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A Simple Succession Plan

Purpose of a Simple Succession Plan

A Simple Succession Plan tends to focus primarily or exclusively on:

the sale of the Business Proprietor's Asset or Equity in the Business (the "Asset Strategy")
upon the occurrence of an Insured Event.

Asset Strategy

In contrast to a Complete Succession Plan, a Simple Succession Plan tends to focus primarily or exclusively on
your Asset Strategy.

Click here to read about the nature of a Complete Succession Plan and how it differs from a Simple Succession
Plan.

The Need for an Asset (or Buy/Sell) Strategy

Click here to read about the need for an Asset (or Buy/Sell) Strategy.

Legal Conveyancing or Sale Agreements

The need to structure the legal arrangements with respect to the Insurance Cover resulted in Lawyers preparing
Conveyancing or Sale Agreements that might or might not be triggered by the occurrence of an Insured Event in
the future.

These Agreements needed to address the relatively sophisticated tax implications with respect to Insurance
Proceeds that are discussed here.

As a result, Lawyers eventually adopted the practice of preparing dedicated "Buy/Sell Agreements", in addition to
any Proprietors Agreements (such as Partnership or Shareholders Agreements) that the Proprietors might have
had.

Buy/Sell Agreements

When the Business Succession Agreement focusses primarily on the Succession Plan (i.e., the Asset or
Buy/Sell Strategy) for Insured Events, it tends to be called a "Buy/Sell Agreement".

Many Buy/Sell Agreements fail to deal with other Succession Planning issues like:

retirement (not just Insurable Events);


increases in the value of the Business over time (not just today's value);
shortfalls in the amount of insurance available to pay the Purchase Price (other funding strategies);
the extinguishment of the Proprietor's liability for Business Debts under Personal Guarantees and
other Securities (not just an Asset Strategy); and
the repayment of Loan Accounts.

These are dealt with in a Complete Succession Plan and the Business Succession Agreement that documents a
Complete Succession Plan.

However, sometimes for business or personal reasons, a Business might prefer to document a Simple
Succession Plan.

Click here to read about Buy/Sell or Business Succession Agreements.

Self-Ownership Buy/Sell Agreements

Most Lawyers (other than IGS) use Self-Ownership Buy/Sell Agreements and recommend that the Buy/Sell
Cover be owned by the relevant Life Insured personally.

Click here to read more about Self-Ownership Buy/Sell or Business Succession Agreements.

Standard IGS Self-Ownership Business Succession Agreement

Click here to learn more about the standard IGS Self-Ownership Business Succession Agreement used for a
Simple Succession Plan.

This is a more traditional Buy/Sell Agreement which deals only with the Buy/Sell or Equity Insurance Cover.

However, unlike most other Buy/Sell Agreements, it includes succession strategies for retirement and events
other than Insurable Events.

IGS usually prepares this type of Agreement where:

a Complete Succession Plan is not required or relevant; or


it is preferred by the Business or its Advisers.

Ownership of Equity by Life Insured

By definition, Self-Ownership must pay the Purchase Price to the Life Insured or their Estate.

Therefore, preferably, each Life Insured should own the Equity in the Business in their own name (rather than in
the name of a Related Party).

IGS normally uses a Business Insurance Trust Agreement, if any of the Equity is owned by a party other than
the Life Insured (i.e., a Related Party Vendor such as a spouse, Family Company or Family Trust).

Equity vs Loan Capital

Many Clients and Advisers misunderstand the difference between Equity Capital and Loan Capital when they
design a Succession Plan.

If a Proprietor has both Equity and a Loan Account, it is important that their Succession Plan facilitates both:
the sale and purchase of the Equity; and
the repayment of the Loan Account.

A proper understanding of the difference is required in order to structure an effective Succession Plan.

In effect, their Succession Plan needs both:

an Asset Strategy; and


a Liability Strategy.

The Liability Strategy involves different legal, commercial and insurance considerations to an Asset or Buy/Sell
Strategy.

A Complete Succession Plan is designed to address these considerations cost- and tax-effectively.

Please click here to read about the difference between the two interests and the implications for the design of a
Succession Plan.

