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[/ezcol_1third] [ezcol_2third_end id=”” class=”” style=””]Guest contributor Don Reichert is the president of Capital Design Associates Inc., an intergenerational wealth management firm. For more than 20 years he has served as the personal financial officer for Upstate families, business owners and medical professionals. He leads a team of 10 personnel, and through Capital Design’s proprietary planning process, they provide an integrated approach to business, estate and retirement planning services.[/ezcol_2third_end]
Over the years, I’ve had the privilege of knowing many entrepreneurs. It never ceases to amaze me how a creative idea, a small amount of capital and a lot of hard work come together to create a fortune. It also amazes me how some business owners become so engrossed in running and growing their businesses that they fail to address the most critical of details necessary to preserve, protect and eventually monetize their equity interest in the business they’ve worked so hard to build.
I’m referring to such critical documents as buy-sell agreements, employment contracts, stay-pay arrangements, business valuations, audited financials, and corporate minutes, to name just a few of the most important.
Most savvy investors holding a traditional security portfolio do not think twice about paying an annual fee of 1 percent to asset managers or their investment advisors to provide professional management of these liquid asset pools. It stands to reason that since the largest equity interest that the average entrepreneur has is the investment in their business, they should not think twice about allocating 1 percent of gross business revenues annually to ensure their business is compliant with tax laws, business principles and prudent risk-management practices.
While there is no such thing as a free lunch, the usual allocation of money and effort will generally enhance the value of the business and protect against many unforeseen and often costly events.
Let’s examine just a few of the more important business practices.
Operating agreements: Most generic operating agreements deal with the major contingencies a business may face, but the document of choice is a well-written buy-sell or stock restriction agreement tailored to the unique attributes of the operating company.
These agreements are carefully deliberated and drafted by competent legal counsel in advance of such contingencies as premature death. It is important that these agreements are carefully addressed and have the mutual understanding and consent of all stockholders while they are of sound mind and body. The arrangement should specifically address not only the method of business value but also the timing of same relative to the business cycle. Most well-written agreements require an annual review and business valuation. In the event the stockholders fail to address the value annually, it is imperative that appropriate default language specifically and fairly lays out the valuation method.
A well-thought out and articulated stock restriction agreement acts as an umpire. It lays out well-defined rules on how all stockholders and related parties will deal with unforeseen contingencies. How and at what price stock will be redeemed should be agreed upon in this written agreement well before premature death, disability, lawsuit, divorce or the bankruptcy of a stockholder. If you don’t clarify your understanding on how to deal with these contingencies while all stockholders are of sound mind and body, you may find yourself having to renegotiate your “understanding” of what was intended with your deceased or disabled former business partner’s heirs, executives or legal counsel.
An often-overlooked item is the long-term disability of a shareholder, particularly one who is working and whose service is essential to the business. The language in the stock restriction agreement should mimic (not conflict with) the definition of disability in various individual disability and buy-out policies, if there are any.
Finally, it’s important to consider that the stock redemption of a deceased, disabled or retiring stockholder is a non-deductible business expense. Unless these exit paths are addressed well in advance with either life or disability insurance, or an adequate sinking fund, the redemption could be financially burdensome to the remaining stockholders.
Stay-pay agreements: The challenge faced by the majority of small business owners who are sole stockholders or owners is that the value of the business is heavily dependent on their services or customer and supplier relationships. They are often supported by one or more personnel, such as a general manager, who significantly adds to the capacity of running the business without the owner’s involvement.
In the event of premature death or disability of the owner, the surviving spouse or heirs often find themselves at a severe disadvantage in trying to run or sell the business. Without the ability to retain key personnel, the ability to monetize the full value of the business is almost impossible.
This is where a written agreement becomes essential with a key person to stay for a specified period of time to assist the heirs to either wind down or sell the business. These agreements bind a key person to a specified commitment of time, provide a significant monetary incentive to fulfill the commitment, and can – in the right circumstances – create or facilitate the creation of a market for the company in the form of a purchase by those same key personnel.
The foregoing documents require some careful thought and deliberation, and most stockholders would rather be playing golf and enjoying time with the family than dealing with the prospect of death, disability or other similar challenges. However, as the old saying goes, “Pay me now or pay me later, but later is often at a much higher cost.”
My advice to my business owner clients is to spend the time, energy and a small amount of money to preserve the value of their most valuable equity holdings – their interest in their businesses. Once you get set up and the heavy lifting is done, maintaining and adjusting these documents to changes in the business environment is relatively easy and is best accomplished through annual business meetings with all of your advisors.
