Business Succession and Exit Strategy Planning Considerations

19 Mar 2017

Business Succession and Exit Strategy

1.   Sobering Statistics

  • Currently undergoing a major generational change in business with a number of ‘baby boomers’ now reaching retirement (5.5 million Baby Boomers = 25% of population).
  • Only 1/3 of family businesses continue into the 2nd generation.
  • Less than 16% of businesses survive to the 3rd generation.
  • Less than 30% of business owners aged between 51-60 have a written business succession plan.
    1. For 4 male business partners all aged 35, the probability that one will die or become totally and permanently disabled before the age of 65 is 77%.
    2. With 6 partners the probability increases to 89%.

2.   What is Business Succession Planning?

A Will and an Enduring Power of Attorney are of assistance for personal death or illness, but what happens to your business/equity?

  • Voluntary (i.e. managed succession):
    1. Sell your business/equity; or
    2. Retire.
  • Involuntary (i.e. crisis succession):
    1. Health/mental reasons;
    2. You or your business goes into liquidation/bankruptcy;
    3. Divorce;
    4. Loss of required business license;
    5. Criminal charges; or
    6. Death or TPD.

3.   What are your Options when Retiring from your Business?

  • What could “retiring from business” mean?
    1. Ceasing to work in the business (e.g. as an employee or consultant);
    2. Ceasing to control the business (e.g. as a director or partner); or
    3. Ceasing to own the business (e.g. as a shareholder or partner).
  • What about “retiring your business”?
    1. Sale of your business or equity; or
    2. Winding-up a company/ trust or
    3. Dissolution of partnership; or
    4. Liquidation, bankruptcy or death!
  • “Cash-out” through Sale of Business (e.g. on the open market, sale to a competitor or management buy-out/in);
  • Sale of Equity (e.g. shares or units) to third party or remaining equity holders, if any;
  • Equity buy-back (by Company) or redemption (by Unit Trust);
  • Prepare for Public Listing (i.e. Initial Public Offering–IPO via Prospectus and AFSL Licensee);
  • Family succession - if it is appropriate to pass down the business through the family (Family Business Association of WA);
  • ‘Funded’ succession (i.e. Key Person insurances and Equity Holder Buy/sell Agreements using Life & TPD insurances); or
  • Closing down the business / Winding-up the company or vesting the trust.
  • Dissolving a Partnership.

4.   What are the possible tax outcomes?

  • Tax outcomes from a sale can be vastly different depending on the business structure and the method of disposal (ie. Share sale v Asset sale)
  • Are the business assets pre-CGT? More importantly if they were/are they still?
  • What options do you have to reduce the tax on the sale (eg. 50% discount, Small Business concessions)
  • Get the right advice before you sign date of contract versus settlement!

5.   Business Structures’ Succession Arrangements

  • Sole traders
    1. Personal estate asset therefore by Will (or, eventually maybe, by Letters of Administration!)
      1. Contractual Options (recommend registration on PPSR) or Gift. Terms to pay off estate?
      2. Hint: Consider income protection insurance in lieu of inability to obtain Worker’ compensation insurance.
  • Partnerships
    1. By written Partnership Agreement or (automatic) dissolution pursuant to s. 44 of the Partnership Act (WA) 1895:
(1)   Subject to any agreement between the partners every partnership is also dissolved by the death or bankruptcy of any partner….
(3)   The dissolution shall take effect from the date of the death, bankruptcy, or notice as the case may be.
  • Family trusts
    1. May actively hold business assets or be a ‘passive’ equity holder (e.g. of a trading company or unit trust).
    2. Note succession is via the Appointer not the Trustee.
    3. Hint: watch for Perpetuity Period (usually 80 years) expiring! This may trigger a deemed capital gain!
    4. Consider updated Family Trust succession provisions for, say, multiple, successor adult children:
      1. Appointed jointly;
      2. Mandated to act unanimously; and
      3. Dispute resolution’ provisions are incorporated e.g. must notify each of any disputed issue(s) first, then required formal mediation and only after that can the Courts’ involvement be sought.
  • Unit trust
    1. Unit holder Agreement (note: not the Unit Trust Deed)
  • Company
    1. Shareholders Agreement (note: not the, rudimentary, Articles or Constitution)
  • TIP - Deeds of Co-Ownership
    1. For any real or personal property owned as tenants in common (i.e. a commercial investment property or valuable asset e.g. vintage car).

