Contingency planning is a critical, yet often neglected aspect of protecting a business. This process addresses what will happen to a business owner’s equity and their family in the event of death, disability, divorce or departure, which can be voluntary or involuntary. These events are also known as the four Ds.
A contingency plan serves as a roadmap for co-owners, managers, owner’s spouses, dependents and legal counsel in the event that one of the four Ds is triggered. The goal is to leave little ambiguity of an owner’s intentions for the business when he or she is not present. The plan should address everything from short-term continuity planning in the event of a demise, to topics such as eventual equity transfer, continued management involvement and transfer of ownership to appropriate personnel.
Adequate contingency planning will also alleviate a lot of the panic that might arise when an owner departs in difficult circumstances. It can provide a means of addressing continuity at an emotional time, and it gives the management team direction as to how to move forward. It can also serve as a guide when the business owner leaves in voluntary situations.
Neglecting to thoroughly prepare for the unexpected exposes companies and individual owners to the risks of financial losses, legal conflicts or even business failure.
The recommended method of planning varies depending on the size and ownership structure of a company.
Single-Owner Companies. Companies with single owners will often use a letter of intention, which can address several scenarios in the event the owner leaves the business, such as who will be the next CEO, who will address certain business relationships and who may be offered an opportunity to acquire the company. This is critical because, as involuntary departure from the business leaves an owner vulnerable, a letter of intention protects both management and the owner’s family.
Multi-Owner Companies. A buy-sell agreement is most often used in companies with multiple owners. The agreement will delineate management succession, direct remaining management on buying back shares from deceased or departing owners and outline financial support for an owner’s family. The document is particularly important in the event of a sudden death, when the departed owner(s) can’t explain intentions or assist with transition. If properly written, the agreement can provide guidance for a company’s management team on how to proceed without one of the primary individuals in the business.
Small-Sized Companies. For most small-sized companies, the business is the sole source of wealth and income for the owner. The owner should carefully consider what will happen if they unexpectedly die or are unable to work due to illness or injury. What measures are in place to support themselves and their family? What measures are in place to cover things like increased medical bills? A contingency plan should account for all such considerations.
Mid-Sized Companies. As companies get larger, valuation and funding become more critical components of contingency planning. Consider, if a primary shareholder dies unexpectedly, the remaining owners will need to purchase the shares of the deceased. The lack of a clearly defined valuation formula may create disagreement about the value of the deceased’s shares leading to conflict among remaining owners and the family of the deceased. Valuation terms such as “fair value” or “fair market value” in a buy-sell agreement can have significant effects on the amount the departing shareholder will receive. Some of the key elements for this difference are valuation discounts, which should be addressed in the document. Ensure that these documents have little ambiguity. Additionally, remaining shareholders must prepare for funding the purchase of the deceased owner’s shares. If a company has to pay for the owner’s shares through working capital, it becomes a burden on the business. Life insurance policies are a great tool to manage this process, assuming the shareholders are insurable. Companies can consider life insurance or disability buyout insurance.
Large Businesses. For large businesses, the buy-sell agreement is all about valuation, taxes and funding. A lot of the fundamentals are the same for larger companies as with smaller companies. There are just bigger dollars. A key area for the buy-sell agreement in larger companies is outlining how the triggering of the agreement will affect the other owners. How will the buy-sell handle majority shareholders versus minority shareholders?
Developing and Maintaining a Contingency Plan
Owners should also consider when to update the contingency plan, which key stakeholders to include in the process and how to determine the readiness of the plan. Some tips include:
Update the Document Regularly: A contingency plan—whether in the form of a buy-sell agreement or a letter of intent—is a living, breathing document. It should be updated (at the very least) whenever there are any significant changes in operations, ownership or lifestyle. Consider putting the buy-sell agreement on the agenda of each and every executive meeting to ensure the owners and managers have amble opportunity to review it on the record.
Plan for Management Succession: A business owner commonly manages everything from banking to purchasing to customer interactions. The departure of an owner, particularly an unexpected departure, can create major problems for the business if remaining leadership is unable to quickly step in and take over. If, for example, the departing owner has had the sole relationship with customers, their departure could lead to a significant devaluation of the company—and customers could start to find other sources of business.
Involve family members when necessary: Spousal involvement is critical in situations where a business is the sole income for a family. Spouses (and other family members) should be made aware of contingency plans in the event of one of the four Ds, as they are bound by the results of either the letter of intent or the buy-sell agreement. This participation is particularly important for minority shareholders, where the value of the stock does not compensate families for loss of income. Therefore, it is important to have a solid commitment to the buy-sell to eliminate any future surprises or potential conflicts like litigation.
Test the Contingency Plan: Simulate the departure and practice implementation of the contingency plan. How will the exit be funded? What is the payout? Who takes over the respective responsibilities that are left unfilled? Are there options within the agreement that provide for better tax advantages? Tests the flow and organization of the prospective document and then modify and make updates.
Ultimately, the whole management team must have a sense of what could happen in reality, should a worst-case scenario occur.
This article originally appeared in “An Owner’s Guide to Exit & Succession Planning: A Complete Introduction with Case Studies from the Glass Industry,” from Glass Magazine, glassmagazine.com, and the National Glass Association, glass.org. It is reprinted with permission.
