direction of the business.
Alternatively, a different heir could have been identified, possibly another family member of Jeff’s. Whatever the case, it defeats the spectre of not knowing whom would be your new partner in case of a shareholder death. It lets you see problems and deal with them before your entire business is at stake.
By planning out precisely who is going to take over the shares of the partner ... business owners can include the potential ‘heirs’ in their plans.
Shareholder protection cover, for example, is designed with exactly these circumstances in mind. It operates in much the same way as death and disability insurance: if the covered person is seriously hurt or killed, an insurance payout is triggered.
The insurance is used to buyout the shares of the deceased or disabled partner. In the above example, if Michael and Jeff had shareholder protection in place, Michael would have received the sum necessary to purchase Jeff’s share of the business.
Kate would have walked away with a hefty lump payment to ensure the financial security of the family, while Michael would have retained total control of the business.
Kate would have walked away with a hefty lump payment ... while Michael would have retained total control of the business. A win-win by anyone’s measure.
Significant cash reserves is possibly the least useful method to prevent this situation, but remains a solution. The problem arises from being unable to buyout the new partner. If you have significant liquid cash on hand, that problem disappears.
However, considering how tight cash flow can be in a small business, every dollar that isn’t being put towards your enterprise growth can be a dollar wasted.
Considering the sheer amount of capital that can sometimes be required to buy half of the business (or more), it would be unusual for an SME owner to choose this route.
Summary
We’ve seen many cases just like Michael’s. A lack of planning can result in a poor situation for both the old and the new partners—and there’s no real need for it.
Investigating shareholder protection cover, succession planning or, at a last resort, developing liquid cash reserves for the sole purpose of purchasing shares can save both you and your new partner grief in the long run.
For more information on getting the right business insurance, check out our free ebook below.