A "Complete Succession Plan"

Click here to read about the nature of a Complete Succession Plan and how it differs from a Simple Succession
Plan.

Sole Proprietors and Family Businesses

The Succession Planning Strategies on this web site are most relevant to Multiple Proprietor Businesses in
which there are arms-length Proprietors or Owners.

However, they can also be relevant to Sole Proprietor and Family Businesses.

Click here for strategies for Sole Proprietors and Family Businesses.

The Four Planning Issues

Set out on the following pages is an overview of four basic planning issues that help understand and design a
Complete Succession Plan:

Issue 1: Strategy (The Relationship Between Business and Personal Needs);


Issue 2: Financial Needs ( "The Three Needs");
Issue 3: Insurance Funding (The One Page, One Policy Strategy); and
Issue 4: Retirement Funding ("Voluntary Events").

Where to Start

Issue 1 is a good starting point to understand the unique benefits of a Complete Succession Plan and how it
differs from other approaches to Succession Planning.
The Complete Succession Plan
Issue 1: Strategy (The Relationship Between
Business and Personal Needs)

Your Business and Personal Needs

This section focuses on the relationship between your Business and Personal Needs at a strategic and
commercial level.

We are used to thinking of our Business interests and needs as separate from our Personal interests and needs.

However:

your interest in your Business (your Equity) is actually a Personal Asset that forms part of your Estate;
and
you might have Personal liabilities for Business Debts and Liabilities (e.g., Personal Guarantees).

Therefore, your Business and Personal interests and needs can be intertwined.

Your Succession Plan should help you to address this bundle of different needs.

Traditional Multiple Policy Approach

Insurance is a funding mechanism that can help you meet a financial need upon the occurrence of an Insurable
Event.

Business People have both Business and Personal Needs.

Traditionally, Advisers have written one Policy for each separate Need, often resulting in four or five different
Policies for each person, often in the name of different owners (the traditional "Multiple Policy Approach").

These arrangements are often difficult to understand and require Policy changes and medical tests each time
one of the persons Needs changes.

How Your Business Strategy Interacts With Your Personal Strategy

Many Clients and Advisers don't realise how the Business and Personal Needs are related or how the insurance
arrangements can be simplified.

"One Page, One Policy Strategy"

Set out below is an explanation of:

how Business and Personal Needs are related;


how your Sale Price and Personal Cover feed into the same "pot" that funds the targeted Capital and
Living Expenses requirement of your Estate or Family;
how your Buy/Sell and Debt Reduction Cover are related;
how you can address all of your Needs on One Policy that operates like an "Insurance Facility" (the
"One Policy Strategy"); and
how these strategies can be adapted to a Retirement Strategy.

The Relationship Between Business and Personal Needs

The Complete Succession Strategy divides your needs into Asset, Liability and Personal Needs.

Of these Needs, the Asset and Liability Needs are examples of Business Needs.

The Asset Strategy is a Buy/Sell Strategy.

The Liability Strategy is a Debt Reduction or Key Person Strategy.

The Personal Strategy takes into account the balance of your Personal Needs after allowing for the payment of
the Purchase Price to your Estate.

Buy/Sell (or Asset) Strategy

The traditional approach to Insurance-funded Succession Planning has focused primarily on the funding of the
Purchase Price of a Business Persons Equity in the Business.

You can insure your Equity, so that you are guaranteed to receive its true value, if you die or become disabled.

For example, if your Equity was valued at $400,000, you might take out a Policy for this amount.

If you die, your estate will receive $400,000 in return for a transfer of the Equity.

This type of insurance is usually called "Buy/Sell Insurance" or "Equity Insurance" (because it insures your Equity
in the Business).

Dual Business and Personal Function

Buy/Sell Cover has a dual Business and Personal function:

it allows the Continuing Proprietors of the Business to purchase the Outgoing Proprietor's Equity (so that
the Business is not damaged by any dispute between the Proprietors); and
it contributes the cash Sale Price to the Life Insured's Estate (in exchange for a transfer of the Equity).

Debt Reduction (or Liability) Strategy

The exclusive focus on the value of the Equity often overlooks the need to extinguish personal liabilities (i.e.,
personal guarantees and mortgages over personal property) with respect to any Debt or other Liabilities of the
Business.

