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#1900-1500West Hastings StreetVancouver, BC, V6G 2Z6p: 604.687.7773tony@tonygilbert.ca
These are copies of archived articles I have written for Canadian Business Franchise Magazine.
Your health is your wealth!!
Critical Illness insurance and why it is needed for the business owner.
Ask yourself this question; What is protecting the success of your new business venture if you are unfortunate enough to suffer a critical illness?
You have spent countless hours doing your due diligence and researching businesses to get into. You have traveled and met with current franchisees and franchisors to see their operations. You’ve reviewed their books to verify their success. Finally, you decided on which franchise suits you best and now the financing has come together via the bank, savings, friends and family. The big day has come and you’ve written one of the largest cheques of your life.
To say the least, there is a lot on your plate. You lie in bed wide awake at 2 AM waiting for the grand opening so you can start making the big bucks and be the entrepreneur you’ve always wanted to be. You are the "boss"! All of a sudden you feel overwhelmed with all of this new responsibility.
For most people all goes well, and hopefully for you it will also. It has been said that 90% of what we worry about never happens. That is human nature. As a business owner you will now worry about many things that you never gave a second thought to before. Sometimes you will think that being an employee wasn’t such a bad thing.
If the bank has loaned you money, they probably requested you take out some life insurance for their protection. That probably makes sense. However, what if you are fortunate enough to survive the heart attack or beat the cancer? What then?
Could you as a business owner afford to take 6 months off without an affect on the success of the business and the bottom line? It’s statistically certain that we will die sometime, that is 100% guaranteed. However the statistics also state that 1 in 4 Canadians will develop a heart condition and that 1 in 3 women and 2 in 5 men will develop some form of cancer over their lifetime. Thanks to medical advances, most of these people are surviving these illnesses and living healthy lives. You may survive, but will your business survive? Will your finances survive? What kind of financial drain will this have on your business profits? How will your banker react; will they still have faith in you paying your monthly loans? How will the franchisor feel? Suppliers? Friends and family that have helped finance you? Will your doctor suggest you get right back to work? Will you want to go back right away or prefer to hire a temporary replacement and take some time off? Lots of questions.
If you foresee no problem in the above scenario, there is no point on reading on. For most of us there will be problems. You have probably insured many other assets in your business such as machinery, contents, vehicles etc, but what about the most valuable asset – you?
Consider implementing a lump sum Critical Illness disability program into your financial plan. Critical illness coverage pays out a lump sum of tax free cash usually 30 days after diagnosis and survival of a covered condition. Conditions include cancer, heart attack, stroke, coronary bypass surgery, multiple sclerosis and many more. Coverage ranges from $25,000 to $3,000,000. There are various ways to structure the coverage but most people plan to have it in place till age 65 or 75. You can have the premiums increase every ten years or remain level all the way through to age 75. There are attractive features with various companies where you can get a refund of your premiums after 10 or 20 years if you collapse the program and haven’t claimed. If you die without a claim the companies refund your premiums. So you get your money back but you’re not around to enjoy it. I was trying to add some levity to the article! This is tough stuff to talk about!
The critical illness concept was pioneered by South African surgeon Marius Barnard, the brother of Christiaan Barnard who is famous for the first heart transplant. Dr. Barnard saw that many people were continuing to live after the organ transplants, but they suffered from financial strain as they had to change jobs or take a lengthy period of time off of work to recover. He approached the insurance industry to develop some type of product that could help future critical illness patients.
Critical illness insurance was created. Individuals and business owners implement the coverage for many different reasons such as:
The key with this coverage is you gain control and flexibility at a time when it is needed most. As another saying goes, if you have a problem and you can throw money at it, the problem tends to go away.
Critical illness insurance has quickly gained popularity as a living health benefit that could save your life health wise and financially. The product has been popular in countries like South Africa, England and Australia for many years and is quickly catching on in Canada.
So could something like this happen to you? Unfortunately the answer is yes, even if you think you are young and healthy and that none of these things could happen to you. The average age of claims is early to mid 40’s.
Do you need this coverage? In my experience few business people can take a forced holiday without it affecting their business. Unfortunately a critical illness is that forced holiday you have no control over.
