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SUCCESSION PLANNING
ECF
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F I R S T
N A T I O N A L
NATIONAL OFFICE DISTRIBUTION LIST P R I N C I P A L ( S )
89 Hoddle Street Richmond VIC 3121 Phone : 1800 032 332 Fax : 1800 832 332 marketing@firstnational.com.au www.fngateway.com.au
S A L E S
P R O P E R T Y M A N A G E M E N T
O T H E R
30
S U C C E S S I O N
P L A N N I N G
Are you thinking of selling your business in the next five years? If you are, now is the time to start planning in order to maximise your return. A majority of First National members are aged over 50 years. The majority of these members are also looking to sell their business in the next five years. If you are looking to sell your business, this booklet will help you prepare yourself and your business for that sale. There is no one size fits all approach that will work for everyone because every situation is different. We cannot give you a simple answer, however, the following pages will provide you with some guiding principles to help you manage your succession. Michael McDonald from mdp McDonald Partners is a succession planning expert. He knows what he is talking about because he has lived through it. Located at the back of the booklet is a DVD of Michael McDonald talking about the key principles of succession planning. This DVD will help you to understand some of the challenges facing you and your business as you plan for your succession.
S U C C E S S I O N
CONTENTS
P L A N N I N G
Introduction
1
WHY DO I NEED A SUCCESSION PLAN?
2
LEGAL ASPECTS OF SUCCESSION PLANNING
4
What do we mean by human issues?
6
WHAT YOU WANT AND NEED NOW
7
KEY PEOPLE IN YOUR BUSINESS
12
TIMING IS EVERYTHING
17
KEEP YOUR EYE ON THE BALL
19
REVIEW YOUR CURRENT AGREEMENTS
21
ARE WE THERE YET?
22
WHO ARE MDP?
23
WHY DOES YOUR BUSINESS STRUCTURE MATTER?
24
COMPARISON OF STRUCTURES
29
1 S U C C E S S I O N
P L A N N I N G
Introduction
Succession planning is an individual and personal process that prepares you for the transition of ownership and/or management from one person, group or generation to the next. Every business has a different set of circumstances – the number of partners, location, competition, industry niche, business structure, economic factors and the personalities and aspirations of the owners, their staff and families, all have an impact on how to approach this challenge. Given these variables, it is virtually impossible to prescribe a specific step-by-step approach to succession planning that will work for every business owner. What is presented here is a series of general principles that will assist you to develop your own personal business succession plan. As most business owners will only deal with this issue once in their business life, it helps to obtain some assistance from professionals who deal with these issues regularly.
What is succession planning? Succession planning is an ongoing process of recruitment, retention and regeneration. It is not simply an exit strategy.
Succession Events Succession events are those things that will trigger a change of ownership and/or management of the business. You cannot prevent these events from occurring, but you can prepare to deal with their consequences. There are two types of succession events: •
Involuntary events such as death or injury; and
•
Voluntary events - any other form of departure from the business.
Insurance will help you cope with the involuntary events; however, the vast majority of succession events are voluntary.
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P L A N N I N G
Why do I need a succession plan?
•
I am contemplating sale of the business or retirement
•
I’m not sure who will buy my business
•
I’m not sure what my business is worth
•
I’m not sure if my insurance is adequate
•
I’m not sure if my business structure will effectively minimise the amount of tax I pay when I sell
•
I’m not sure if my business structure effectively protects my personal assets if we are sued
•
I want to take a holiday but I’m worried about how this will affect my business
If any of these statements sound like you, you’re not alone - but you do need some help with succession planning. You need a succession plan because it will have an impact on the value of your business. A business with a succession plan is inherently more valuable than a business without one. If you can walk away from your business for three months with the confidence that your absence will not harm the business, then the goodwill that prospective purchasers are paying for when they buy your business has real value. However, if your business falls apart when you are not there, prospective purchasers will have legitimate concerns about the actual value of the goodwill that they are purchasing. The more time you put into planning your succession the better the outcome. That is, the transition will be smoother and you will receive more in return for your share of the business. The paradox for real estate businesses is that the value of the business is determined by the least profitable aspect of the business. That is, most of the profit is in sales, whereas the value is primarily determined by a function of the rent roll. This is curious because your business may, at the same time, be at its most profitable but not its most valuable. Increasing the rent roll is one way to increase the value of the business, however, most real estate agents are natural salespeople and would prefer to increase sales than rent roll.
3 S U C C E S S I O N
P L A N N I N G
Case study
Throughout this booklet, THREE case studies will be used to demonstrate the way various succession planning principles apply in different scenarios.
CASE STUDY 1 - BOB
Bob is from Bendigo and he is a sole proprietor. He is 54 years old and has one son, Bert, who works in the business as a sales consultant. Bob is married to Brenda. Bob has no Will and no Power of Attorney and, because he is a sole proprietor, does not have a shareholders’ agreement.
CASE STUDY 2 - NEVILLE
Neville, aged 55, is from Newcastle. He is married to Nelly but they have no children. He is in partnership with Nick and he thinks Nick is a bit dodgy. Neville holds his house in his name, not Nelly’s. Nick holds his assets in a family trust. Neville has a partnership agreement but no buy/sell agreement. The business has employment agreements and Neville has a Will and an enduring financial power of attorney. Neville is also contemplating an employee share ownership plan, whereby he sells small amounts of his business, say 2% each, to 4 key employees to act as an incentive for them to stay with him and increase profits.
CASE STUDY 3 - PAULA
Paula is from Perth. She is in business with three other partners - Peter, Pip and Patrick. The business is a partnership of trusts and each of these trusts has a corporate trustee. Paula is 48 years old and interested in expanding the business to take advantage of Perth’s hot property market. However, she is concerned that some of her older partners are not similarly inclined. Paula and her partners have a shareholders’ agreement, a buy/sell agreement and employment agreements. All partners have wills and powers of attorney and they have an active employee share ownership plan.