Many Business People assume that, if they die and sell their Equity, their personal guarantees will die with them
or the Bank will release their personal guarantees.

Unfortunately, these guarantees stay alive and cling to the assets in your Estate.
You do not know whether you have safely passed your Sale Price or any other assets onto your Beneficiaries,
until you have made arrangements with the Bank to release your guarantees.

For example, if the debts of the Business totalled $400,000 and they were jointly and severally guaranteed by the
two Proprietors of the Business, you might insure each Proprietor for $200,000.

The reduction of the debts of the Business (by half) upon the death of a Proprietor will help create a commercial
argument that the Bank should release the personal guarantee without requiring any additional security from the
Continuing Proprietor.

This type of insurance is usually called Debt Reduction Cover or Key Person Cover.

Dual Business and Personal Function

Debt Reduction Cover has a dual Business and Personal function:

It reduces the Debt owing by the Busienss; and


it justfies the Bank releasing the Life Insured's personal guarantee (so that the Life Insured's Estate is
no longer liable to the Bank).

Personal Strategy

The above needs are examples of Business Succession Needs.

Business People also need to consider their Personal (or Estate Planning) Needs.

In a sense, your Personal Strategy complements your Business Strategy.

It addresses needs that your Business Strategy did not address or did not address adequately.

Example

For example, if you wanted to fund pre-tax living expenses of $50,000 per annum, then you would need a capital
sum of $1,000,000 invested at an interest rate of 5% per annum.

If you own your Equity in the Business in your own name, the Sale Price of your Equity (e.g., $400,000) will
usually be paid to your Estate.

However, it might only meet part of the capital amount required to fund your family's living expenses (e.g.,
$1,000,000).

Personal investments (including superannuation) and insurance cover are intended to meet the $600,000
shortfall.

To the extent that your Sale Price and your other investments are inadequate to fund your Personal Needs, you
can use Personal Insurance to fund the shortfall.

For example, if you had no superannuation or other investments, you might need additional Personal Cover of
$600,000.

Your Purchase Price and Personal Cover Contribute to the Same "Pot"

Business People have traditionally been encouraged to keep their Business and Personal Strategies separate.
However, ultimately, there is a link between your Business and Personal Needs and Strategies.

Because your Equity is your personal interest in the Business or the Business Structure, the Purchase Price
forms part of your Estate.

Therefore, it contributes to your Personal Living Expenses Need.

Both Price and Personal Cover feed into the same "pot" required to fund the $1,000,000 capital requirement of
the Living Expenses for you or your Family.

In summary, the Sale Price of your Equity will contribute to your personal "pot", because your Equity is your
personal interest in the Business.

However, as the value of your Equity increases, it does more of the job of filling the million dollar pot.

Increasing Need for Buy/Sell Insurance

If you use Buy/Sell Insurance to insure the Sale Price of your Equity, then the Buy/Sell Cover will do more of the
job of filling the million dollar pot as your Equity increases in value over time.

Most Business People with growing Businesses find that:

their need for Buy/Sell Insurance to fund the Sale Price of their Equity goes up;
their Buy/Sell Insurance contributes a greater amount into their personal "pot"; and
their Personal Cover can come down.

Example

For example, as the value of your Equity and other investments increases (e.g., your Equity grows from $400,000
to $500,000), they contribute a larger amount to the capital required to fund your living expenses.

If you had separate $400,000 Buy/Sell and $600,000 Personal Cover, you would normally increase your Buy/Sell
Insurance as the value of your Equity grows.

If you leave your Personal Cover at the same level (e.g., $600,000), your total sum insured will increase (e.g., to
$1,100,000).

Therefore, you might end up with more Personal Cover than you need to make up the shortfall.

Reducing Your Personal Cover as You Increase Your Business Cover

One option would be to reduce your Personal Cover from $600,000 to $500,000, at the same time as you
increase your Buy/Sell Cover from $400,000 to $500,000.

These changes can involve time, energy, medical tests and underwriting requirements.

Sounds like a pain, doesn't it? And it is, sometimes literally!

