As promised, the next six posts will focus on Business Killers, an innovative educational program designed to help business owners avoid key mistakes that even successful business owners make.
In the first Business Killers scenario, a recently widowed mother of three young children meets with her deceased husband’s surviving business partner. After a few pleasantries, she gets down to business. She’s got a mortgage and kids to deal with, but her husband didn’t leave her much money because most of his wealth was tied up in the business. Worse, the buy-sell agreement – a contract between business owners that sets the rules for valuing the business and often provides for life insurance to fund a buyout after the death of an owner – in place at the time of his death was undervalued. Thus, the widow is getting less insurance money than the current market value of her late husband’s share of the business. The business partner is sympathetic but says that he can’t give her anything more without selling the business, and admits that the company hadn’t updated the buy-sell agreement for the past 10 years. The widow shrugs and says she’s hiring a lawyer because she knows the business is worth more than what she’s getting.
Like all of the Business Killers scenarios, failure to know the value of your company results from failure to plan and its close friend procrastination. When a business owner dies, there are several issues to analyze, each with potentially disastrous results for the business and the surviving owner.
First, we need to know if a buy-sell agreement was ever prepared. If not, there will be a claim by the deceased owner’s estate against the business for the fair market value of the deceased owner’s share of the business. That means lawyers (hopefully no guns) and money. And even if the remaining owner and the estate avoid litigation by agreeing on the value of the business there is the problem of paying for the decedent’s share when the company has just lost an owner and the corresponding value that he or she brought to the business.
If a buy-sell agreement was signed, we still need to analyze whether it is valid. Was it properly signed? Do the valuation provisions make sense? Are there ambiguous terms that result in different outcomes depending on their interpretation? Again, the legal team and potentially costly lawsuits await.
Even if a valid buy-sell agreement exists, we need to know if it was properly funded. That’s the problem depicted in the scenario above where the two partners never updated the value of the business (and therefore the amount of life insurance proceeds that would be available if one of them died).
Most companies choose life insurance as a cost-effective funding mechanism for a buy-sell agreement, but owners can also set aside money in a reserve fund. Either way, it’s critical to know the true market value of the company to ensure that enough funds are available to buy out an owner’s share of the company, especially if the buyout comes at an unexpected or inconvenient time.