4 S U C C E S S I O N
P L A N N I N G
Legal aspects of succession planning
The human aspects of your business dictate the content of any legal agreements, not vice versa. This means that while you can purchase a shareholders or buy/sell agreement or Will pro forma from the internet, this will not, of itself, form the basis of a succession plan. You must do the groundwork of analysing the human issues within your business and seek professional assistance to develop the documents to reflect your circumstances. The initial steps in developing your succession plan need to focus on understanding the emotional and human consequences of a partner leaving the business because of death, disability, retirement or any other reason. However, you will also need a legal framework to deal with the ownership of the business and the financial consequences of any succession event. Legal documents such as shareholder agreements and buy/sell agreements will form part of the legal framework that will help you to deal with the consequences of succession events. A shareholders’ agreement is signed by the existing partners and deals with the operational rules and issues - that is, how the business is governed on a day-to-day basis by the current partners. This can help you to cope with some of the legal consequences of a succession event but it will not adequately prepare you for the human consequences. Relationships with clients may suffer or breakdown if you lose a key person. This could put the entire business at risk. You can and must plan for this possibility. A buy/sell agreement prescribes the process to be followed when a current partner or director exits the business either voluntarily or as a result of an involuntary event such as death or disability. Examples of the issues that may be covered in a buy/sell agreement include whether there is a compulsory notice period prior to departing to allow the remaining directors to find a successor for the departing director. The agreement would also outline the consequences if a departing director fails to give sufficient notice and this could include providing the remaining shareholders with a discount when purchasing the departing director’s shares or giving them a longer period in which to pay. Other elements of the legal frame work include: • • • • • •
Sale and purchase agreements for newcomers Employment agreements Trust deeds Wills Powers of Attorney Employee share ownership plan (if required)
The importance of Wills and Powers of Attorney cannot be underestimated. Your business may be literally paralysed if you are unable to sign documents because, for example, you are in a coma. An enduring power of attorney gives your nominated representative the power to sign documents and make legally binding decisions if you are unable to do so. A poorly drafted Will or a poor choice of executors can also paralyse your business after you have departed if it creates a dispute amongst your beneficiaries. All States in Australia have legislation that enables the Court to make an order that provision be made out of the estate of a deceased person for the proper maintenance and support of a person for whom the deceased had responsibility to make provision. That is, your Will may be open to challenge if you don’t look after people you should look after. Challenges to your Will can tear families apart and see much of your estate spent on legal fees. One way to avoid this is to sell or distribute some of your assets in your lifetime, particularly your business assets. You owe it to your family and any current business partners to make sure that your affairs are in order in case of an unforeseen incident.
5 S U C C E S S I O N
P L A N N I N G
CASE STUDY
CASE STUDY 1 - BOB
Bob is hoping to transition his son, Bert, into the business as a part owner. Bert’s wife Betty is concerned that they do not have sufficient financial security to buy into the business. Bob wants to give Bert 10% of the business, to enable him to earn a sufficient share of the profits in order to buy the next 10% of the business. There is a problem for Bob. As a sole proprietor he cannot sell part of the business. He needs to restructure. Another looming problem is that Brenda and Betty are arguing. Brenda thinks that Betty is a gold digger only after her son’s money.
CASE STUDY 2 - NEVILLE
Neville has identified a problem. Nick has broken the law and its looks like the business will be sued. Nick has been suspended; therefore Neville is running the entire business himself. Nick and Neville have never trained anyone else to manage the business and this is creating tremendous problems for Neville, because he is always tied up with work. He faces the financial pressures of having to wear the consequences of Nick’s mistake. His marriage is shaky because he is never home.
CASE STUDY 3 - PAULA
Pip wants to retire. As a group, Paula and her business partners will ease Pip out via a part time arrangement and ease a new employee into the business to take Pip’s place. The remaining directors want to purchase Pip’s shares as she departs. Paula thinks this is the wrong move because now would be a good time to bring in someone younger as a partner and spread their risk. Two of the key staff who had bought 2% of the business through the employee share ownership plan had performed really well and were ready to buy into the business. However, their buy/sell agreement is an off-the-shelf contract and it gives existing directors the first option to purchase departing director’s shares.
6 S U C C E S S I O N
P L A N N I N G
What do we mean by human issues?
The human issues are the what, who, when, and how of succession planning. Discussing the human issues means deciding what your plans are and what you need to achieve those plans. You need to ask yourself the following questions: •
what do you and your spouse want and need now;
•
what do you want and need in the next phase of your life, which may or may not be retirement;
•
what do you want the business to look like when you leave;
•
who are the key people in your business;
•
who is a potential successor;
•
with whom you would like to work;
•
when can that person enter into an equity position;
•
when do you or your partners wish to leave or retire; and
•
how do we manage the process and implement change.
These questions cannot be answered quickly and simply but having a trained professional facilitate a meeting between the key individuals can help you to work your way through the possibilities. Until you address these issues, you are wasting time and money by developing a legal agreement to document the process.
