What happens when a business owner dies?
Life as a business owner can be stressful at the best of times. But if you think owning a business is tough, figuring out what happens when a business owner dies (or leaves suddenly) can be an absolute nightmare.
The death or permanent disability of a partner or business owner can result in chaos for other business owners, business associates and the family. It can often threaten the core survival of the business itself.
Did you know that fewer than 30% of small business owners have a succession plan in place?
That’s a shocking statistic – but it makes complete sense when you consider that most businesses are started informally between two or more people.
Often the partners are so busy growing the business that they don’t have the time or money to put anything formal in place. And when they do, they often form a company or a partnership with the prime focus around shareholding or equity.
Thinking about death at the start of a business venture is the last thing on their mind.
Short Term Fixes and Potential Issues
When a business owner dies or becomes permanently disabled, the remaining owner(s) need to figure out ways the business can continue with the least disruption possible. Some of the options include:
- Recruit a qualified replacement
Hiring a candidate with similar skills can quickly fill a void. Keep in mind that the person will not have the business knowledge or personal relationships that the previous owner had. The remaining owners will need to factor in time to bring the new person up to speed, and they may need to take over the management of client relationships for the key accounts.
They cannot expect the new person to match the 100% efficiency of the previous owner. It is a good idea to consider applying the 80/20 rule where they get the new candidate to work on the 20% of the business that will provide 80% of the benefit.
- Train an existing employee to do the job
Existing employees will often understand how the business works, and will already have relationships with many of the existing clients. If the job is not too technical, consider training the employee to fill the void. Once again, concentrate on the things that will have the greatest positive impact on the business. Paying Bonuses can often motivate staff to step up into the new role.
- Offer shares to existing employees
While most employees will be unable to take up this type of offer, your most senior employees may be in a position to help. The added benefit is that the employee is more invested into the business and will want to see it succeed.
- Contract work out to a qualified competitor
In most cases this will not be a practical option. This should only be considered if the remaining owners are able to isolate the work into client or contract lots, without exposing big parts of the business. This option is especially helpful if there are non-performance clauses, and the competitor can guarantee completion on time.
The remaining owners may want to consider implementing a confidentiality agreement. However, even with a confidentiality agreement in place, they need to be prepared for the competitor to gain knowledge about the business that can be used against them in the future. More often than not, this means working with competitors is untenable.
- Borrow to fund a reduction in cashflow
A short-term reduction in cashflow is almost inevitable. Borrowing funds can help them get over the temporary shortfall. They should only consider this option if they are sure the business can return to its previous income levels, and that it can service its loans in the meantime. If they are unable to service the loan, they may be forced into liquidation, and if they are considering closing down the business anyway, they don’t want to be adding further debts into the company accounts. The bank will require additional security, and may require new personal guarantees.
If they are really desperate, they can consider “factoring” the debtors ledger. This will give them a short term cash boost – but will result in significantly reduced cash-flow in the months that follow.
Remember that “trading while insolvent” is an offense that will make them personally liable for company debts. If they think this is a possibility, they should get advice from an accountant as soon as possible.
- Sell assets to fund a reduction in cash-flow
Have a look around the business to see if there are surplus assets that can be sold to inject cash into the business. They need to be assets that don' need replacing in the immediate future. The assets will not realize their full value, and may not be easy to sell. If it is necessary to replace an asset shortly after it has been sold, this is merely delaying the cash-flow problems (and actually making it worse in the long run)
What happens to the business?
When a business owner dies without a plan, the business structure can often dictate the outcome.
- Sole Proprietorship :
In a Sole Proprietorship, the business and the owner are essentially the same thing. If the owner of the business dies, it is almost certain that the business will too. The business assets will become part of the owner's estate, and will be liquidated to pay off any business debts. If there is anything left, it will be distributed according to the persons will (if they had one – but that’s another story)
In some cases the business can be transferred or sold to another person. This needs to be handled within the owner's last will and testament. While the business itself may not be worth much without the owner, the business may contain significant good will (eg key customers) that can realize a value if it is sold to a competitor. Not only does this help the family of the deceased owner – but it can help the owner's of the old businesses to move forward.
There may be cases where a family member can step in and continue the business. In a sole proprietorship, this presents its own set of problems.