Using the "One Policy Strategy" to Create an "Insurance Facility"

In contrast , a Complete Succession Plan is designed to aggregate Business and Personal Cover onto One
Policy.
This allows you to use any excess Personal Cover to provide the Buy/Sell Cover required to fund the increase in
the Purchase Price of your Equity.

In other words, it enables you to re-purpose your Cover as your Needs change.

In effect, the strategy creates an "Insurance Facility" or an "Insurance Pool" that allows you to change the mix or
break-up of your Insurance between the different needs over time.

"Changing the Mix"

If we aggregate both Needs onto the One Policy, we might find that we have the right total for the indefinite
future.

All that needs to change is the "mix" or the "colour" of the Cover.

This process occurs internally within the Policy and does not require any interaction with the Insurance Company.

In other words, once the Insurance Company has accepted the risk, it is on the hook for the Total Sum Insured,
regardless of any changes in the internal composition of the Sum Insured.

A Complete Succession Plan enables the Proprietors of the Business to focus on the aggregate of Business and
Personal Needs (i.e., the Total Sum Insured) in their relationship with the Insurance Company.

At the same time , it allows the Proprietors to focus on the "mix" or segregation of the Total Sum Insured in their
relationship with each other.

The Complete Succession strategy is about:

aggregation at the time of establishing the Succession Plan; and


segregation at the time of the Claim.

Personal Cover as a Warehouse or Comfort Zone for Future Growth

The One Page, One Policy strategy enables the Proprietors to use the Personal Cover as a "warehouse" or
"comfort zone" for future growth in the value of their Equity.

Some of the Cover might start its life as Personal Cover, but might end up as Buy/Sell Cover.

In a sense, a One Policy Strategy recognises that your "Green Cover" can be "Future Blue Cover".

Click here to read more about the dual role of Personal Cover.

No Medical Tests or Underwriting

Because the insurance company sees one Policy for the Total Sum Insured, you might not have to satisfy
medical tests and other underwriting requirements, if all you need to do on a review is "change the mix".

You can avoid most, if not all, of the pain!

Responsibility for Payment of Premium


The fact that Business and Personal Cover might be incorporated within the One Policy and Facility does not
change the underlying responsibility for payment of the Premium.

Normally, the Premium attributable to any Personal Cover will remain directly or indirectly payable by the Life
Insured.

Relationship between Buy/Sell and Debt Reduction Cover

The above analysis highlights the relationship between the Buy/Sell and Personal Cover.

As one type of Cover increases, the other can decrease.

Mathematically, this is an inverse relationship.

However, there is a similar relationship between Buy/Sell and Debt Reduction Cover.

Relationship between Liabilities and Net Asset Value

As the Debt of the Business reduces, the value of the Equity in the Business increases.

This occurs because, in effect, the value of the Equity is a proportionate share of the Net Asset Value of the
Business (i.e., Gross Assets - Liabilities).

Assuming the Gross Asset Value of the Business remains constant, any reduction in the Liabilities will result in an
equivalent increase in the Net Asset Value of the Business.

Aggregation of Buy/Sell and Debt Reduction Cover

The One Policy Strategy allows Proprietors to aggregate Business and Personal Cover.

Whether or not Personal Cover is incorporated onto the One Policy, it makes sense to aggregate Buy/Sell and
Debt Reduction Cover, so that inevitable or predictable increases in the value of the Equity can be funded by re-
purposing the Debt Reduction Cover.

In other words, as the Debts of the Business decrease over time, the Debt Reduction Cover can be re-allocated
to Buy/Sell Cover.

This is particularly relevant to investments in Property where the Debt is being repaid on a Principal and Interest
basis.

Like Personal Cover, Debt Reduction Cover can have a dual role.

Not only does it reduce Debt in the event of a Claim, it can be re-purposed as Buy/Sell Cover as the Debt
reduces and the Net Asset Value of the Business increases.

Example

Click here to see a Risk Analysis Worksheet that demonstrates a typical change in the Asset, Liability and
Personal Needs of a Proprietor over five years.

Please note how increases in the Buy/Sell Cover are funded by first re-purposing the Debt Reduction Cover and
then the Personal Cover.
One Page Summary

Click here to see a one page summary of how a typical Complete Succession Plan works.