7 S U C C E S S I O N
P L A N N I N G
What you want and need now The best place to begin is to identify and articulate your personal aspirations and your business aspirations. You need to give serious thought to the lifestyle you are currently enjoying and the anticipated lifestyle in your next business or your retirement. It is generally recommended that you bring in a new partner gradually to provide some time for adjustment. You may need to adjust to reduced dividends from the business. If, for example, you sold 40% of your business to one of your existing sales staff, and if that person did not increase the profit of the business and you relied on profit rather than salary, you and your family may be faced with a 40% reduction in income. What’s more, if you are funding part of your lifestyle from the business in a manner that does not strictly adhere to the best accounting practices, this will more than likely stop once you bring in a new partner. You need to consider how much money you need now and how much you want to put into superannuation. You should aim to contribute the maximum possible to superannuation while this is a tax effective means to save money. You should consult a financial planner to obtain professional advice tailored to your needs. Understanding your financial situation and identifying what you need now and what you will need in the future will form the first plank of your succession planning strategy. Transition Unless you can find someone to purchase the entire business in one fell swoop, there will a transition from one owner to the next and this process needs to be managed. Given that real estate agents are generally sociable people, relationships are the cornerstone of the business. Therefore, the importance of establishing and managing the transitional phase cannot be underestimated. The transitional phase is where the principal gives the successor the best opportunity to build their own reputation and harness the goodwill that the outgoing principal has developed by building relationships with the departing partner’s contacts. To do this in the principal’s presence is the ideal handover. This allows the principals to ease out of the business and gradually adjust to a new way of life. This is especially important where the change of lifestyle is entering retirement. If you can grow the business in the transition phase you will also be better off because you will be able to maximise your superannuation contributions and take advantage of your capital growth once you are ready to sell the remainder of your share.
8 S U C C E S S I O N
P L A N N I N G
CASE STUDY
CASE STUDY 1 - BOB
Bob seeks legal and financial advice. He restructures his business and runs it through a unit trust. He gives Bert 10% of the units. This enables Bob to bring Bert into an equity position, while simultaneously giving his son some security through increased earnings and reduced liability for the debt. Bob and Bert enter into a sales contract whereby Bert can buy the next 10% provided he and the business meet some targeted and well thought out Key Performance Indicators (KPIs). Bert will pay Bob a fair market rate for the second 10% of the business according to a formula in the contract, which enables Bob to put this money into his superannuation in a tax-effective manner. Brenda’s squabbling with Betty is putting pressure on Betty and Bert’s marriage which was already a little shaky.
CASE STUDY 2 - NEVILLE
Nick and Neville are in strife. The value and profitability of the business are diminishing, because Neville cannot sufficiently service his existing clientele, and the stress of Nick’s suspension and departure has reduced his professional effectiveness. Furthermore, if the partnership loses their fight in court, both Nick and Neville stand to lose all assets held in their names. Neville and Nelly may lose their house because of Nick’s mistake. Nick is at fault but he will not lose his house. If Neville had put his house in Nelly’s name they would have kept the house. If they had a buy/sell agreement (or if their partnership agreement contained buy/sell provisions) this could have outlined a process to follow to give Neville the option of buying Nick’s share of the business once Nick was suspended. Neville tries to use Nick’s employment agreement to force him out but the agreement is silent on the matter, having just been copied from an example on the internet.
CASE STUDY 3 - PAULA
Paula is in the process of trying to convince Peter and Patrick to bring in a new partner. Patrick suddenly dies. The remaining directors look at the buy/sell agreement, which requires the remaining directors to use an insurance payout to buy Patrick’s shares from his wife. Unfortunately, Patrick was 59 and an overweight smoker and was virtually uninsurable. The agreement does not specify what to do if the insurance is inadequate or non-existent. Paula speaks to a lawyer who advises that a good agreement would have made provision for the remaining partners to buy Patrick’s shares over an extended period of time.
9 S U C C E S S I O N
P L A N N I N G
What you want and need in the next phase of your life (which may, or may not, be retirement) It is crucial to the succession planning process that you make informed decisions about the next phase of your life. If you intend to retire, you need to ensure that you have sufficient funds to enjoy the lifestyle in retirement that you deserve. If you intend to retire, the most tax effective way to realise the equity you hold in your business is via superannuation. If you intend to move into a different business, then there will be different tax consequences involved in this decision, depending on your current business structure. There are a range of Capital Gains Tax (CGT) discounts available to small business holders that you may be able to take advantage of, depending on your circumstances. You should seek the advice of a qualified accountant or financial planner in order to ensure that you obtain the maximum benefit from the sale of your business and invest the proceeds in the most effective way to suit your lifestyle. When you do retire or leave the business, it is not always a matter of resigning ‘cold turkey’. As mentioned above, there is great benefit to be had from a gradual transition out of the business. For a start, the continuity helps the incoming partner and enables them to see real value in the goodwill of the business. Secondly, it enables the principals to gradually adjust to a different lifestyle where work is not the primary consideration.
10 S U C C E S S I O N
P L A N N I N G
What you want the business to look like when you leave ‘What the business will look like when you leave’ is about looking at every facet of the business. It includes the corporate structure, number of partners, profitability, the mix of services provided, the staff and their age and sex, the premises and more. The simplest aspect of this, in terms of your departure, is how much the business will be worth. The benefit of looking forward to what you expect the business to look like when you retire or leave is that you can then begin to put in place a plan to move the business towards that goal. In determining your end point, and how to get there, the primary considerations will be money and lifestyle. Once you have determined how much money you need to enjoy your chosen lifestyle in retirement, or your next venture, you will be able to anticipate how much you need to recoup from the business in order to finance and fund the next stage of your life. This will determine whether the business needs to grow to meet that expectation, and the business plan should reflect this. If you require substantial and dramatic growth from the business, you will need to consider whether your health and family situation will tolerate rapid growth and the strains it may place on you personally. You will also need to consider whether you have the right staff, business structure and premises to cope with growing the business. Growing the business by incrementally increasing sales and expanding your rent roll is one way to increase funding for your retirement. Other options include merging with another business or acquiring another business. Each option comes with its own pitfalls and rewards. You will be in the best position to gauge what will be the best option for you. Whether you choose to grow organically, merge or change the business in other ways, you will still need to consider whether you have the right staff, business structure and premises to cope with the change. There are so many variables involved in this process it is difficult to give specific recommendations. However, if you are planning for retirement and hoping to use the sale of your business to fund this, we recommend that you seek professional financial planning advice to ensure that your plans are realistic.