6.   Equity Holder Agreements

1.       DEFINITIONS AND INTERPRETATION
2.       GOOD FAITH
3.       ALLOTMENT AND TRANSFER OF SHARES  
4.       MANAGEMENT AND OPERATION OF THE COMPANY
5.       COMPANY’S FUNDING
6.       COMPANY POLICIES
7.       PRE-EMPTIVE RIGHTS
8.       DRAG ALONG RIGHTS
9.       TAG ALONG RIGHTS
10.     SALE OF EQUITY FOLLOWING A SUCCESSION EVENT
11.     CALCULATION AND PAYMENT OF PURCHASE PRICE
12.     RESTRICTIVE COVENANT
13.     CONFIDENTIALITY
14.     GUARANTEE AND INDEMNITY
15.     BANK ACCOUNT
16.     ENCUMBRANCES
17.     AGREEMENT TO PREVAIL
18.     FURTHER ASSURANCE
19.     NOTICES
20.     DEFAULT IN PAYMENT
21.     NEED FOR EXECUTION BY ATTORNEYS
22.     PARTY’S OBLIGATIONS
23.     CHARGES AND OTHER DEALINGS
24.     VARIATION
25.     TERMINATION
26.     DISPUTE RESOLUTION
27.     DUTY, TAXES, COSTS AND EXPENSES
28.     DIVIDEND POLICY
29.     BINDING EFFECT
30.     TIME OF THE ESSENCE
31.     GENERAL
32.     SPECIAL CONDITIONS

7.   Succession Events

Succession Event the occurrence of which will result in payment of the Purchase Price being calculated at the rate of 75% of the then Market Value Option held by Retiring Shareholder Option held by each Continuing Shareholder Time by which Option must be exercised
  1. If a Shareholder’s Equity has become the subject of an enforcement process (eg PSSO) following a judgment debt of $10,000 or more and which debt is neither the subject of appeal or discharge within thirty (30) days of date of judgment.
  2. If a Shareholder or its related Director or employee (as the case may be) breaches any Essential Terms of this Agreement and fails to rectify the breach within fourteen (14) days of written demand to that effect by the other Shareholders or the Company.
  3. If a Shareholder or its related Director or employee (as the case may be) is convicted of an indictable offence leading to a possible prison sentence of 12 months or more.
  4. If a Shareholder or its related Director or employee (as the case may be) is guilty of unprofessional conduct result­ing in the cancellation, suspension or restriction of their relevant license or practising certificate in Western Australia or any other jurisdiction.
  5. The bankruptcy or liquidation of a Shareholder or related Director or employee (as the case may be).
  6. If a related Director or employee (as the case may be) is, by the unanimous decision of the other Shareholders, dismissed from their employment by the Company for breach of employment by serious misconduct.
  7. If a Shareholder or its related Director or employee is absent from work for more than 3 months, other than in respect of any leave entitlements
Sell Option Buy Option in respect of a proportion of the Retiring Shareholder’s Equity which is equal to the proportion that the Continuing Share­holder’s Equity bears to that of other Continuing Shareholders.
 
Three (3) months from the Succession Date.
 