Because the business forms part of the owner's estate, it is normally distributed as part of the will. If there is no will in place, then the distribution follows a predetermined formula that doesn’t automatically allow the entire business to be passed to one person. Depending on the country and state/city the owner lives in, the rules may vary slightly. But as a rule of thumb, the spouse or defacto partner will receive 50% of the estate and the remaining 50% will be split evenly between any children.
If the family can reach agreement, it may be possible to pass the business to one member of the family – but it may be challenged in a court of law. For this reason, it is a good idea to have the business accurately valued to stop any future arguments about unfair/preferential distribution under the will. It will also be necessary to get the business valued if the tax department requires an estate tax return to be completed.
- Corporation or Limited Liability Company :
The value of a Corporation or Company lies in its shareholding. Because a Corporation is its own legal entity, a Corporation will survive the death of one of its owners.
When one of the owner's (shareholders) dies, the shares will normally become part of owner's estate and will be handled within the provisions of their will. If the owner holds the majority of the shares, or is a sole owner, the new owner of the business will be the estate.
- LLC :
LLCs have their own operating agreement which normally includes a provision that explains what happens if a member dies.
If the agreement allows the LLC to continue after the death of a member, new members can be admitted in their place. If the agreement doesn’t have a continuity clause, the local laws will determine what happens.
In most cases, this will involve the winding up of the LLC and the distribution of assets.
- Partnerships :
If a formal agreement is in place, there may be provisions for sale or purchase of a deceased partner's interest.
Without the existence of a formal partnership agreement, the death of a partner will automatically dissolve the partnership.
This can cause significant problems for the remaining partner. It is their responsibility to wind up the business. They will have to run the business to complete any unfinished contracts, not take on any new business, pay off debts and distribute whatever is left. If there is not enough left at the end of this process, it is the surviving partner and the deceased estate's responsibility (liability) to pay for any shortfall.
Even if the remaining partner can continue to run the business in their own right, it cannot be continued under the existing partnership. The process of winding up a partnership can cause substantial damage to the finances and goodwill of the business. It can also take considerable time to sort out. Obtaining a probate to a deceased partner's estate can take months and can significantly slow down the process.
If a partnership agreement is in place, provision can be made for payment to a dependent spouse/partner shortly after death. The amount is normally discretionary and determined by the surviving business partner. It can be offset against the deceased share of the partnership and means that dependent spouse or partner can receive income before the estate of the deceased person completes probate.
Winding up a business or partnership can take a long time. Two or three years is not unusual. Delays can be caused by the need to prepare financial accounts as-at the date of the partner's death, subsequent payment of creditors and winding up the actual business.
You may have options
If you are in a position where you don’t have to dissolve the business and the business can continue without the previous owner, you have several choices available to you:
- Take the deceased representative or heir into the business :
This option can tend to be problematic, especially if the representative or heir is not as passionate, experienced, or willing to negotiate as your partner was.
Before heading down this path, ask yourself if they will support or oppose the decision of the remaining shareholders. Are they only in it for the cash/dividend payments? Will they be willing to put in the time and effort to support the business? Do they have the skills and technical knowledge to carry out the responsibilities and duties of the previous owner? If they are not going to put in the same effort as the previous partner, are they going to be negotiable on the current distribution of dividends and/or remuneration? What if the heir or representative is a minor and unable to enter into binding contracts? Do they have the resources to support the business if additional capital is required?
- Sell out to the deceased Owner’s representatives or heirs :
Unfortunately, this option can lead to a lot of arguing over the purchase price. This may also not be practical if the proposed new owner is not qualified to operate the business, or the remaining owners are not prepared to retire or remain as business employees.
Before heading down this path, ask yourself how you will determine the price. Often the best solution is to get the business valued. However, this costs money and can take considerable time and expertise to come up with a realistic value. The other problem is that a valuer may not fully appreciate the good will included in the business and the emotional value the business has to the remaining partners. They may not be ready to retire yet, and this has some bearing on the value of the business. It also depends if the business is in financial distress and its ability to continue trading without the previous owner.
Once a price has been determined, there is also the question of payment terms and the ability to be released from any business debts and personal guarantees.
- Bring in outsiders to purchase the deceased owners share :
Sometimes new partners can be a good thing. The problems with this option are very similar to selling out to the deceased owner's representatives or heirs. The advantage with this option is that you can select someone who can add real value to the business or has domain experience (eg marketing, technical etc)
Unfortunately there may not be a pool of willing buyers, and you may have to discount the price, or offer equity in exchange for work. The instant injection of expertise to replace the missing owner will often justify this sacrifice.
