Here are a few business housekeeping items you’ll want to address this year if you haven’t already.
- 1) Protect Your Intellectual Property
Small business owners often fail to plan to protect their company’s intellectual property (IP). IP includes brand identity, which can be protected through trademarks, and also includes unique ideas or inventions that can be protected by patents. Regardless of the specific IP needs, companies often don’t take the time to allocate financial resources for this protection. Instead, they just have a lump sum for the legal budget. Intellectual property attorneys often can provide cost estimates, and can help map out a plan based on reasonable assumptions and available resources for protecting the company’s innovation.
- 2) Update Employee Benefit Plans
Small business owners also may not know about changes to employee benefit plans that require plan amendments. For example, health flexible spending account plans now can be amended to add a $500 carryover. This is a major change from the traditional ‘use-it-or-lose it’ rule. The carryover feature can be effective for the 2013 year, but only if plans are amended by December 31, 2014.
Another change relates to same-sex spouse benefits. The United States Supreme Court has ruled that the Defense of Marriage Act’s (DOMA) definition of spouse as only applying to a marriage between a man and woman is unconstitutional. That means that any existing plan documents defining ‘spouse’ with reference to DOMA must be amended to include a new spouse definition.
- 3) Long-Term Strategic Planning
Small business owners often get stuck working in their business when they should be working on it. Running a successful business certainly requires close attention to fundamentals. However, successful businesses also develop and follow a long-term strategic plan that includes annual goals and how to reach them. The beginning of a new year is a great time to develop or revise that vision. And as business coach Sherry Jordan notes, creating a plan but leaving it on the shelf doesn’t help. It’s important for business owners and management teams to review the plan regularly–at least once a quarter–to stay on track and measure success.
- 4) Review Your Buy-Sell Agreement
Every multi-owner business needs a buy-sell agreement to establish a value for the company and determine how owners can transfer their ownership interests. Often, buy-sell agreements call for an annual updated valuation of the business. Unfortunately, this task is often neglected and the oversight isn’t discovered until after a triggering event, such as the death of an owner. If the buy-sell agreement hasn’t been updated recently, it’s likely that the pre-determined value of the business will be too high or too low. To avoid this unhappy situation, business owners should review their buy-sell agreement annually to confirm that the pre-determined buy-sell valuation or formula is appropriate.
Last month we discussed six common mistakes that business owners make and their potentially devastating consequences for those companies. This month we’ll go a step further and let readers examine their own risk level for each of these mistakes. The first mistake involves not knowing what your business is worth.
Answer the following questions to see if your company is vulnerable:
• Has the business value been appraised by an outside expert?
• If so, has the appraisal been reviewed within the past three years?
• Is there a written buy-sell agreement?
• Is the buy-sell agreement funded through insurance or adequate cash reserves?
• Does the buy-sell agreement protect the business owner’s family and co-owners?
• Has the buy-sell agreement been reviewed within the past three years?
• Is the signed buy-sell agreement readily locatable?
The more “no” answers, the greater the risk. How does your company look?
If you don’t have a buy-sell agreement, you’re not prepared to deal with an owner who wants (or needs) to sell his or her stake in the business. A buy-sell agreement sets the ground rules for how that ownership stake can be sold or transferred and specifies how it will be valued.
Most companies with buy-sell agreements choose life insurance as a cost-effective funding mechanism to deal with the unexpected death of an owner, but insurance won’t help when an owner retires or simply wants to sell and move on. Although companies rarely fund 100 percent of future obligations in advance, it may be wise to consider setting aside money each year to help offset the financial burden of cashing out an owner at retirement. 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.
Business Killers is an innovative educational program for executives and business owners put on by my friends Mark Baker and Lisa Brumm of AXA Advisors. For more information, contact Mark at firstname.lastname@example.org or Lisa at email@example.com
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.
Anyone who’s wrangled over the value of marital assets in a divorce understands the value of a well-drafted prenuptial agreement. For the same reason, closely held businesses with multiple owners need a buy-sell agreement. A buy-sell agreement is a legal document that spells out how to value ownership interests and how and when owners may sell those interests. More importantly, a buy-sell agreement can provide a source of funding for the purchase of an owner’s interest in the business in case of death or disability.
A “standard” buy-sell agreement may prevent the sale of an owner’s interest in the company to anyone but another owner, or require consent of all other owners to bring in a new owner. If an outsider makes an offer, there may be first rights of refusal that allow either the company or individual owners to match the terms of the offer.
In addition, a buy-sell agreement should provide for a valuation method to minimize disagreement over how much money an owner gets for his or her share of the company. Valuation methodologies come in all shapes and sizes, and some are more appropriate than others depending on the nature of the business. And while mathematical formulas relating to multiples of earnings offer a quick answer, it is rare if ever that a simple equation will correlate to the true “going concern” value of a company. For those reasons, many buy-sell agreements contain a default provision requiring the owners to hire a qualified business appraiser to value the business if the owners can’t agree.
The buy-sell agreement also may require a mandatory company buy-back of an owner’s interest in the business if the owner dies or becomes disabled. Typically, the buy-sell agreement will include language that lets the company purchase life or disability insurance on all of the owners to ensure sufficient cash to fund a company purchase. However, many companies don’t get around to buying the appropriate insurance policies, or they don’t update the value of the company regularly to know how much insurance is needed. In situations where an owner dies or becomes disabled, an unfunded buy-sell agreement isn’t much better than no buy-sell agreement at all.