Here are some sample costs from a leading insurance company:
$100,000 of coverage, level premiums to age 75 for a Non smoker:
Male aged 35 $68.94/mth
Female aged 35 $56.34/mth
Male aged 45 $119.00/mth
Female aged 45 $91.44/mth
You can now see how some proactive planning can provide you, your business and your family with the peace of mind that is necessary to succeed. Setbacks happen to all of us at different times. Having the right safety net in place is important when something happens.
For more information regarding illnesses www.mayoclinic.com
The a, b, c’s of life insurance.
Hmmmm, fun topic to discuss this month. Buying insurance for when you die. I know it isn’t the number one topic of conversation at the dinner table but it does warrant attention for anyone with debt or financial obligations, which in today’s world basically means all of us.
This article will attempt to explain why people need coverage and the different types of life insurance available in the market place.
There are two basic reasons why millions of people around the world buy life insurance. To either eliminate debt upon death or to replace an income upon death. One other reason why many are purchasing a permanent type of life insurance called Universal Life, is because there is a tax deferred investment component attached to this product. Under section 12.2 of the Income Tax Act, additional funds can be deposited and invested on a tax deferred basis.
Ask yourself this question; What would happen if I were to drop dead tomorrow? Of course everyone has a will – right? Well what does your will say? Does it say that you leave everything to your spouse? If that is the case then what is everything and what does your spouse do with all of that? Do they get an income to help continue to pay the bills and put food on the table? Do they get some much needed liquid cash to pay off the debts such as the mortgage, business loans or credit cards? If you are just making ends meet today, think just how bad things could be tomorrow if you weren’t here.
For many of the readers of this article, you are looking to purchase a franchise. Unless you have a lot of liquid cash, you are going to end up carrying some debt. Who will be left holding the bag if you die? What would happen to the business? Would the bank, creditors or the franchisor lose faith in the success of the business now that you are gone?
If the previous questions have left you uncomfortable then you probably have a need to review your life insurance program. Now the question is what type is best for you; term or permanent?
Term insurance is usually used for short term needs whereas permanent insurance is usually used for both short and long term planning needs. There are mainly two types of permanent insurance offered today, Whole Life and Universal Life. I will discuss Universal Life as I believe it is a superior product when compared to Whole Life due to its flexibility and guarantees.
In a nutshell, all insurance is really term insurance. Some is in the form of 10 or 20 year term which means the premiums increase every 10 or 20 year period with the product expiring at some point in time such as at age 80. Other types of term insurance have a level cost till the day you die, this would be term to age 100, Universal Life or Whole Life.
Term insurance can be purchased in several different formats. The most common is ten year renewable term where the annual premiums increase every ten year period. You can also buy five, fifteen or twenty year term insurance. This product is excellent when covering short term needs such as a business loans, mortgages or the raising of a family. No cash is built up in the product you simply pay your premium and if something happens then the tax free insurance proceeds are paid to your beneficiary.
A relatively new feature that has been added to the term life product is called ‘preferred underwriting’. What this means is that there may be a range of premiums that the insurance company will offer to someone in your age group and depending on your health, family history and other underwriting criteria you will usually fall into one of the classes. If you have had good health, your cholesterol and blood pressure are in good order and your siblings and parents haven’t had too many challenges you may been put into the best classification and save some money versus the person who has not had such a clean bill of health.
With this product you are paying the mortality charge for someone in your age group. So if you are 30 years old you pay what the actuaries calculate to be the cost of insurance for a 30 year old. Since not many 30 year olds die each year it is quite inexpensive. However as you get older the cost goes up.
As an example if you are a 30 year old male non smoker and you buy $500,000 of ten year term insurance, you would pay approximately $390/yr for the first ten years then when you turn 40 it would go up to $875/yr, then at 50 it would increase to $2,080/yr and at age 60 it would now be $5295/yr and it would increase again until the product expires at age 84. So in the long term this product is not very cost effective as it will get so expensive that you can no longer afford it. The alternative to this problem is Universal Life insurance where the annual premiums are often a level cost throughout the life of the product.
Why would you need insurance in your later years? Well the unfortunate truth is that when you die there are estate taxes to be paid. The ideal situation would be for you to die at a specific point in time when all your money is spent or given away. However, this certainty would take a lot of excitement out of life.
