Is your business protected?
02 October 2017
The impact of a key individual passing or being unable to work for a period of time can have a huge impact on a business. Zurich's Richard Smith discusses the ways you can protect your business against these risks.
IT’S YOUR BUSINESS
Business protection – whether for your business or your clients’ businesses – can keep the company afloat and aid succession planning, writes Richard Smith
Of the estimated 5.5 million businesses in the UK, government statistics suggest that there are just over 3.6 million active registered companies. This figure includes 7,000 public limited companies and 55,000 limited liability partnerships, the rest being private limited companies.
The balance is made up of individuals running business that don’t need to be registered such as partnerships, sole traders and the self-employed.
Whilst business models are set up in different ways for different reasons, one common theme is that very few have protected themselves against the loss of a key individual, or put in place a business succession plan to ensure business continuity on the death of an owner.
The perception amongst business owners is that it is too expensive, even although it is possible to put cover in place for most businesses for as little as 1% of gross profit.
The table below shows the likelihood one person in a group of individuals dying before reaching age 65. If we take a typical business owned equally by four people with an average age of 40, there is a one in three chance that one of them won’t survive to age 65.
But, of course, death is not the most likely occurrence. It is far more likely that an individual will be unable to work for a period of time due to a temporary disability or a critical illness. You could argue that temporary illness or disability is worse for the business than death as there are so many uncertainties, but any of these events could create issues and pose questions for the business.
Will the individual need to be replaced? How much will it cost and how long will it take? Will profitability be affected and for how long? Are there any business debts that would need to be repaid? Who will inherit their shares and what will they want to do with them? Do the surviving business owners have the means to purchase the shares or will they end up in the hands of a competitor? All of these questions are best faced head on whilst the business is trading and the owners are in good health.
PROTECTING THE BUSINESS
Ensuring the business survives the loss of a key individual means providing cash for a replacement, cover for loss of profit and the repayment of business debt.
When protecting the business, it is important to be as accurate as possible when calculating the sum assured. Try to ascertain the actual impact on profit of the loss of the key person. Always try to use gross profit rather than net profit. If we lose a key individual, it’s turnover and gross profit that will be affected first and foremost. For some this will be possible, a top salesperson for example, but for others this will be more difficult and an educated guess may be required.
When considering replacement costs, don’t just think of the salary. What other costs may be involved in replacing a key individual quickly? This could include recruitment costs, relocation costs, training or a ‘golden hello’, for example.
There are many different types of business liabilities, the most common being bank loans and directors’ loan accounts. The bank may insist on a policy to repay the debt on the death of an owner.
In fact, if it’s already been done through the lender, it may be worth reviewing as many lenders have been single tied and only able to offer the policies of one provider.
Generally, the debt would be apportioned equally amongst the key individuals so that on the death of one individual, a proportion of the debt is repaid. However, it’s not out of the question that the lender has asked for all the debt to be repaid on the death of any key person.
Directors’ loan accounts are increasing in both number and size. With lending criteria still relatively harsh, more and more business owners are lending their own money to the business. What is not commonly known is that these debts become repayable on demand to the estate of the deceased director. If the company doesn’t have the means to repay it may have to attempt to borrow, at a time when it’s just lost a key individual.
PROTECTING THE BUSINESS OWNERS
It is equally important to ensure that the surviving owners keep control of the business and the family of the deceased are compensated fairly.
A limited company requires both a memorandum of association and articles of association. The memorandum is the document that sets up the company and the articles set out how the company is run. Often these are basic documents that don’t go any further than is legally required and have never been reviewed.
However, some businesses have taken the opportunity to put a “company will” in place. This is commonly known as a shareholder agreement and sets out, amongst other things, what will happen in the event that a shareholder leaves the business, whether through death, incapacity or retirement.
This can help us to ensure that we set the succession plan up in the correct way to reflect the wishes of the business owners.
It is important that the agreement does not imply a contractual obligation for the sale and purchase of the shares. Ideally, there should be options for the sale and purchase of the shares as this is one of the conditions that will help to retain business property relief, an important consideration which keeps the value of the shares outside of the estate for inheritance tax purposes.
The scheme is likely to be set up in one of two ways, and there is a subtle difference between the two methods: company share purchase where the company buys back the shares of a deceased shareholder, or shares of a deceased shareholder being purchased by the surviving shareholders.
The first will be set up with policies owned by the company. On the death of a shareholder the company uses the proceeds to buy back the shares and then cancels them. The end result is that there are fewer shares in existence, but they are each worth more. This can be quite a complicated process and legal advice will be required as HMRC approval is needed for company repurchase where the value of shares being repurchased is more than £15,000.
The second method is set up with policies owned by the shareholders and written into a business trust for the benefit of the surviving shareholders. On the death of a shareholder the survivors buy the shares of the deceased. The result here is that the shares are still priced the same, but the survivors own more of them. The good news is that no HMRC approval is required, although legal advice should still be taken.
Maybe now is the time is start thinking about your business clients. In fact, why not start by thinking about your own business? Have you got a company will? Have you considered how your business might be affected by the death of an owner or a key individual?
Richard Smith is a protection specialist at Zurich
PROBABILITY OF ONE PERSON DYING BEFORE 65