Simplifying the Valuation Issue

Click here to see how the One Policy Strategy simplifies issues with respect to the valuation of the Business and
the determination of each Proprietor's Purchase Price.

Misunderstanding the Valuation of the Business

In many cases, Business Proprietors have an inflated view of the value of their Equity in the Business.

This impacts on the expectations of their Spouses and Beneficiaries if they die and can cause disputes with the
Continuing Proprietors.

Their expectations are usually driven by the need for the cash required to fund their living expenses, as well as
any personal debt, alternative venture or investment strategy.

Ultimately, this is a personal need.

However, it affects the value they place on their Equity in the Business.

Two Sources of Income from the Business

While the Life Insured is alive, the income from the Business effectively derives from two sources:

the labour of the Life Insured (their salary); and


the profit attributable to the investment of capital in the Business (their dividend or profit distribution).

When the Life Insured has died or is no longer able to work, they are no longer able to generate income from
their labour.

However, theoretically at least, their capital might still be able to generate a profit (subject to any drop in the
revenue or goodwill of the Business).

Valuation Methodology

Because the Business funds two sources of income, it is understandable that people will try to value the Business
on the basis of the capital value of both sources of income.

However, in most cases, the valuation of the Business (including the goodwill) will not take into account the
amount of the salary received by the Life Insured.

Most valuations assume that the Business will pay market salaries for the labour supplied to the Business, before
its capital value is calculated.

They will assume that, if the work was done by someone else, that person (not the Proprietor) would receive a
market salary for their labour.

In most cases, the valuation will only take into account the recurring profit attributable to the capital investment in
the Business (multiplied by an appropriate "cap rate" or capitalisation ratio to arrive at the capital value of the
goodwill).
As a result, the value of the Life Insured's Equity in the Business will normally compensate the Spouse or
Beneficiary for the capital value of the profit from the Business.

It will not necessarily compensate the Spouse or Beneficiary for the loss of the Life Insured's salary income.

This need would normally be funded by superannuation, other investments or Personal Insurance Proceeds.

Complete Succession Plan

Using the language of the Complete Succession Plan, this means that:

the capital value of the profit will be addressed by the "Asset" (or "Blue") component of the Succession
Plan; and
the capital value of the salary will be addressed by the "Personal" (or "Green") component of the
Succession Plan.

As a result, a Complete Succession Plan allows Proprietors to achieve the appropriate target amount of capital,
as well as enabling them to divide it appropriately between Business and Personal Needs.

Simple Succession Plan

In the absence of a Complete Succession Plan, the Spouse or Beneficiary might expect the valuation of the
Business to compensate them for the loss of income.

In other words, they will expect the Sale Price to take into account both:

the value of the Business based on its profit; and


the loss of salary.

These expectations and valuation issues can lead to significant disputes, a break-down in relationships, loss of
customers, and the loss of capital value.

These disputes can be minimised, if the parties have pre-agreed the Purchase Price of the Equity.

Pre-agreeing the Purchase Price

Click here to read about the ability to avoid valuation disputes by pre-agreeing the Purchase Price.

Implications for Your Retirement Strategy

Many of the issues involved in the design of an Insurance Strategy also arise in the case of a Retirement
Strategy.

Click here to read about how these strategies can be adapted to help design your Retirement Strategy.

The Other Three Issues:

Issue 2: Financial Needs ( "The Three Needs")

Click here.
Issue 3: Insurance Funding (The One Page, One Policy Strategy)

Click here.

Issue 4: Retirement Funding ("Voluntary Events")

The Complete Succession Plan


Issue 2: Financial Needs ( "The Three Needs")

This section focuses on the financial needs that should be addressed in a Complete Succession Plan.

"The Three Needs"

A Complete Succession Plan helps you to identify and prioritise three separate financial needs:

Buy/Sell or Equity Insurance (Asset Needs);

Debt Reduction and Key Person Insurance (Liability Needs); and

Personal or Estate Planning Insurance (Personal Needs).

These needs are relevant to both Insurance and Retirement Strategies.

Asset Needs (Buy/Sell or Equity Insurance)

Click here for an overview.