11 S U C C E S S I O N
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CASE STUDY
CASE STUDY 1 - BOB
Bob and Bert need to expand the business so that by the time Bob retires, he will have been paid a large amount of money for his share in the business. Bert will be able to afford to buy Bob out because he will be increasing his own earnings through his equity share. Just as things are going well, Bob has an accident and ends up in a coma. Bob forgot to finalise his enduring financial power of attorney and the business goes backwards because the cheques need to be signed by both Bob and Bert. If Brenda had been able to sign for him, the business would have continued to thrive. Brenda is now worried that if Bob dies, Betty will take part of Bert’s inheritance. A well drafted Will could have allayed this fear. Bob and Bert never signed a partnership agreement so there is no clear path to follow in the event of either death or divorce. Family businesses need legal agreements too, just like any other business.
CASE STUDY 2 - NEVILLE
Neville is losing business as the news gets out about Nick’s legal problems. Staff at the agency decide to take jobs with Neville’s rival. Two of the sales people say they would have stayed if they had some equity in the business. Neville tries to sell but the assets of the agency are frozen pending resolution of the law suit. Everything is unravelling, both personally and professionally and Neville can’t believe how easily it can all fall apart.
CASE STUDY 3 - PAULA
Patrick was the best salesman in the agency and all the clients loved him but his clients barely knew the rest of the sales team. Pip does most of the office management and no-one else has the skills or experience to manage the staff. Paula is devastated. They thought they were so well prepared. They had all the agreements that they were told to have but they had not trained anyone to fill Pip’s shoes and Patrick never introduced his clients to the rest of the team. They had some legal documents but no human plan. The legal documents did not work without an understanding of their circumstances.
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KEY PEOPLE IN YOUR BUSINESS
Who are the key people in your business? The real estate industry is very much driven by personality and relationships. It is important to recognise who, in your current business, is crucial to the survival of the business and gain an understanding of the relationships they have with clients and suppliers. The purpose behind identifying key people in your business is to identify a plan for their replacement in the short term or long term. For example, you may have a sales or management person who is the popular face of the business or who carries a lot of the business’ corporate memory or ‘know how’, that is, information that is not or cannot be written down. You need to find ways for them to share their knowledge with others and introduce key clients and providers to other staff members. The aim is that when key staff leave the business, either involuntarily or voluntarily, their understanding of the business and the relationships that they have established that are crucial to the business will not be lost. When you identify who is critical to the survival of the business then you may wish to contemplate giving them the opportunity of purchasing a small amount of equity in the business (for example two or three percent, with no voting rights). By allowing key staff to purchase equity you will create an environment that will help you to keep them working with you. This will also serve to act as an incentive for improved and increased performance because it will provide a profit sharing arrangement for these key staff. The crucial aspect here is not to gift the equity. It must be purchased by the individual. This sends a message that it is something that is a reward for hard work and is not to be taken lightly.
13 S U C C E S S I O N
P L A N N I N G
Who is a potential successor? As the proprietor of the business, in most cases, you will know your market better than anybody else and you will be able to identify the type of person who has the skills to succeed you as a partner in the business. One means by which to gain additional insight into an individual’s capacity to deal with the responsibility of equity is to give an internal candidate a taste of that responsibility and opportunity. The retention of key staff can be achieved with an employee share ownership program or scheme. Such a program allows key employees to purchase small amounts of equity and potentially gives them a seat on the board. You may or may not wish to allocate voting rights to those shares. This enables you to identify whether they have the capacity to think strategically about the business and whether they appreciate the extent of the opportunity available to them. The following diagram shows how a share ownership model for a small business can be used to retain key staff and identify and reward potential future equity partners:
Your Business Pty Ltd is wholly owned by you and your spouse
Your Business P/L 100% owned by you and your spouse through your Family Trust
Your Family Trust
Mr You
Mrs You
Voting Shares for Potential Future Owners
Your Business P/L 80% owned by you and your spouse through your family trust
20% owned by A and B
Your Family Trust
Mr You
Mrs You
Mr A - 10% Voting Shares
Allowing key staff to buy 20% of the business enables them to share in profits while you retain 80% of the ownership and control of the business
Ms B - 10%
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Key Staff Buy Small Non-Voting Shares
Your Business P/L
Mr You
Your Family Trust
70% owned by you and your spouse through your Family Trust
Mrs You
20% owned by A and B
Mr A - 10% Voting Shares
10% owned by key staff
C
D
Ms B - 10%
E
F
G
H
Non-voting shares. No-one holds more than 2%
Key staff (C, D, E, F, G and H) are given small holdings for retention, motivation and education. These staff shares have no voting rights so control still rests with you. You can ensure that you retain first option to purchase shares held by employees and this will eliminate the risk of an unwanted third party buying in. While staff may come and go, equity partnership is critical. The real estate industry is full of sales people who come and go, however, equity must be treated differently. Bringing in a new partner can have a revitalising effect on your business if you choose the right person. It is crucial that you devote time and thought to selecting suitable equity partners.
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P L A N N I N G
Choosing the right person begins with identifying the skill sets required. When identifying prospective future partners you need to consider: (a) (b) (c) (d)
the skills required their age their financial capacity their compatibility, both personally and culturally
(a) Skills The usual skills required in real estate are: 1. 2. 3. 4.
sales and marketing skills management ability or potential to develop management ability personal integrity strategic thinking
People with these skills may be working within your current business or they may be working for another business. You can bring these skills and people into your business by recruitment, merger or acquisition.
(b) Age There is no right or wrong age for a prospective partner - the key to succession is to have a good spread of ages. That is, you do not want to be top heavy and have four directors at 58 years of age who will all retire at the same time. There will probably be some similarity in the ages of your partners because it is unlikely that a 21 year old will have sufficient skills, finances or experience to immediately step in as a director or equity holder in your company. This is not to say they could not do it, it just appears unlikely. A spread of ages is something to consider when identifying prospective future partners because it reduces the chances of multiple succession events occurring at or about the same time. It may also help with staff and customer relations.