When we die, everything that we own is deemed to have been disposed of the moment prior to our death. If you own a business or a vacation property, there may be capital gains tax payable. If you haven’t spent all of your RSP and you don’t have a spouse then every penny within your retirement fund is taxable income on your final return. This means that much of what you have worked hard to accumulate over your lifetime is often shared 50/50 with the government of Canada and your hiers. Other expenses to consider are probate fees, legal fees and executor fees.
The solution to minimizing the tax hit at death has been the use of life insurance due to the fact that it is much cheaper than paying the various taxes dollar for dollar. Life insurance is simply a special bank account that you contribute small monthly deposits to and when you die this bank account becomes very large and provides tax free cash to take care of financial problems at death.
Statistics show that most people die in their later years. So the inexpensive ten year term insurance will not work because it will become too expensive or the coverage will end prior to your death. With Universal Life the cost is typically level throughout the life of the product so it is much more palatable in your later years to pay for. There are various ways to structure the product so that you may not have to make any deposits after a certain age. It is kind of like paying for a home. You can pay for it in ten years or spread it out over 25 years.
Universal Life offers several additional benefits to that of term life. In addition to the life insurance coverage there is an investment vehicle where additional funds can be deposited to the contract over and above the cost of the insurance and invested. Using section 12.2 of the Income Tax Act, any deposits in excess of the cost of insurance are invested on a tax deferred basis. Within the contract there are many different investment choices offered by insurance companies from GIC’s to popular indices like the S&P 500. This tax deferred growth can be an effective investment tool when compared to other non registered choices. The funds within the Universal Life contract can be accessed in later years to help supplement other retirement savings.
Universal Life insurance has many other features and can be utilized in many different ways to enhance peoples financial plans. One should contact their advisor to discuss the merits of the product further to see if it is something they should implement.
As I mentioned at the start of this article, this is not an enjoyable topic for the most part. However in saying that, it is one of the most important areas in financial planning and should be addressed and reviewed on a regular basis.
Protecting your most valuable asset – YOU!
Over the past few years, I have written about various financial planning topics to help educate the small business/franchise owner. This article is another along the same line to hopefully help the reader make an informed decision when looking at their various financial planning needs.
This article will discuss one of the most important and often overlooked areas; income replacement insurance (aka disability insurance). Many feel that something like a disability will never happen to them. The other issue is many financial advisors don’t discuss protecting their clients income as this coverage has many different features and is not easily understood. The underwriting process can also be difficult with many contracts being amended, rated (charged more) or declined. Well folks, got news for you. We have a lot more hospitals and doctors than funeral homes for a reason. Statistics state that we have a much greater risk of getting sick or injured during our lifetime for a lengthy period of time versus dying. This is a good thing I suppose.
Another reason that income replacement insurance is overlooked is that many people (including advisors) find that it is expensive. The answer to this is that yes it is not cheap but neither is your ability to earn an income.
That is what income replacement insurance does, it replaces your monthly earnings when you are unable to do your job which obviously enables you to maintain your current lifestyle.
If you are not independently wealthy then you should have income replacement coverage.
When looking at an income replacement policy, there are many different bells and whistles that can be added on but 4 key areas should be addressed as the core of the policy:
1. What is the definition of disability? What does it take for the insurance company to pay you?
This is the most important aspect of the contract and one of the best definitions available today is what would be called a ‘regular job’ definition. What this means is that if you are unable to do the substantial duties of your current job then you would be considered disabled. A poor contract would have a definition that might say if you are unable to do ‘any’ job then we (the insurance company) will pay you.
The difference between a ‘regular’ and ‘any’ job definition is substantial.
2. What is the definition of partial or residual disability?
Often people are not fully disabled but may be only partially disabled. Most business owners due to the vested interest they have in their business will make all efforts to go to work, but what if you are putting in all the time and effort, but due to a disability such as chronic head aches or a sore back you are not as effective and your revenue drops? Having a contract with a residual definition of disability would help top up some of the lost income. A contract with a definition covering partial disability would help provide a percentage of your monthly income replacement benefit if you are only able to do some of your important job duties or can only work half the usual time.
3. What are the exclusions in the income replacement contract? What are the reasons for the insurance company not to pay?
Things like mental nervous disorder or stress have caused havoc with companies in the disability arena. Who isn’t stressed out nowadays and with it being so subjective it is now often excluded in many group contracts or poor individual contracts. Other poor contracts exclude or limit benefits for disabilities caused by drug or alcohol abuse or soft tissue back injuries.
