Premium Advice: The need to review buy-sell arrangements

In the current economic environment, many business owners have to face the reality of the true sustainability of their business due to constrained cash flows, increased and more aggressive competition and the deferral or cancellation of orders. Unfortunately, for businesses undergoing an unforeseen exit of a major shareholder, many of those same challenges can be the reality even in a strong economy.

Consider the situation of Jones Manufacturing, a fictional company that was started by two former co-workers who ventured out on their own. Franklin Jones, an engineer, and Bradley Armbruster, a sales professional, have built their firm into a local success story with revenues of more than $20 million, a staff of 30 and steady seven-figure profits every year. By carving out a niche based on service, excellent relationship management and quality product, they have nudged a space in their marketplace among larger, better-capitalized national and international competitors.

However, an unforeseen death or disability could cause havoc to Franklin and Bradley’s business. If this were to happen to Franklin, who is responsible for the design and quality control of their material goods, or Bradley, who manages revenue generation, they would not have the luxury of planning and executing a well-thought-out transition strategy. Change would be thrust upon them.

In small businesses, specific relationships and expertise are often in the hands of a few. If one of those few is gone, people start to wonder whether the new regime can continue with the same level of expertise and relationship management. What if the quality of goods diminishes? What if the ability to fill orders with the same speed and accuracy diminishes? What if the level of sales revenue diminishes? What if the same level of financial constraint and profitable management diminishes?

Suppliers, clients and creditors ask these questions, and competitors know this. If the capital or cash flow is not present to cover off revenue gaps, hire new expertise and buy out the deceased or disabled person’s shares upon the trigger event, then all of the above cash-flow issues will only be exacerbated. Normally the buy-sell clauses of shareholder agreements deem how the purchase must take place, either in lump sum or serial share redemption over a short time frame.

So Franklin and Bradley need to ensure that enough funding is in place to fulfill their own obligations to each other as shareholders in a small business. After all, private businesses are not easy to value, and during a stressful time, this only becomes more problematic. Consider these factors in valuing a business:

Is there an open and unrestricted market? For private businesses, especially those looking to take on a potentially non-majority shareholder, there are only so many people or firms willing to invest in such a venture.

Is each party of equal willingness or necessity to act? In the event of a severe disruption to their business caused by the untimely demise of a major owner/manager of the firm, the surviving shareholder and employees could be in a tight time frame to make a decision.

Is each party of equal negotiating strength? Depending on the intellectual and financial capacity of the parties involved on each side, one side could possess an advantage in any negotiations.

In any event, whether looking at outside funding from a new shareholder or applying for credit, neither option is ideal. Preferably the parties have funded their obligations at least partially (if not fully) through lump sum capital creation, which insurance products can supply. In the next article, we’ll examine some of the methods to structure the funding.

Chris Paterson is vice-president of sales, living benefits, at Manulife Financial and has over 13 years of experience marketing various insurance products.

(04/02/09)