(c) Financial capacity Financial capacity is a factor to consider when determining who is a potential successor. This is not to say that only the wealthy should be potential successors, however it is a factor because someone who clearly cannot afford to borrow the necessary money to buy into the business is not a likely candidate for succession. There may be people who are willing to take larger risks than others and to a certain extent a person’s financial capacity is related to their risk profile. It is, in some ways, desirable to have someone who can only just afford to buy into the business because it means that the success of the business is critical to their own success.
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(d) Cultural and personal compatibility The importance of cultural and personal compatibility is often underestimated. A business partnership is a relationship and it is unwise to go into business with someone for purely financial reasons. You do not need to be best friends but you do need to have a good working relationship. Life is too short to have business partners you do not get along with. The following section expands on this theme. With whom would YOU like to work? You and your potential business partner/s need to understand each other’s personalities and cultures. You need to understand how each partner copes with stress and deals with conflict. You need to know what each other believes is a ‘fair day’s pay for a fair day’s work’. You should understand each other’s risk profiles, for example, how much debt or risk a person will tolerate. You do not need to be the same, in fact many argue that difference is valuable and can be complementary but you do need to think about how this will impact on your ability to make joint decisions that will affect the business. While it is not essential, it is also important in small business that the partners’ spouses get along. If the spouses get along and if everyone can see a shared future, then they will be prepared to make some sacrifices for the sake of the business. The issue of sacrifice is important for proprietors in any business, however, it is even more important in real estate because so much work is done during traditional family time such as after normal business hours or on weekends. The spouse and the family need to accept and embrace this because it will affect the business partners’ relationship. These factors are also critical if you are contemplating a merger or acquisition. Many mergers have failed due to cultural and personality differences.
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TIMING IS EVERYTHING
When should prospective partners enter into an equity position? The means by which you intend to sell and the date at which you begin the transition is related to your business plan, your ability to identify future equity partners and their ability and capacity to purchase equity. As mentioned previously, profit in real estate is made primarily from sales, however capital growth comes from expanding the rent roll. This is not to say that the two are not connected. Sales growth will feed into an expanding rent roll, thus you can increase profit and capital value concurrently. It is important to leave something behind for your successor or a prospective purchaser as it makes the notion of purchasing or succeeding in the business a more appealing proposition. That is, they will be able to share in the growth rather than purchasing a fully mature business that is not likely to experience further growth. This means that your succession plan must run in parallel with your business plan. While it is ideal for the retiring partner to exit the business at the highest possible value, it may be wise to bring in a partner at an earlier stage to share the growth. The new partner can then utilise the growth and their increased earning power to enable them to build sufficient wealth and assets against which to borrow in order to purchase a greater share of the business. Hence, the general tip in relation to timing is to bring in a new partner while the business still has a capacity for growth. Ideally, your new partner will drive much of that growth. This increases their capacity to purchase more equity, increases your profits and superannuation contributions and ultimately increases the value of your equity. It sounds easy, but it can be tricky if you leave it too late. In order to give a new partner the capacity to purchase their initial stake, you may need to offer a discount or an option to purchase more at the current valuation. Principals often need an immediate injection of funds to put into their superannuation fund and enjoy the growth of the fund, however, the timing and the method are very much dictated by the individual circumstances. When you or your partners expect to leave or retire When you leave the business will be determined by a range of issues - some will be within your control, others will not. In determining when you will pass your business onto the next generation or when you begin that transition, the starting point is to look at your objective. You may have determined earlier that you would pursue a merger, a sale or recruitment of a future partner. There are, however, other factors to be considered such as your age and health. Retirement is one of the most common forms of voluntary departure from any business. While people once retired automatically at 65, the times have changed and many people are deciding to work for longer, or if they can afford to do so, retire sooner. You may be able to retain a passive shareholding in the business into your retirement, however, you will have to accept that those working in the business will need higher salaries to compensate for a share of profits going to a passive partner. If you do not reward those working in and growing the business in some way, they will quickly leave.
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How to manage the process and implement change Before you can address the management and implementation of change you need to determine the type of succession contemplated. For example, will you be undergoing: (a) (b) (c) (d)
merger? acquisition? recruitment of a new partner? sale of the entire business or part of the business (immediately or on vendors terms)?
These factors will determine the range of skills that your business needs. In some ways, this is similar to an audit. That is, you should identify the following: • • •
The types of skills you currently have Other things that make your business successful Which of these skills or attributes will the business lose upon your departure?
From there you can identify which of these skills or other attributes need replacing. If you want the business to grow, you may look through your business plan and identify which skills you need in order for that growth to occur. There are different ways of acquiring these skills. As you can see from the list above a merger, acquisition or recruitment are some of the means by which you can bring additional skills into the business. Alternatively, you can train existing staff members or place them in a position of sufficient responsibility to help them develop these skills. Brand Equity Most real estate agency businesses are not huge corporations. While brand names are important, the individual principal’s role is still significant. It is, therefore, generally in your interest to have a prospective purchaser who comes from within the business or to provide a new partner with an opportunity to work within the business to make the transition from one high profile person to the next. This is particularly the case where the business is called John Smith Real Estate. When John Smith departs, will the name become a liability for the new partner? Does its continued success depend on John Smith’s presence? If you are in this position, you may wish to consider beginning to remove your personal name from the business’ brand. This does not need to happen overnight and, if it is managed carefully, it will not have an impact on your business. For example, Latrobe First National (VIC) took the plunge and removed Graeme Yalden’s name from the business name and the results show that the business continued to grow. Michael McDonald from law firm mdp McDonald Partners has taken the first step as part of a gradual change. The firm was previously known as ‘McDonald and Associates’, then changed its name to mdp McDonald Partners. Once clients become familiar with the ‘mdp’ component of ‘mdp McDonald Partners’, the brand will be simply changed to “mdp” to remove the focus from Michael McDonald. In conjunction with other strategies, this will reduce the business’ reliance on the principal partner. Maintenance of your brand is crucial in succession. Your brand is your reputation. Your brand is how other people perceive you and your business. As you have built your business you have built equity in your brand. A smooth succession process will not only ensure that you can realise your equity in the brand, it may even result in the enhancement of your brand.