A good contract should have minimal exclusions. Standard exclusions are usually a disability caused by an act of war, transplant surgery in the first six months of the policy being in force, normal pregnancy or childbirth and periods of incarceration.
4. Finally what are the guarantees in the contract?
The best contracts state in black and white that the policy cannot be altered or modified in anyway by the insurance company as long as your premiums are paid. This means that once the contract is in force, the insurance company cannot make any changes.
Poor contracts would state the insurance company has the right to change premiums for different classes of those insured or cancel contracts at their discretion. For example, if the insurance company is having high claims experience from electricians then they can change the premiums paid by all those in this classification.
If you are starting out in a new business venture, obtaining the best income replacement contract with an adequate monthly benefit may be difficult initially. The reason for this is that many new businesses fail, so insurance companies are not willing to issue policies with all the best components right away. Insurance companies like to see a track record of financial stability before they issue the top quality policy.
The good news is that some of the companies offering coverage have recognized the trend of people starting their own businesses and have products specifically for them. After a few years of financial stability is established by the owner and the business, this contract can be converted to a better one which would include many of the features I explained above.
The best way to do things is to have your income replacement coverage in place prior to setting out on your new business venture. The challenge here is that in the application the insurance company usually asks if you are aware of any changes that will occur in the next 12 months that will change your occupational duties or employment status. So if you are currently employed and think down the road you might like to go into business for yourself then you should apply for some personal disability coverage today while you have a steady income.
If you are unable to obtain the monthly benefit coverage desired, an alternative product available to make up a shortfall is Critical Illness insurance. This insurance is not tied to your earnings or occupation.
Several additional riders can be added onto your basic policy. Some of these are:
In business we insure all sorts of things from the equipment we use to the building we operate out of, but often we overlook protecting ourselves. Everything you have today is because you can get up in the morning and earn an income. How would your life and business be affected if this were to stop one day for a lengthy period of time. Contact your financial advisor to address this very important part of your financial plan.
Don’t Go It Alone
What is your game plan when it comes to investing?
Ah, the world of investing; how exciting it can be! Or on the other hand, if you are like most people you don’t find it exciting. More of a daunting experience, one you would rather avoid altogether, like visiting the dentist. (My apologies to the dentists reading this).
Unfortunately you cannot just let the investment world pass you by. It is an extremely important component to you and your family’s financial future. This article will attempt to explain a few of the common pitfalls for investors and how to avoid them.
Investing in stocks, bonds, mutual funds and real estate can be a very profitable experience. It can also be an unprofitable experience! I’m sure you’ve been at a cocktail party where one of your friends tells you about this ‘hot stock tip’ and how you have to get in on it quickly. Inevitably, you start thinking of the windfall you will have if this investment takes off like everyone is expecting it will. So you make the investment only to have it plummet in value. Then the self doubt starts as you ask yourself why you ever listened to that loser in the first place and "what was I thinking about". So you decide to cut your losses and sell.
What you have done is what many others have also done – investing speculatively and it rarely pays off. The greed factor is human nature. When we hear of others doing well and see the stock markets or real estate markets chugging along upward, we decide that we need to get in on the action.
Have you ever heard the saying ‘buy low - sell high’? This is a simple investing basic but most investors choose to buy high and sell low. They get caught up in the excitement of things such as Nortel or dot com stocks and forget the fundamentals. They just assume that since this has been going up like gangbusters over the past year or two that it can only continue to go up. Inevitably, they buy at the peak and their investment shrinks quickly. If this happens then the best thing to do may be to hold onto your stock or mutual fund. Maybe even buy some more if it is still fundamentally a good investment, and in line with your original objectives. This is called averaging down your purchase or what I like to call ‘Bay Day’- it’s on sale!