Another issue you may face is that outsiders may not be interested if the result is a minority share. You may have to give up more of the business to attract the right talent – and this may put you in a position where you lose control of the business anyway.
- Buy out the deceased Owner’s interest :
Often, this is the best choice. However you will still have to negotiate price and settlement terms, and you will need to come up with the money to fund the agreed price. This is where a buy-sell arrangement can help. Without a buy-sell agreement, and without any other purchasers, the parties may feel that they are paying too much or receiving less than they deserve. Strained negotiations and legal delays may make it difficult to reach a mutually acceptable position. Additional difficulties can occur if the deceased or disabled owner has given a Personal Guarantee on a lease or business loan.
- Liquidate the business or sell to a third party :
Unless the parties can agree on another option, this alternative may be forced on them. Unfortunately a business that is forced to liquidate or is in distress has a much lower value than when it is a going concern. Finding a way to run the business in the short term will often result in a greater return – providing there is a pool of willing purchasers. However, if the business is in a specialist niche, finding a buyer may be a real problem and you may be forced to liquidate the business.
Dragging the process out is also not a good idea. If the sale or liquidation is delayed there may not be sufficient cash to pay all debts. This may result in the forced sale of personal assets to meet personal guarantees.
A buy-sell agreement
A buy-sell agreement is a legally binding contract that spells out exactly what is to happen if one of the business owners dies or becomes permanently disabled. A buy-sell agreement is also referred to as a business continuation agreement, a stock purchase agreement, or a buyout agreement. Buy-sell agreements can also be triggered by retirement, divorce, bankruptcy of an owner, conviction for a crime or loss of a professional license required to work in the business.
The document can be as simple or complex as needed and can provide for virtually any contingency. In most cases it states that the survivors will buy the deceased owners share of the business. It will also include an objective formula to work out a value or an actual purchase price.
The agreement is put together well before it is needed and when the owners are on a level playing field. It provides a fair way to arrive at a value, and allows the surviving partner(s) to keep control of the business.
Raising the money and payment terms
A buy-sell agreement normally documents a method to fund the purchase of the business when it is needed. If the buyer does not have the cash or access to cash when needed for the buyout, the agreement won’t serve any useful purpose.
Common ways of funding a buyout include Key-person Insurance, Life Insurance policies held in trust for the other business owners, Debtor factoring or Bank Loans. When an owner is retiring, the agreement may also include options to fund the buyout from future revenues with extended payment terms.
What can you do now?
No matter what, have a plan!
We can't stress this enough. Take the time to sit down with your business partners or family to discuss a succession plan, and then PUT IT IN WRITING. It is definitely important to decide who will take over a business, but it’s just as important to decide how they will take over – and what that means to the rest of your business partners and family, both financially and emotionally.
For when you are sick or disabled :
Consider getting “Key Person” insurance for each of the owners. If you are a sole trader, you need to look into “Business Expense” insurance and “Total Permanent Disability” insurance. Key Person cover will pay a business an agreed monthly benefit for a set period if a key person is disabled because of a continuing sickness or injury. A key person is anyone in the business responsible for generating business income.
For when one of the owners dies :
Consider getting life insurance held in trust for each of the other owners. Life insurance provides a lump sum payment to help minimize the financial impact on your business if you or a key team member dies or is diagnosed with a terminal illness.
Prepare a Buy-Sell agreement :
Unless you plan to be lucky forever, you’d better have one. Without it, a closely held or family business faces considerable financial and tax problems on an owner’s death, incapacity, divorce, bankruptcy, sale or retirement.
The cost of a buy-sell agreement is tiny compared to its benefits. A buy-sell agreement can ward off infighting by family members, co-owners and spouses, keep the business afloat so it's goodwill and customer base remain intact, and avoid liquidity problems that often arise on these major events.
Put the business in a trust :
A trust can be a particularly good option for family-run businesses, offering tax advantages and flexibility in the way profits are distributed to beneficiaries. They also provide a legal entity that does not die.
A trading trust can survive the death a traditional business owner. But trusts can have their drawbacks as well. As with any major decision, professional advice is paramount in deciding if a trust is right for your business.
WishesKept has an entire section devoted to business continuity.
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Provisions have been made for recording account details and supplier/client instructions.
The information is highly encrypted and can only be shared if you become incapacitated or are no longer here.