Although much of the financial advice industry’s focus in recent years has been on the shortfall in adequate succession planning, there is another, more urgent issue that most advisors need to address before they can move on to developing a plan for their transition into retirement. That challenge is continuity planning – establishing a strategy and process to protect the clients and the business’ cash flow in the event of the owner’s sudden death or disability, whether temporary or permanent.
A strong continuity plan provides for a smooth, orderly transition of control in the event of a sudden departure from the practice of any of its owners. While the range of questions to be addressed in developing such a plan is broad, there is one gating consideration that every business will need to deal with in order to craft a successful continuity strategy: Where will the funding come from? As with any change of control agreement, a continuity plan simply will not work without a clear source of financing to compensate the departing owner (or his or her estate) for the value of what he or she has built.
Seller Financing: The Default Structure
The default arrangement for a buy-out triggered by death or disability is seller financing over an extended period of time, generally five to ten years. In this scenario, the buyer, whether it be the company (through redemption of the departing owner’s shares) or one or more individuals (typically the remaining shareholders or partners in a multi-advisor business) through a cross-purchase arrangement, executes a promissory note and makes payments to the seller or to the estate of the deceased or disabled partner.
Seller financing can be used to facilitate an emergency continuity transaction or to fund an existing buy-sell agreement. As we will detail below, finding the optimal funding source to help the buyer make the initial down payment and ongoing periodic payments under the continuity plan is vital in these cases to secure the long-term health of the business. We recommend against using an earn-out arrangement for a seller-financed continuity transaction stretched out over five to ten years.
Buy-Sell Agreements: Planning Ahead To Establish The Optimal Funding Solution
A buy-sell agreement is a common and familiar means of establishing a continuity plan and for facilitating longer-term succession planning, as well. When used in crisis situations, however, these agreements often run into an unexpected hurdle – namely, that low levels of liquidity in the business tend to result in a very small down payment. Frankly, it is difficult to maintain a high level of liquidity in a small business in anticipation of an event the owners or partners hope won’t ever happen within the context of a pass-through entity structure. The most common advisory business structures simply are not built to save or sit on a lot of extra cash.
A nominal down payment, in turn, will place a heavier load on the cash flow stream of the business or individual buyer for many years to come. Considering that buyers must often make payments on their promissory notes using after-tax cash flow, and occasionally during the course of a recessionary event, planning ahead to fund a sufficient down payment becomes even more crucial. Without adequate funding, the new owners of the business may be solving one serious problem – the continuity challenge – while simultaneously creating a different and equally serious one – placing unsustainable burdens on the business’s future cash flow.
For many businesses, the optimal funding mechanism for ensuring a smooth continuity process is life insurance or lump-sum disability insurance. For buy-outs triggered by death, a life insurance policy held by the buyer (in many cases, the business itself) on each of the owners can be an effective option for funding either a down payment or the entire purchase price. Lump-sum disability insurance is also an option for buy-outs triggered by disability, but such policies are generally aimed at providing a down payment only, relying on the acquired cash flow to pay the balance.
Financing a buy-sell agreement using insurance funding strategies requires a high level of advanced planning and professional guidance. These strategies depend on whether the corporate entity will be the buyer, or whether it will be one or more of the remaining individual shareholders or partners. A business’ options will also depend on the structure of the corporate entity (C-Corporation, S-Corporation, or LLC taxed as one of three different models). To obtain the correct answers, owners will need to consider the challenges from legal, tax, regulatory and cash-flow perspectives, and then make decisions based on the talent level left behind to “mind the store” and handle the obligations. Since the answers to all these questions tend to shift over time, it is also vital that business owners and their designated buyers review buy-sell agreements on a regular basis.