Evanna Phoon wrote the below article and she is a Senior Franchisee of Rockwills. She can be contacted at email@example.com
This article appeared in Malaysia SME magazine.
” Adam was a successful businessman. He had joined his childhood friend, David, to start a factory manufacturing carpets. Adam had a 60% share of the business while David had the remaining 40%. Ever since they started, the business had grown by leaps and bounds. Annual profit was now in the region of RM2 million. Their accountant had indicated that the business should have a value in the range of RM10 to RM15 million.
Then tragedy struck. Adam was diagnosed with third stage cancer of the liver and his health deteriorated. Adam immediately wrote a will to give his assets to his wife and children. He took comfort in the thought that the value of his share of the business alone was enough to take care of his family comfortably and see his kids through their tertiary education. He also felt comfortable that his partner, David would not short change him as they had been childhood friends and had gone through thick and thin together for so many years.
After Adam’s departure, his wife wanted to dispose of his shares because she has no interest to run her late husband’s business but David turned her down because he was already controlling and running the company.
Unfortunately for her, no outside party was willing to buy her shares and she had no choice but to plead to David to reconsider the purchase of the shares. He offered her a price of only RM1 million, rather than the actual value of RM4 to RM6 million. Adam’s wife had no choice but to accept the offer even though clearly, she was short-changed.”
This was a real case story that happened to a friend of mine and will continue to happen to many SME business owners if there were no awareness being created that it is crucial to have proper exit planning put in place.
This doesn’t directly apply to family owned SME businesses & I will be sharing more in-depth about planning of family run SME businesses in future articles. In this issue, I am going to share about exit planning for SME businesses where the shareholders are non-family related.
Having a Will is very important, and it is the basic document that all business owners should have to dispose their personal asset. But when it comes to partnerships or private limited company (Sdn Bhd), Will alone is not a complete solution to secure smooth transition of shares and interest among business owners when unforeseen events happen.
A large number of businesses in Malaysia do not have a plan to handle such events. In most Wills that I have seen, there are 2 common intentions of a business owners, 1st option is they wish to sell their business interest or 2nd option is they wish that their shares to be inherited by their heirs. However, there are problems that we commonly see with this type of arrangement when triggering events happen.
Triggering events that normally will cause disruptions to businesses are death, total permanent disable and retirement of a business partner. However, depending on different types of business activities, there are also other triggering events such as critical illness, bankruptcy, divorce, loss of professional license or even a deadlock between co-business owners. All the mentioned events will cause huge lost to the business value.
On the untimely death of a business owner, his/her heirs inherit his/her interest and quite often the heirs are unqualified or inexperience to work with the surviving business partners. And due to their inexperience, it may cause disruption to the business and the heir could be demanding for things without a good understanding of the business.
In some cases, the heirs may not even be interested in the business like Adam’s case; his wife has no interest to continue his business and wanted to sell her shares quickly. But her problem was there is no ready market for private limited companies (Sdn Bhd) and partnership and it is very difficult for her and David to agree on a price (or the value of business) when Adam was no longer around. Another fact is that David, being the remaining business owner knows that Adam’s wife is desperate. People’s perception of things changes when money is involved, especially substantial sum of money.
Even if the remaining business owners would want to buy-out the heir’s, they will have difficulty raising the money because funding was never planned for such buy-outs. Indirectly, it will affect business credibility, employee’s confidence and in most cases, it is not uncommon to see some profitable business has no choice but to go for dissolution & discontinuation due to this major disruption.
In short, if business owners do not have an exit plan, it will lead to problems for his/her family and surviving business partners. To minimize these problems, a proper business exit planning or business value protection planning is important. Some authors describe it as “premarital agreement” between business owners. Where business owners during their lifetime and when everyone is still alive make necessary arrangement to plan for available options on how to dispose his/her business interest in the any unforeseen triggering event.
There are typical checklist questions that you can spend 5 minutes asking yourself to roughly gauge whether there’s a need for an exit planning for your business
- If your business partners die today,
- Can you work with his family to run the business?
- Can you work well with your partner’s family members?
- Can you afford to buy out his business share at a fair price?
- If you as a business owner passes away today,
- Can your family run your business?
- Can your family members work well with remaining business partners?
- If your family where to sell of their shares to the remaining business partner, would you want to ensure they get to sell a fair value?
Assuming that the answers above indicate a need for business owners to create a business exit plan, we will then proceed to state down some important elements to address in our legal documents. They are
- the value of the business;
- the agreed trigger events for a sale and purchase to be made;
- whether a forced buy-sell is to take place or a “wait and see” buy-sell is to adopted
- the funding for the purchase of the business interest;
A complete Business Exit Plan must include all 4 documents below.
- Buy-Sell Agreement or Cross Option Agreement
- Power of Attorney
- Trust Deed
- Life insurance or funding
The diagram below indicates the relationship between the various parties and the relevant documents.
A brief explanation about the functions of the various documents?
a) Buy-Sell Agreement: stating the terms and condition of the sale including the share value of the parties, triggering events of the buy-sell and funding (normally it would be life insurance and cash) to purchase the business interest. When such an agreement is adopted, upon occurrence of any of the trigger events, the outgoing business owner MUST sell his business interest and the remaining business owners MUST buy.
b) Cross Option Agreement: This is sometimes called Double Option or Put and Call Option. It is a flexible form of buy and sell agreement whereby e.g. in the event of the death of a business, the estate of the deceased has the option to sell and the remaining business owners have the option to buy. When one option is exercised, the other must follow. Cross Option Agreement is used when it may be difficult to decide in advance what steps to be taken by the business owners upon the occurrence of certain specified events. Once the exercise of those options (either “Put” or “Call”) it creates legally binding contract.
c) Power of Attorney: each of the business owners instructs and empowers the Trustee to sign the transfer documents of the outgoing business owner to the surviving business owners when a trigger event occurs. The usage of a power of attorney will eliminate any delay caused by the death or disability of the outgoing business owner and the Trustee need not rely on the business owner’s Executor of the estate to obtain the Grant of Probate before such transfer can be made.
d) Trust Deed by each business owner: upon the receipt of the sale proceeds by the Trustee, the Trust Deed provides the necessary distribution instructions. It states the manner of distribution to the beneficiaries which will avoids the need to obtain the Grant of Probate or Letters of Administration.
e) Life insurance/Other Funding: it is prudent that in any Buy-Sell or Cross Option Agreement it is to be funded. One of the easiest methods to provide such funding is by way of a life insurance policy. Where each business owner buys on his own life worth the value of his business interest and the remaining business owners pays the premium, this is known as a 1st party policy;. Alternatively, the business owners can pay cash to purchase the business interest when one of them exits. However, it is financially burdensome on the purchasers.
For businesses, there’s time to make money, and there’s time to protect your money. Planning for a “Premarital agreement” or “Exit Planning” among business owners are consider an important step made to look into options to protect your money and loved ones. And it is advisable that this planning & discussion should take place when all business partners are still around.
About the Author:
Evanna Phoon is CEO & Founder of www.MalaysiaWills.com. Her website has FREE downloadable ebooks & over 300+ videos on the topic of Will Writing for Personal & Business. She can be contacted via firstname.lastname@example.org.