Here is an example: You invest $10,000 in mutual fund ‘A’ at $10.00 per unit, so you have 1000 units. The next week when you look at this mutual fund you find it has gone down to $5.00 per unit in value. You do some quick math and find that you have lost $5,000. But you haven’t! This is the problem most investors have when not guided by a competent financial advisor. Human nature would tell us that this has been a poor investment and that we had better sell this loser and move to something else. Wait a minute! Ask yourself what your investment objective was when you initially purchased the fund. Has anything changed such as your time frame for using the money or has anything changed regarding the mutual fund and its objectives? If you are investing in equity type investments, I hope that your time frame is at least 4 years out as short term investing is quite risky. So if your time frame is 10 years, why sell this fund now? If it is still a good fund then the smart thing would be to add some more money. Let’s say you have another $5,000 so you put this into the fund. You now get another 1000 units ($5,000 divided by $5 per unit).
So where are we at now:
Purchase 1: 1000 units at $10/unit, total investment $10,000
Purchase 2: 1000 units at $5/unit, total investment $5,000
Total: 2000 units at an average price of $7.50/unit for a total investment of $15,000
Another month passes and you figure you can bear the pain, you decide to look up the mutual fund price in the local paper. Glory be! This fund isn’t a dog after all, it has now gone up to $8.00 per unit. You think to yourself, what a savvy investor I am by buying this one at $5.00. Again you reach for the handy calculator to figure out where you stand.
You now have 2000 units at a unit price today of $8.00 per unit, this means that your portfolio is valued at $16,000 and you have only invested $15,000. You are up even though you purchased some units at $10 per unit and the fund is only at $8 per unit. By staying the course, staying focused on your long term objective, and adding in some money when the fund was down, you have improved your financial position.
You see, if you look back over the last 50 years the stock market has been an up and down place to have your money. But on average over 5, 10, or 20 years, it has been one of the most profitable places to have your money invested. I describe it as someone walking up a staircase with a yo-yo in their hand. Based on history, the markets have moved upwards (walking up the stairs) but throughout this time there are many ups and downs; daily, monthly and yearly. This is what you have to be able to stomach. For some this is very tough, even for professionals who do this day in day out. We don’t know where the markets will go tomorrow, however there is a good chance that over the next 10 – 20 years they will be higher than today.
Why is that? Well, I believe there are always going to be strong companies in the market place making profits and being successful and investors will want a piece of this success. That is what the markets are made of, companies like General Motors, Royal Bank and Microsoft. Do you think all these companies will fold up tomorrow? Or do you think they will continue to operate efficiently to bring profits to their bottom line for their shareholders – you?
Back to my original comment above where I stated the investor hadn’t lost any money when the fund dropped to $5 bucks. Technically I was wrong as on paper the person has lost money. But that is the key. It is only on paper! Once you panic and forget about your objective for the investment and sell it, then you have a real loss.
I believe that because of the internet and easily accessible information that many people feel they can invest and plan on their own without any formal training. This is much like someone who knows nothing about automobile mechanics working on their own car. After surfing the web and watching the knowledge network, they grab their tools and start overhauling their engine. Most likely it won’t work. My suggestion is discuss your investment game plan thoroughly with a qualified advisor, talk about your risk tolerance (the magnitude of the ups and downs that you can withstand) and keep focused on the long term. Don’t go it alone.
Many charities today are in search of much needed financial support. There are many worthy causes to give to, so how can you as an individual help make a large impact upon a charity that is close to your heart?
Instead of doing the $20 here or the $100 there what if there was a way to make a larger donation and keep it tax efficient so that you and your estate benefit? Well there are several options to consider when giving to charities and the government actually helped out by changing the Income Tax Act back in 1997.
The government increased the maximum credit allowed when gifting to a charity in the year of death and the prior year to 100% of income. Prior to this it was 20% so quite a significant change. This change has made the use of permanent life insurance much more advantageous and I will explore some of the reasons.
Firstly to make charitable gifts, you can do it while you are alive by simply donating an asset such as a stock portfolio to a charitable organization and by doing this you will receive a tax receipt. What if we don't want to donate such an asset but would rather make a very large donation at the time of our death to benefit the charity?
The use of life insurance is the best method and there are several ways to structure a program.
The donor, applies for some permanent life insurance on their life. Once the policy is approved, they assign the ownership over to the charity which is also the beneficiary. By doing this, the donor (who will pay the premiums) can now use the premiums as a tax credit on their annual tax return. So it is really no different than giving a charity $20 or $100/mth as the tax credit is the same, however what happens is when that donor dies a large sum of tax free money is paid out to the charity. The end result is a much larger donation than could have ever been done via monthly cash donations.