IGS describes these Needs as "Blue Needs".

Liability Needs (Debt Reduction and Key Person Insurance)

Click here for an overview.

IGS describes these Needs as "Red Needs".

Personal Needs (Personal or Estate Planning Insurance)

Click here for an overview.

IGS describes these Needs as "Green Needs".


The One Page Strategy

The "One Page Strategy" is a convenient method of analysing your financial needs (the "Three Needs") on a
one page Risk Analysis Worksheet.

The One Policy Strategy

Once you have identified your Needs, you can aggregate your Insurance Cover onto One Policy ( the One Policy
Strategy).

The One Page, One Policy Strategy is an alternative to the traditional Multiple Policy Approach.

The One Page, One Policy Strategy

When combined together, IGS describes these Strategies as the "One Page, One Policy Strategy".

Click here for an overview.

The Other Three Issues:

Issue 1: Strategy (The Relationship Between Business and Personal Needs)

Click here.

Issue 3: Insurance Funding (The One Page, One Policy Strategy)

Click here.

Issue 4: Retirement Funding ("Voluntary Events")

The Complete Succession Plan


Issue 3: Insurance Funding (The "One Page, One
Policy Strategy")

This section focuses on how the financial needs identified in your Succession Plan can be addressed in the case
of Insurable Events (such as Death, Disability or Trauma).

The One Page, One Policy Strategy

Your Succession Plan should make it as easy as possible to deal with the diversity of your Business and
Personal Needs.
Because your Needs change over time, the insurance and legal arrangements for your Succession Plan should
also facilitate change.

A Complete Succession Plan achieves these goals by using a One Page, One Policy Strategy.

One Page Summary

Click here to see a One Page Summary of this Strategy applied to a typical scenario.

Two Strategies

As the name suggests, it consists of two separate strategies:

the One Page Strategy; and

the One Policy Strategy.

The One Page, One Policy Strategy is an alternative to the traditional Multiple Policy Approach.

The One Page Strategy

The "One Page Strategy" is a convenient method of analysing your financial needs on a one page Risk Analysis
Worksheet.

The One Policy Strategy

Once you have identified your Needs, you can aggregate your Insurance Cover onto One Policy ( the One Policy
Strategy).

The One Page, One Policy Strategy is an alternative to the traditional Multiple Policy Approach.

The Other Three Issues:

Issue 1: Strategy (The Relationship Between Business and Personal Needs)

Click here.

Issue 2: Financial Needs ( "The Three Needs")

Click here.

Issue 4: Retirement Funding ("Voluntary Events")

The Complete Succession Plan


Issue 4: Retirement Funding (Voluntary Events)
This section focuses on how the financial needs identified in your Succession Plan can be addressed in the case
of Retirement.

Your Retirement Strategy

Many of the issues involved in the design of an Insurance Strategy also arise in the case of a Retirement
Strategy.

However, funding mechanisms other than Insurance are required (e.g. a Bank Loan, Instalments or Vendor
Finance).

Options to Purchase ("Call Options")

The standard provisions in a Shareholders Agreement or Partnership Agreement usually include:

An Option to Purchase the Outgoing Proprietors Equity exercisable by the Purchasers only (a Call
Option); and
A requirement that the Purchase Price be determined by a valuation process.

This gives certainty to the Purchasers, but not to the Vendor.

The Vendor (usually the Deceased Life Insured's Estate) will not know whether a sale will take place or what the
Purchase Price will be, unless and until the Purchasers exercise their Call Option.

Usually, the Purchasers will not exercise their Option unless:

they are prepared to pay the required Purchase Price; and


they can fund the Purchase Price (either personally or by way of bank loan).

The second issue effectively makes the exercise of the Option conditional upon the Purchasers having a funding
mechanism in place.

What if the Purchasers Don't Exercise the Call Option?

It is difficult for the Purchasers to exercise their Option, until they have determined the Purchase Price and
assessed the feasibility of borrowing and paying this amount.

If they don't want to pay the agreed Price or can't afford to borrow or fund it, they would let their Option to
Purchase (or Call Option) lapse or fall over.

The parties would then have to haggle over an alternative arrangement.