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KEEP YOUR EYE ON THE BALL Keep your licence up to date Losing your real estate licence is often overlooked as a risk to your business, but we all know that it can be easy to take your eye off continuing professional development (CPD) when you are busy. While licence requirements and CPD requirements vary from State to State, the industry is unlikely to become less regulated in future. This means you need to be aware of issues that affect compliance with your licence and make sure that your business does not suffer from an embarrassing lapse.
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STRUCTURE AND TAX Your structure will affect your ability to maximise your return on exit. This is something that most people do only once in their life, therefore, it makes sense to get the assistance of a professional who has been through this process before. It is never too late to restructure your business in a tax effective way. The primary consideration in succession planning for most business owners is Capital Gains Tax (CGT). Put simply, by operating through a trust or partnership will ensure you receive CGT discounts on assets you have held for more than 12 months. Companies are generally not eligible for CGT discounts. Structuring is not simply about a tax effective exit, it is also about the ability or capacity to attract future partners to your business. That is, you want to be able to give them something to buy. This can be problematic if your business interests are held in certain structures. For example, using a discretionary trust, the beneficiaries (or objects) of that trust have no enforceable right to a distribution, they only have an expectation. Whether beneficiaries obtain anything is at the discretion of the trustee(s). If you want to sell part of your business, this is not an ideal structure for an incoming partner to buy into because they have no right to a dividend or share of profit. A company is a simpler structure for succession because it is easy for incoming partners to buy shares in the company. However, this may not be appealing for an incoming partner because the company’s liabilities will remain in existence. An alternative is to sell the assets of the business rather than shares in the company. However, the problem with this scenario is the company is generally not eligible for CGT discounts upon sale of those assets. A further consideration in structuring is asset protection. The following are common causes of legal action in the real estate industry: • • • • • •
breach of s52 of the Trade Practices Act 1974 breach of the Estate Agents Act 1980 (Vic) or its equivalent in other states copyright infringement misquoting insolvent trading negligence
Bear in mind these causes of action do not necessarily have to come as a result of something you have done as an individual but may be a consequence of your staff or business partner having triggered them. The consequences of these events will vary according to your structure. For example, assuming one of your partners is sued for negligence and you are in an unincorporated entity such as a partnership, the assets of all partners will be exposed and you will be both jointly and severally liable for the damages. Jointly and severally means that partners are liable for all the debts of the partnership, both as individuals and as a group The ideal structure for CGT purposes may not be the ideal structure for attracting new partners or for asset protection. It is a matter of striking the right balance for you and your family and partners in your individual circumstances. You should seek the assistance of a professional advisor.
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REVIEW YOUR CURRENT AGREEMENTS
Are my legal agreements adequate? If you have a shareholders’ agreement, it may be inadequate if it does not deal with every eventuality. The following list of questions will give you some idea as to whether your shareholders’ agreement is adequate: 1. Is each partner expected to contribute capital in equal proportions? What are the consequences if one partner cannot contribute? 2. What happens if directors/partners want to borrow money from the business? 3. Is there a process to deal with acquisitions? 4. How do you deal with decisions about the entry of a new partner? Do the majority decide or do you need unanimity? 5. Does your agreement provide for a mechanism to manage major decisions (such as the sale of the entire business to a third party or large borrowings)? Should those decisions be made unanimously or by simple majority? 6. When a new partner comes in, are the existing partners expected to sell down in equal proportions?
Some common issues in buy/sell agreements are as follows: 1. Are there any pre-emptive rights? For example, do the existing partners have the first option to purchase a departing director’s share of the business? 2. Are the remaining directors able to acquire the departing director’s shares in equal proportions or proportional to their current shareholding? 3. Is there a compulsory retirement age? 4. Is there a pre-agreed value for the business? 5. Is the value to be determined by agreement or an independent valuer? 6. Is there a notice period enabling the remaining directors to find a successor for a departing director? And what happens if a departing director does not give sufficient notice? 7. Does the agreement impose compulsory insurance? 8. Does the agreement require directors to upgrade their insurance to match the value of the business? 9. Who owns the insurance and is it effective in terms of capital gains tax consequences? 10. Does your agreement allow a current partner’s spouse to vote in the event that the partner is absent or if they die or become permanently disabled?
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ARE WE THERE YET?”
What happens next? You will be able to achieve the best result and will be on the way to a smooth transition if the items in the following checklist apply to you: Checklist •
I have discussed my personal and business plans with my spouse and business partners.
•
I have made sure that my personal plans and business plans do not conflict.
•
I have identified who my key staff are and put in place strategies to retain them.
•
I know what my business is worth.
•
I know my insurance is held in the right name.
•
I know that my business structure effectively protects my personal assets if we are sued.
•
I know that my business structure will effectively minimise my tax when I sell.
•
I know who could be a potential successor and who could buy my business (or my share of the business).
•
I know legal agreements and documents are needed to provide a frame work for my overall succession plan.
After considering this, call your solicitor or mdp McDonald Partners who are experts in succession planning.
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WHO ARE MDP?
