Many successful private businesses are owned and managed by a limited number of partners. Sometimes these partners are family members or life-long friends. Other times the business partnerships formed after trusted working relationships were fostered. But I’ve noticed a dangerous trend in these types of businesses.
It seems many closely-held, privately owned businesses do not have formal agreements in place to protect the business owners from unforeseen circumstances that could dramatically impact them and their families. A high degree of personal trust and loyalty, handshake agreements, seem to suffice between partners. I believe this is a mistake. I’d like to share my perspectives with you.
The five reasons
Here are the five reasons that business partners need formal agreements:
- You never know what life will throw at you.
- A significant portion of your net worth is likely tied up in your business ownership.
- Your family needs protection and so do your business partner’s loved ones.
- Your business needs the assurance of strong leadership no matter what may come.
- Formal contingency plans help business partners clarify their vision for the future.
Before we look at each of these in more detail, let me say for the record that I know many people are uncomfortable with having these discussions and drafting formal agreements. Between some business partners, it can even be seen as a sign of disloyalty.
But I think if you handle this process the right way, with all due respect for everyone’s point of view and a willingness to listen, partnerships are actually strengthened. This process should result in partners having greater peace of mind that their interests and their family’s need for income are secure. This allows you to focus on your business instead of being distracted by unspoken concerns.
Reason 1 – You never know what life will throw at you
Over the years I’ve had the privilege of working with many successful business owners. Most of these individuals have been part of a business where they share equity with someone they respect and admire. Often times the owners have a close relationship with a partner’s family members that has been built over many years.
When I review their financial plan with them, it is always striking to me how much of their personal net worth they have tied to their business. But that is a risk that most business owners are willing to take. They feel empowered to take this risk because they are making the decisions about the business.
Business owners are skilled at launching a new product, entering new markets, expanding production and the like. However, very few business owners give a second thought to how their business and families would be impacted if something unforeseen happened to them or their partners. When I probe a little deeper with them about their business relationships, I see lights begin to turn on. I ask these types of questions:
- What would it mean for you if tomorrow you were in business with your partner’s spouse? What about your partner’s children?
- If you were to pass away suddenly, what would happen to the equity in your business? Could it be extracted to support your family? What impact would this have on your business partner and his or her family?
- What if your business partner decides to retire soon and wants to sell their share of equity in the business? Do you have a say about who buys equity in your business?
- What would happen to your family if you were disabled and could no longer perform your functions for the business? What would happen if your partners did not have the cash on-hand to buy-out your equity?
The reason I ask these questions is because these are all scenarios that I know about where business owners were caught off-guard and unprepared to deal with the unintended consequences. My point is this – you never know what life will throw at you. Having a formal contingency plan will help to ensure that your business and families are protected. This is particularly important in light of my second reason.
Reason 2 – A significant portion of your net worth is likely tied up in your business ownership
When I meet with business owners and review their net worth, almost invariably a large percentage of their wealth is tied up in the equity of their companies. This may not come as a surprise to you, but let me paint a scenario that I do think will be surprising.
Let’s say you are an affluent business owner who has been wise with investments, tax mitigation and retirement vehicles. For 20 years you have faithfully contributed to tax-deferred retirement accounts and saved and invested. This has allowed you to build a nice nest-egg of $2 million.
However, you are also one of two business partners in a company that is valued at $10 million. Your minority ownership interest of forty percent is valued at $4 million. In other words, your business is worth twice as much as your portfolio.
Let’s also assume that any one of the scenarios I’ve outlined above occurs unexpectedly to you. This means that sixty six percent of your net worth is now on shaky ground. Suddenly all of that control you thought you had over your future, the very reason you were willing to take a risk, seems more like an illusion.
Reason 3 – Your family needs protection and so do your business partner’s loved ones
You may not be aware of this, but there are several common-sense measures that can be put in place to make your family and your business partners’ loved ones much more secure. For instance, if your business partner were to unexpectedly pass away, you would probably feel a significant obligation to provide for his or her family.
But what if you did not have the cash on-hand to buy-out your partner’s equity and provide a lump sum to his or her loved ones? What would you do? Would you try to liquidate your business in a fire-sale? What would this mean to your net worth?
With the right purchase agreements and insurance products in place, this becomes far less of a concern. With the proper planning in place, the partner’s family can be taken care of, while allowing the remaining owners to focus on running the business.
Reason 4 – Your business needs the assurance of strong leadership no matter what may come
Passionate entrepreneurs who love what they do usually hate to talk about succession planning. But it is inevitable. There are only two types of succession plans: those that are anticipated and those that are a surprise. Either way, you and your partners will not own your business forever.
This is why it’s so important to put a plan in place now for leadership, decision-rights and who gets to set the strategic vision for the business. This matters for two very important reasons.
First, the transfer of leadership responsibility is a key driver in liquidity events. Business owners typically sign earn-out agreements that span from twelve to thirty six months wherein they help ensure a smooth transition to new company leaders. Leadership transitioning could have a big impact on how much wealth you realize from the business sale. Put the right plan in place and you’ll realize a better outcome.
Second, there are scenarios in which it makes sense to separate decision-rights from ownership. For instance, if a minority-share partner loses a majority-share partner to death, and the majority-share partner’s child, a recent college graduate, wants to take over the business, what happens next?
If the recent college graduate is not experienced enough to run the business but insists on doing so, what recourse does the minority-share partner have? This becomes particularly significant if the minority-share holders’ net worth is heavily weighted in the business.
Reason 5 – Formal contingency plans help business partners clarify their vision for the future
When I start asking questions of my clients regarding these issues, I tend to see a common response. Their eyes open wide and I can see their wheels turning. Suddenly they are thinking about things that are outside the everyday events of running a business.
We all get so busy with our lives, families and work that we often don’t think about the impact of events that may be outside of our control. But these conversations help my clients think clearly about what they want in the future and what it will take to get there.
There is no doubt that these conversations can be difficult and uncomfortable to have with your business partners. But if the questions and the process are handled the right way, with the right advisors providing guidance, the end result should be peace of mind and a higher degree of protection for partners and their families. If you or someone you care about needs to have these discussions, let’s talk.
The information contained in this article is provided for informational purposes only. No illustration or content in it should be construed as a substitute for informed professional tax, legal, and/or financial advice.