A Call Option gives the Purchasers certainty (if they want it), in the sense that it allows the Purchasers to fix or
"cap" the Price they must pay to the Vendors.

However, it doesn't give the Vendors any certainty, until the Purchasers decide to exercise their Option.

In a sense, a Call Option creates a "Ceiling Price" for the Purchasers (i.e., a maximum Price thay can be asked to
pay), but it doesn't create a "Floor Price" for the Vendors (i.e., a minimum Price they will receive).
Put Options

In order to give the Vendors certainty, the parties need a "Put Option".

A Put Option allows the Vendors to require the Purchasers to purchase the Equity for a Pre-agreed Price and
on pre-agreed payment terms.

In effect, a "Put Option" is the reverse of a "Call Option".

IGS is reluctant to document a Put Option, unless there is a pre-agreed Funding Mechanism in place.

If a Purchaser commits to buy the Equity regardless of whether there is a Funding Mechanism in place, then
effectively they are taking on a contractual obligation to pay the Purchase Price, regardless of whether they can
ultimately obtain or borrow sufficient funds.

If they cannot obtain or borrow the funds, then they could be sued for breach of contract.

"Put and Call Options"

A Call Option does not necessarily result in a Sale and Purchase of the Equity.

It needs the Purchasers to exercise their Call Option.

They will only exercise their Option, if they have a satisfactory Funding Mechanism.

However, it is possible to design a more binding Succession Plan (from the Vendor's point of view), if there is a:

Pre-agreed Purchase Price; and


Pre-agreed Funding Mechanism (such as Vendor Finance).

The pre-agreement of the Price and the Funding Mechanism means that:

there is no uncertainty about the amount of the Price; and


the Purchasers have a Funding Mechanism (other than borrowing from a Bank) that takes into account
their ability to pay the Price out of the cash flow of the Business over time.

This strategy takes away the uncertainty with respect to funding that is a reason for many Call Options not being
exercised.

If this Strategy is acceptable to all of the parties, it is possible to structure a Succession Plan that consists of a
combination of:

a Put Option that would be exercisable by the Vendor; and


a Call Option that would be exercisable by the Purchasers.

The exercise of an Option by either party would trigger a Sale for the Pre-agreed Sale Price on the pre-agreed
Vendor Finance terms.

The use of a combination of Put and Call Options is common in the context of Insured Events, in which case the
Insurance Proceeds will provide the Funding Mechanism.

However, the same concept can be extended to Retirement, provided there is an acceptable Funding Mechanism
for the Purchase Price.

The Agreement can provide that the Purchase Price be paid by way of:
Bank Loan; and/or
Instalments or Vendor Finance.

Pre-Agreement of the Purchase Price

When designing a Retirement Strategy, it is helpful to estimate or pre-agree the Purchase Price of the Retirees
Equity.

This makes it easier to formulate funding strategies for the Pre-agreed Purchase Price now (when there is less
emotion involved).

For example, if the value of the Equity might be $400,000 at the time of Retirement, the Proprietors can examine
the cash-flow implications of:

a future Bank Loan; or


Vendor Finance.

Bank Loan or Finance

One option is to fund the whole or a part of the Purchase Price with a loan from a Bank.

However, the parties should not lightly assume that Bank Finance would be available at the time of the Un-
funded Event.

For example, Bank Finance might not be practical if the Bank was likely to question the amount of the Pre-agreed
Purchase Price or the ability of the Purchasers to service the Loan at the time of the Un-funded Event.

If this is possible, then the parties should consider Vendor Finance.

Bank Loan Funds Upfront Instalment

IGS often drafts Vendor Finance Provisions that require an upfront Instalment to be paid to the Vendor.

It would normally be expected that the Purchasers could fund this Instalment out of their existing resources or by
way of Bank Loan.

In these circumstances, it would be necessary to disclose the Vendor Finance arrangements to the Bank in order
to obtain approval of the Bank Loan.

Vendor Finance Provisions

Vendor Finance is designed to allow the Purchase Price to be paid over time.

The aim of Vendor Finance Provisions is to determine a timeframe that is:

short enough from the Vendor's point of view; and


sufficiently long from the Purchasers' point of view to enable them to fund the Purchase Price out of the
cash flow of the Business.