Some things to be aware of via this method are that once ownership is assigned to the charity, you lose control. This means that if you change your mind you cannot take back ownership or change the beneficiary as the charity owns the policy. You could, however, stop paying the premiums but the charity could simply take on that obligation keeping the policy in force.
An individual could take out a life insurance policy on their life and make the charity the beneficiary which would enable the donor to retain control, however structuring it this way leads to no tax benefit while alive or at death as the premium cannot be deducted and by having the charity as direct beneficiary there is no tax receipt issued.
This is the most optimal solution I believe. First the donor retains control of the policy and if they decide to change the beneficiary in the future it can easily be done. There is no tax credit for premiums however at the time of death is when the major tax benefit occurs.
At death the policy would be paid out tax free to the estate, via their will they would have a gift/bequest to donate $X to a given charity. The executor would write a cheque to the charity who then would issue a tax receipt to the estate. So the insurance has flowed into the estate and now been paid out generating a tax credit.
Example: the person at death had a taxable income of $400,000 from RRIF's, capital gains on stocks and other income. Remember everything you own is deemed disposed of at death. Some assets will rollover to a spouse however when the last spouse dies, taxes have to be paid by the estate before passing onto the next generation. So in this example the estate has $400k of income with potentially $200k of tax owing (50% marginal tax bracket), if the person had insurance of $400k that was paid to the estate and subsequently paid to a charity via the will, a tax credit for $400k would be created which would for the most part nulify the tax burden the estate would have faced.
By doing this, the deceased has eliminated $200k of tax which heirs of the estate are pleased about (Canada Revenue Agency isn't happy of course as they were cut out) while at the same time donating a large amount of money to a worth while charity.
This is a long term plan but is certainly a win win. Now you don't have to do the full amount but even small insurance policies can help much needed charities and provide tax relief for your estate. The important thing is you are helping in a much greater financial way.
Permanent insurance such as Universal Life, Term to age 100 or Whole Life are the ones that will work as they usually have level premiums for life and will be in force when you die. Term life such as 10 or 20 year will just get too expensive to keep and therefore will not work.
To help keep the cost affordable purchase the insurance at a younger age or look at joint last to die policies.
For those looking to explore this idea further please don't hesitate to contact us at our toll free line or via email. We are licenced in BC, Alberta and Ontario and do a great deal of insurance via phone/email.
Understanding the purpose of shareholder agreements.
If you are thinking of starting a business or buying a franchise, often you may have partners involved other than your spouse. With this in mind, it is important to consider the extra layer of complexity that this adds from a business planning perspective.
Starting a business takes a great deal of financial resources so having a partner or group of partners is helpful in accumulating the capital required to purchase a franchise and all of the other incidentals involved. Depending on the type of franchise, the cost can go from $25,000 to as high as $500,000.
It is important that if you go into business with a partner that you draw up and sign a partnership agreement. This agreement will detail all the different facets of the business and how they apply to the partners. It is unfortunate but differences do evolve when you have several individuals involved in the success and growth of a business. If you do not have a partnership agreement in place that addresses various issues how can you easily resolve any that arise? The courts will ultimately get involved to settle any dispute and this is the most disruptive and costly method to all those involved and the businesses success could also be in jeopardy.
So what is a partnership agreement?
The agreement discusses many different areas such as what are the responsibilities of each partner and what is their involvement in the business. In this article, I will discuss some key ideas that pertain to financial planning and their effect on the business. These ideas include:
The concerns listed above are important issues to address and cover in the agreement. More often than not, most business people that I visit with do not have a formalized agreement and if they do it is often not ‘funded’. I’ll discuss what I mean by this a little later. Another thing that is often overlooked because all is running smoothly today, is that the agreement has been drafted but not signed by the partners. They have not got around to it as they are so busy or there are some small revisions to be made. So it sits and collects dust since it is not needed today.
Good business sense would be to get this document in place before the front doors to the business open. From my experience, once the business is going full steam ahead, it is difficult to find the time to get all the partners together to discuss and implement an agreement.