 
Succession Event the occurrence of which will result in payment of the Purchase Price being calculated at the rate of 100% of the then Market Value Option held by Retiring Shareholder
 
Option held by each Continuing Shareholder
 
Time by which Option must be exercised
 
  1. If a Shareholder’s related Director or employee (as the case may be) has, by reason of unsoundness of mind or of ill health, become incapable of being involved in Full Time Employment for a continuous period of six (6) months or more.
  2. If a Shareholder’s related Director or employee (as the case may be) dies.
  3. If a Shareholder’s related Director or employee (as the case may be) is married or has been living with a partner in a marriage-like relationship with a person of the same sex or different sex (or howsoever described) or a de facto relationship as defined by a Commonwealth, State or Territory law, and begins to live separately and apart from her or his spouse or partner in a manner that constitutes a separation for the purposes of a Commonwealth State or Territory law, and has not settled within three (3) months of their separation, by way of court order or financial agreement, the financial claims or rights arising from the relationship of both the individual and her or his spouse or partner.
  4. If a Shareholder is unable to provide the monies as required pursuant to a Drawdown Notice issued in accordance with clause 5.4 of this Agreement.
Sell Option Buy Option in respect of a proportion of the Retiring Shareholder’s Equity which is equal to the proportion that the Continuing Share­holder’s Equity bears to that of other Continuing Shareholders.
 
Three (3) months from the Succession Date.
 

8.   Buy/Sell Agreements

  • Separate Agreement for Insurance-Funded Buy/Sell Agreement (not incorporated into a Equity Holders Agreement). 
    1. Note: must be an option agreement without consideration at time of signing not mandatory otherwise potential for immediate CGT- event trigger (s.104-35(2) of ITAA)
    2. Essential that the Succession Event be a condition precedent to the formation of the Buy/Sell Agreement.
  • Upfront agreed certainty of payments (funded by insurance) for specific events i.e. death & TPD only
    1. Self owned (different to key person insurance) vs Cross owned
    2. Trauma/ Critical (not appropriate for income protection)
    3. Stepped or Level?
  • Valuation methods (agreed in advance and linked to Equity holders Agreement).
  • Fully-Funded or partial funded with possibility of Vendor Finance ‘top-up’ (e.g. 12 months with above method %);
  • Waiting period to exercise option, e.g. 3 or 6 months (watch that shorter period may not be covered if dividends are being paid);
  • Does the insurance discharge all the insured's liabilities as well as their equity’s value?
  • Note: Always obtain appropriate licensed insurance advice.

Managing the Succession Process

  • Think of yourself, not as the founder but as the steward of your business.
  • Do you do it in your ‘twilight years’ or sooner?
    1. It’s not uncommon for succession discussions and planning process to take years before something workable is agreed and properly documented.
    2. Hint: succession planning should be in place right from the establishment of the business – because it’s always going to happen!
  • Incremental or full succession?
    1. Incremental is not uncommon common in juniors buying–in and with some management buy-outs.
    2. Hint: in addition to them being able to afford$ to buy their equity, ensure equity sale is linked to employment conditions, agreed KPIs and even the conditional passing of the AICD course.
  • Threshold between level of equity holding and “control” e.g.
    1. Shareholding only below, say, 20%; and
    2. Only the entitlement to Directorship above 20% shareholding plus with associated personal responsibilities & liabilities!)
  • Market value discounting for early, voluntary succession (i.e quitting!) by a new equity holder e.g. Say:
    1. 50% reduction in 1st year;
    2. 40% in 2nd year; and
    3. 30 % in 3rd year, and so on.
  • Restrictive/Protective covenants for exiting party
    1. to protect goodwill component paid for business or equity
    2. Vendor’s related parties agree to restrict future employment, consultancies, investor TP interests.
  • “Drag-along” and “tag-along” for third party buy-out offers.
  • Forced sale to liquidate business/equity (i.e. “shotgun”!) clauses.
    1. Firstly pre-emptive rights,
    2. If waived, then sale offer to third parties (with ‘last rights of refusal’),
    3. Then, if no TP offer, vendor must re-offer to remaining equity holders at say 20% reduction of initial offer price; and, lastly
    4. Forced business/equity sale activates.

For further information contact Murfett Legal by emailing one of the following directors:

 
Jason De Silva (Director):     jason.desilva@murfett.com.au
Kelly Parker  (Director):       kelly.parker@murfett.com.au
Peter Broun  (Director):       peter.broun@murfett.com.au


Author:     Tom Meagher

 

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