Michael McDonald is the principal partner in mdp McDonald Partners, a boutique law firm that specialises in succession planning, commercial law and intellectual property. mdp McDonald Partners helps clients all over Australia and New Zealand with their succession planning issues. The firm has substantial experience in helping people navigate through the complex series of arrangements, plans and structuring issues that will be part of your overall succession plan. Michael McDonald is an expert in succession planning because he has lived through it himself. When he was 29 years old and the youngest of three partners in a large law firm, one partner died and the other partner decided to go part time. Michael coped with an involuntary succession event (his partner’s death) and a voluntary succession event (the other partner deciding to go part-time). While he and his partners thought they were prepared because they had insurance and other legal and financial support, the business was not prepared for the human consequences of succession. Since then, Michael has been called upon to help other people with succession because he learnt a valuable lesson, and he learnt it the hard way. An initial consultation with mdp McDonald Partners can be arranged over the telephone. While it is impossible to put a specific cost on helping you develop your own succession plan (because every situation is different), the average price is somewhere between $4,000 and $15,000. It is also possible to spread the cost amongst a group if you and another business wish to hold a combined succession planning workshop. When you compare this with the amount of Capital Gains Tax you could pay if you are incorrectly structured, or the risks you may be taking if you have the wrong business structure and you are sued, or alternatively the costs of doing it wrong or just not doing anything – can you afford not to call in an expert?
Contact: Michael McDonald or Rachel Guthrie mdp McDonald Partners Level 4, 91 William Street Melbourne VIC 3000 Phone: (03) 9620 9660 PO Box 273 Collins Street West Melbourne VIC 8007 Email: info@mdplaw.com.au
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WHY DOES YOUR BUSINESS STRUCTURE MATTER?
Divorce (a voluntarily succession event) Sole Proprietor In the event that a sole proprietor divorces, the longer the marriage the more the business will be considered to be an asset to which both husband and wife have a right. Partnership Divorce of one of the partners will inevitably increase the stress of the remaining partner or partners, as they will probably need to take a greater role in the business. This will potentially reduce the value of the business. A partnership agreement should prescribe certain rules to follow in the event that one of the partners has to sell their share of the business due to divorce. Company Divorce of one of the directors or major shareholders in the company will not have a dramatic impact on the business of the company if there is a buy/sell agreement. The buy/sell agreement should prescribe certain rules such as a pre-emptive right for the continuing director’s to purchase the divorced directors shares where the divorcing director is forced to sell their holding in the business. In the event that the divorcing director is forced to sell, it can be advantageous to have identified a prospective partner to take their place. This spreads the risk across more directors and equity can serve to motivate younger sales members to increase their performance.
The business is sued Sole Proprietor In the event that the business or the sole proprietor is sued, the immediate impact will be that the business will lose value. Operating as a sole proprietor is a terrible structure for asset protection - assets of the individual will be available for creditors who sue the business. Partnership In the event that the partnership is sued, the partners are jointly and severally liable for the debts of the business. All partners are liable for the debts of the partnership. So, if the business is sued for one million dollars, and one of your partners has $200,000 in assets and you have $800,000 then you will both lose everything, even though you were equal partners. Company The company is a separate legal identity. Shareholders of the business are, in most circumstances, protected if the company is sued. Assets of the company will be available to the creditors but the assets of the shareholders will not.
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Death Sole Proprietor Death of the sole proprietor may or may not mean the end of the business. If the sole proprietor does not have a Will or if their Will is inadequate (e.g. with insufficient provision for their dependants), their Will may be open to challenge. This could challenge the existence of the business. Partnership Death of one of the partners may result in the remaining partners being compelled to go into business with the dead partner’s spouse, or to raise sufficient funds to purchase their share. To avoid this generally undesirable outcome, you must develop a buy/sell agreement or include buy/sell provisions in the partnership agreement. If you do not make the provision for the transfer of the partner’s share of the business before their death, you will be left to follow the vagaries of their Will. Insurance can cover the cost of purchasing the dead partner’s shares and your buy/sell agreement should provide a process to achieve this. Where problems can arise is if the deceased partner is underinsured. The buy/sell agreement should provide for extended time to purchase the shares or a discount on the unfunded component. Company Death of one of the directors may result in the partner’s spouse or family members holding equity in your business. This generally undesirable outcome can be avoided by a well-written buy/sell agreement that transfers the equity in the business from the beneficiaries of the dead director to the remaining director’s or to an intermediate trustee in return for an insurance payout. Alternatively, the death of a director could trigger an option to purchase the departing directors equity, which can be exercised by the remaining directors or an identified successor. Where problems can arise is if the deceased director is underinsured. The buy/sell agreement should provide for extended time to purchase the shares or a discount on the unfunded component.
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Accident Sole Proprietor In the event that a sole proprietor has an accident, insurance will serve to provide some comfort for their family, but the business may not survive. In the absence of a natural successor within the business, such as a manager or senior sales consultant to keep the business going in the sole proprietor’s absence, the business may suffer a fatal blow. Also crucial in the case of an accident is that the sole proprietor has an enduring power of attorney granted to someone who can make decisions in the event that the sole proprietor can not. For example, if the sole proprietor were in a coma, the running of the business could come to a stand still if his/her signature is required for certain day to day functions of the business. Partnership In the event that one of the partners becomes sick or has an accident, insurance should be in place to allow the injured party to continue to receive an income whilst they are sick. The injured person’s absence from the business can be managed in the short term by the remaining partners. However, in the event that the partnership does not have a manager or senior sales assistant to step into the injured person’s shoes in their absence, any prolonged absence will be detrimental to the business. The day to day running of the partnership should not be affected because the remaining partners should still be able to sign cheques and documents to continue running the business. Nevertheless, it is still in each partner’s interest to have a power of attorney, to enable someone to make decisions for them in the event that they are unable to do so. These decisions may relate to sale of personal property or access to personal finance required for the business. A prolonged absence can cause many problems – both operational and personal – as other partners may resent the absent partner drawing profits without working. Your buy/sell agreement can allow for a forced sale in the event of a prolonged absence of, for example, 18 months. Company Insurance should cover the value of the shareholding of any of the directors. Where problems can arise is if the deceased director is underinsured. The buy/sell agreement should provide for extended time to purchase the shares or a discount on the unfunded component. A power of attorney may be required in the event that they are unable to make their own decisions and these decisions do not solely relate to business, such as those relating to sale of personal property or access to personal finance required for the business. A prolonged absence can cause many problems – both operational and personal – as other directors may resent the absent director drawing profits without working. Your buy/sell agreement can allow for a forced sale in the event of a prolonged absence of, for example, 18 months.