One experience that I had with a business which almost caused it to go into bankruptcy was just as I detailed above. An agreement had been written up by the lawyer however several years into the partnership, it still had not been signed by the three partners. By this time it was too late as conflicts had arisen and there was animosity among the partners. This dissention amongst the partners caused problems in the day to day operations of the business and it almost went under. It got so bad that one of the partners started to work for the competition! Finally after thousands of dollars in legal bills and a great deal of stress, one of the partners decided to buy out the disgruntled partner so that the business could move forward. Do you think he is pleased with how things went? I don’t think so, however had the partnership agreement been signed, then there would have been a documented process on how to buy out a partner. This is often called a ‘shotgun clause’.
What if a partner dies.
In this situation, the partnership structure changes drastically and immediately, there is no going back to put things in place. If there is no buy sell agreement in place then the estate or spouse of the deceased shareholder is now your partner. The buy sell part of the partnership agreement details the process of how the remaining partners or the company will purchase back the shares of the deceased shareholder. If you don’t have this area dealt with you could end up in court to have them decide what is fair or you could simply have a new partner.
Do you get a long with the deceased partners spouse? Do they even want to be in the business? If the shareholder who died was a majority shareholder now his spouse controls the decisions, what do they know about the business? How would this affect decisions going forward? If they don’t want to be in the business, who will buy their shares and at what price? They will want the highest price possible and could cause major disruptions to the business before all is said and done. If the remaining shareholder wants to buy out the deceased shareholders estate or spouse, where does the money come from? You have used all of your capital to finance the business and the bank has lent you all they want to. Do you take it out of daily cash flow? What will this do to the business bottom line? There are so many questions to answer. How would creditors, suppliers and franchisors feel about this? Would they lose confidence and call some loans?
So as you can see there are many issues to deal with when someone dies aside from their personal affairs. An agreement addressing this issue will make the problem quickly go away. In conjunction with the agreement, you need to come up with a method to execute the repurchase of the shares of the deceased shareholder. The most cost efficient method is by having life insurance in place on each shareholder. The money is then readily available when something happens. Other methods of funding this part of the agreement are by creating a sinking fund or taking out a loan, however they are not as efficient as simple life insurance.
So address this area and arrange funding through life insurance using either term or universal life coverage.
What if a partner becomes sick or injured and is unable to return to work?
This area of the agreement is often overlooked and this is strange considering there is a much greater liklihood based on statistics of a partner becoming sick or injured before age 65. If it is addressed, there is often no methodology of how to buy out a partner who cannot return and be productive at the business.
First off, you want to make sure there is adequate income replacement coverage in place for each partner. This will transfer the risk from the individuals shoulders or the company’s shoulders to the insurance company where it belongs. If you do not have this coverage in place and a partner becomes sick or injured where will they go for an income? If a partner is looking like they are not coming back to work then how do the remaining shareholders buy out the disabled partners shares?
This can be an expensive proposition if the value of their shares are in the six figures. Again a loan can be an option, but will the bank go along? What if the shareholder was one of the key people in the business and/or worked closely with the bank? Similar to the death of a shareholder, will the bank or franchisor lose confidence in the success of the business?
Some insurance companies offer lump sum disability buy out coverage. Again this is the best method to finance such a liability because the money is readily available when needed and the product can also be used in conjunction with the partnership agreement wording to set the effective date for this all to happen. What this means is you can buy the product where it will pay out a lump sum of money after 12, 18 or 24 months of disability. So the agreement could reflect the product and the time frame you have agreed upon. For instance, if you buy a 12 month elimination period then after 12 months of disability by the shareholder, the insurance would kick in and be used to buy out the shareholders shares. He/she has the value agreed upon for their shares in the business and the remaining shareholders now have proportionally more shares and now do not have to worry about the disabled partner.
What if a partner decides they have had enough and want to sell their shares?
Who gets the first opportunity to buy them and at what price? A well written agreement will address this area so that there are no arguments or legal actions. Usually the remaining partners will have first right of refusal to buy the shares and if they don’t want to do it then the shareholder can sell the shares to whomever they want to.
Unlike the other two issues previously discussed, there is not an insurance product available to help fund this buy out. Usually a loan would be involved if the partners do not have the cash readily available. Another method would be to buy out the partner over a period of time from the cash flow of the business. Both of these methods can for obvious reasons be a strain on cash flow to both the partners and the business.
These and many other issues are extremely important to address as you start your business. The success of it could depend on the pieces of the pie that you implement today. Don’t take it lightly, contact a competent lawyer and financial planner who deal in these arenas on a regular basis.
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