If the Pre-agreed Sale Price is $400,000, then the parties need to determine whether the Price will be funded by:
a combination of an upfront payment and instalments; or
just instalments.

Upfront Payment and Instalments

The Vendor Finance Provisions could provide that the Purchase Price of $400,000 will be paid in:

one upfront payment of $200,000 (funded by a Bank Loan); and


four annual instalments of $50,000 per annum (plus interest).

Once these arrangements are formulated (at least tentatively), the Purchasers can examine the commercial and
cash flow implications of taking out significant Loans or Liabilities shortly before their own Retirement (see
below).

Where part of the Price is funded by a Bank Loan, the Purchasers would need to fund both:

the principal and interest payments owing to the Bank; and


the instalments and interest owing to the Vendors.

Instalments

The Vendor Finance Provisions could provide that the Purchase Price of $400,000 will be paid in:

four annual instalments of $100,000 per annum (plus interest); or


eight annual instalments of $50,000 per annum (plus interest).

How Many Instalments?

The number and amount of the instalments should take into account both:

the need of the Vendors; and


the cash flow of the Purchasers.

The decision will usually be a balancing act between the interests of the different parties.

However, it is a lot easier to resolve these issues when they are abstract than when someone is actually ready to
retire.

At the time of retirement:

one party is wearing a Vendor's hat and wants to reduce the timeframe for payment; and
the others are wearing a Purchaser's hat and want to increase the timeframe fro payment.

Your Purchasers' Own Retirement Strategy

It might not be wise for the Continuing Proprietors or Purchasers to assume these Liabilities to a Bank or the
Vendor, unless they have considered the implications for their own Retirement Strategy (including the identity of
the Purchaser for their own Equity).

Ability to Repay Bank Loan and Vendor Finance Before Own Retirement

After the Retirement of the first Proprietor, the Purchasers will presumably:

own 100% of the Equity in the Business; and


reduce the Bank Loan and Principal owing under the Vendor Finance arrangements over time.
However, if there are any outstanding Liabilities at the time fo their own Retirement, the Purchasers will need to
repay them out of the Sale Proceeds of their own Equity when they retire.

Therefore, it is desirable that the Purchasers be able to identify a likely Purchaser (another Proprietor or, in the
absence of a Proprietor, potentially an Employee or a Third Party) who will be able to pay the required Purchase
Price at the time.

This issue is particularly relevant to Businesses where there are only two Proprietors or the Proprietors are of
similar ages (and wish to retire at similar times).

Selling the Whole of the Business to a Third Party

If the Continuing Proprietors cant identify a likely Purchaser for their Equity before or at the time of their own
Retirement, there is a risk that the Continuing Proprietors might not be able to sell their own Equity and discharge
the Liabilities.

This might make a Vendor Finance strategy impractical.

If so, the desire of one Proprietor to retire might force all of the current Proprietors to consider the feasibility of
selling the whole of the Business to a Third Party.

This might involve bringing forward a potential sale to the time of the first Proprietors Retirement.

This would mean that the Continuing Proprietors would not have to fund the Purchase Price.

The Purchase Price would be funded by the Third Party Purchasers.

This would allow the market to determine the value of the Business.

All of the Proprietors would share in the market value proportionately to their Equity.

Under this arrangement, the Continuing Proprietors would avoid the risk that they might assume a large Liability,
but not be able to repay it at the time of their own Retirement.

Whether the Business is sold to the Continuing Proprietors or a Third Party , the proposed Succession Plan can
be pre-agreed and documented now.

The Valuation Process

A Business can "switch off" the pre-agreement provision in the standard Agreement, if it would prefer a valuation
process at the time of a Retirement.

If the Purchase Price is not pre-agreed, care needs to be taken in the design of a Vendor Finance strategy,
because the ultimate Purchase Price might be higher than the amount used for the purposes of any cash-flow
analysis.

Fact Finder

Please click the following link to see the Un-Funded Purchase Price Item of the Complete Succession Fact
Finder that has been completed for a Retirement Strategy:

Un-Funded Purchase Price Worksheet (Item 7).