Imagine you died last night. Don't think about how, just think you're dead!
Now what happens? What will happen to your family? What will happen to your business? What VALUE will be placed on your business?
In many instances, we treat the value of a business as just a number, which is estimated by the amount of income the business generates. However, we don't probe into this number to understand the assumptions that are used for its determination.
A key component that needs to be understood is how dependent the business is on the owner. An examination of this will have a direct and significant bearing on the value of the business. We have all heard the term goodwill; however, do we really understand what it means?
Goodwill can be defined as the difference between the capitalized earnings value of a business and the value of its net assets. There are a number of factors that attribute to a company's goodwill. The physical location of a business may result in a competitive advantage and, therefore, increased earnings as compared to the same business in a different location. The products or services a business sells may have created a positive reputation or identity in the minds of its customers, which leads them to purchase products and services from this business instead of from your competitors.
Certain contracts or licenses held by your business may give it a competitive advantage and greater earnings than a competitor. Employees also add value to the business by the skills they bring to work each day. Most of us would agree that without people a business would not exist. However, not all employees of a business are critical to its success. In many owner-managed businesses, the key individual is the owner-manager. While some people may have great advice for keeping business PR and reputation solid when the owner-manager is alive, it's also important to consider what happens to the business when the owner-manager is no longer involved in the business. A key question is: "Could the business survive the death, permanent disability or retirement of the owner?" Many businesses are inseparable from their owners. If one of the proceeding events occurred without proper planning, then the business would fail.
Let's look at what could happen. You have owned a building materials store for 17 years. You died last night. This morning, your spouse calls one of the employees to inform them what happened. The employee's first thought is what about their jobs - this will affect their lives and income they bring to their household. They may lose confidence in the ability of the successor to continue the business and will look for employment elsewhere; customers may lose confidence that the business will be a steady source of supply; suppliers may lose confidence in the company's ability to pay; and financial institutions may believe that their loans are in jeopardy.
Alternatively, the business may be so well organized that someone else could perform the owner's duties and responsibilities without any serious loss. However, there are two different aspects to the added value that people can bring to a business: personal goodwill and individual goodwill. It is important to understand the difference -
Personal goodwill has been described as the unique advantage an individual enjoys because of his or her particular abilities, good name and/or reputation. These advantages are not transferable by contract or otherwise. Personal goodwill ends when the individual who provides them is no longer involved in the business. Since personal goodwill is not transferable, no commercial value can be attached.
On the other hand, individual goodwill accrues to a business because of an individual's abilities, business contacts, good name and reputation. It could, or would, be harmful to the economic well being of the business if you can't substitute other people to fill the role. In an open market context, it is non-competition agreements that often result in individual goodwill having commercial value.
For example, if the business owner were absent and someone else could step into his or her shoes and maintain the relations with the customers, then the goodwill is individual goodwill and would therefore have value as long as there is some assurance that the current owner will not compete with the new owner.
The opportunities to be gained by understanding the nature of the goodwill can be identified under different objectives that a business owner may have:
Quite often a business owner is asked to provide personal guarantees to the bank or leasing companies. The death or permanent disability may cause a business crisis due to lack of management strength. The crisis could result in a default on loans or leases. This, in turn, could cause the estate or disabled owner to be required to pay the principal amount to the lender under the personal guarantees. Therefore, where evaluating the dependence of the business on the owner, an assessment must be made of the risk that the owner's estate would be required to meet any personal guarantees. Steps can then be taken to protect against those risks with life or disability insurance. Alternatively, other capital can be set aside to pay the liability. If the business is very dependent on the owner, then insurance policies and investments that are meant to provide for the family should be owned outside the business, which will reduce the risk that these would not be available to the family when the funds are needed.
If the plan is for the business to continue, then steps need to be taken to reduce its dependence on the owner. This will maximize the value of the business by minimizing the individual goodwill and maximizing the personal goodwill. As well, it will allow for an orderly succession for family or employees. Until dependence is reduced, there is a risk that the business will fail in the event of a sudden loss of the owner. In that case, insurance can be used to provide cash to the business to allow it to meet the obligations to suppliers and employees as they fall due. If the dependence on the owner is not too great, this may allow the business to continue until new management can be put in place.
Most business owners have plans in place for the event of their death or retirement. The owner may decide that the business should be liquidated on death and wish to ensure that an orderly liquidation takes place. The owner may want customers' outstanding orders filled, suppliers paid and any long-term employees paid salary due, plus some severance for their years of loyal service. This can be achieved by insuring the owner's life for an amount that would meet the estimated obligations.
On retirement, however, the owner may want a son or daughter to take over the business. Even if this occurs, the dependence issue still exists. Now, the concern is how dependent the business is on the successor. If the business it very dependent on him or her and the parent has a significant investment remaining in the business by the way of loan or shares, then the parent's investment is at risk. If the successor were to die or be permanently disabled, the business could fail and the parent would be unable to recover all of the investment. This remaining parental investment may represent the retirement capital and/or equalization payment to other children. Therefore, it may be of value to provide for the buy-out of the parent's remaining investment through life or disability insurance taken out on the successor it is unlikely that someone who has been retired for many years will want to take over a business in crisis.
Recent changes in the insurance industry have limited the ability of life insurance proceeds to flow through the capital dividend account to reduce a tax liability. However, all is not lost. If a surviving spouse inherits the shares on a rollover, these can be redeemed with the resulting taxable dividend reduced to the extent there is a balance in the capital dividend account and an election is made. Also, the tax changes allow for a grandfathering of some current arrangements. Finally, if all else fails, the life insurance proceeds can be used to actually pay the tax liability.
Remember, people don't plan to fail, they fail to plan!
CLU, CPCA, CFP