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Early retirement Sole Proprietor A sole proprietor needs to identify a successor and plan the transition of equity and the transition of relationships. The transition of equity will probably require a restructure as this structure will not accommodate multiple owners.The transition of relationships is crucial, as the sole proprietor is generally the face of the business. In their absence the business may collapse completely. Early retirement may not necessarily be a problem, it just needs to be planned. Partnership One of the partners may retire without notice. For example, if they see a friend die while in a stressful job and think, I don’t want that to happen to me, so I will retire or go part-time now. This can impose stress on the remaining partners. Ideally, a buy/sell agreement or a partnership agreement should prescribe the terms or a process to follow in the event that one of the partners leaves the practice voluntarily without notice. Many buy/sell agreements impose a penalty of sorts on the departing partner if they fail to provide adequate notice. For example, the agreement could allow for the remaining partners to buy the departing partners share at a discount purchase price. Alternatively, the terms upon which the departing partner sells their shares may be heavily in favour of the remaining partners – for example, they may have 3-5 years to finally payout the departing partner. In the absence of a buy/sell agreement, the remaining partners may be forced to purchase the departing partner’s share of the business and possibly to compete with other businesses for the departing partner’s share of the business. This is an invidious situation for the remaining partners. The impact of a premature departure not due to death or TPD can be more traumatic for the business, as it is an event for which you can not protect yourself via insurance. Company One of the directors may retire without notice. This can impose stress on the remaining directors. Ideally, a buy/sell agreement should prescribe the terms or a process to follow in the event that one of the directors leaves the practice voluntarily without notice. In the absence of a buy/sell agreement, the remaining directors may be forced to purchase the departing director’s share of the business. This is an invidious situation for the remaining directors. The impact of a premature departure not due to death or TPD can be more traumatic for the business, as it is an event for which you can not protect yourself via insurance. In the event that the outgoing shareholder wants the remaining directors to purchase his share, there will be occasions where the business is simply too successful and the shares are too expensive for the remaining directors to purchase at short notice. In this instance, many buy/sell agreements will allow for a discount purchase price if there is retirement without sufficient notice. Alternatively, the terms upon which the departing director sells their shares may be heavily in favour of the remaining directors – for example, they may have 3-5 years to finally payout the departing director.
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Planned retirement Sole Proprietor If retirement is planned sufficiently, the sole proprietor will have identified a successor or purchaser, and have taken advantage of superannuation to identify tax effective investment of proceeds from the sale of business.This planning will enable to the sole proprietor to enjoy the lifestyle in retirement that they deserve. Partnership Like a partnership, the crucial aspect of planning retirement in a partnership is identifying a successor. This requires an analysis of the existing skills within the company and the skills required for the business to move forward. Identifying a successor and a planned retirement and smooth transition is not something that can be achieved in 2-3 years. A partnership agreement and buy/sell agreement should outline the terms upon which the departing director will be leaving the business. Company The crucial aspect of planning retirement in a partnership is identifying a successor. This requires an analysis of the existing skills within the partnership and the skills required for the business to move forward. Identifying a successor and a planned retirement and smooth transition is not something that can be achieved in 2-3 years. A partnership agreement and buy/sell agreement should outline the terms upon which the departing partner will be leaving the business.
Decision making Sole Proprietor The sole proprietor makes his/her own decisions for better or for worse. Partnership A Partnership agreement should outline a decision making system. Some decisions will require a simple majority while there will be other decisions that a partner will be able to make individually. Some decisions may require a special majority, e.g. 75% and certain decisions require unanimity. This decision making process should be given substantial consideration, as it will affect the day to day operation of the business and the relationship between the partners. Company A shareholder agreement should outline a decision making system. Some decisions will require a simple majority while there will be other decisions that a director will be able to make individually. Some decisions may require a special majority, e.g. 75% and certain decisions require unanimity. This decision making process should be given substantial consideration, as it will affect the day to day operation of the business and the relationship between the directors. It is often recommended that the directors appoint an independent chairman who can assist in decision making at board meetings. Examples of decisions that require unanimity are the declaration of a dividend and the winding up of the business. An example of a decision that may be better served by requiring a special majority or in some cases unanimity is the appointment of a new director. Requiring unanimity is dangerous where there are many directors because it is virtually giving a power of veto to each director.
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Comparison of Structures 1. Tax Payable On Income Trust Income of the trust flows through to the beneficiaries who then pay tax according to their own tax profile (i.e., the bracket into which they fall). Partnership Distributed in accordance with the respective share of the partnership. Tax is paid according to the individual’s own tax profile. Company Companies in Australia are taxed at 30% on profit. If no dividend is distributed then no tax is payable by a shareholder. If the profit is distributed by dividend then further tax may be payable by the shareholders according to their tax profile.
2. Losses Trust Trapped within the trust which means the losses cannot be offset against profits in other entities. However, in some circumstances, if the trust owns other assets which make a profit, these can be set off against other losses. Partnership Flow through to the individual partner. Company Trapped within the company. Subsequent years profits may be set off against losses.
3. Capital Gains Trust Flow-through to the individual beneficiaries who can then take advantage of CGT concessions. This structure is useful where you expect considerable capital growth. Partnership Flow-through to the individual beneficiaries who can then take advantage of CGT concessions. Company Trapped 30% plus extra upon distribution according to the individual’s tax profile. Not always suitable for expected capital growth.
This information is of a general nature only and is not intended to be a substitute for legal, accounting or financial planning advice. We recommend that these matters be discussed with a qualified professional practitioner.
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