Three Risk Areas

There is an unavoidable link between business succession planning and insurance. In Maurice’s Book – “Diary of Two Enlightened Men” – he explains how these three Risk Areas are considered by the two protagonists of the book – Jim and Bob.

The section goes like this:

“Managing the 3 Key Risk Areas”

Our core business, after all, is insurance. What’s that got to do with buying and selling of businesses?

Short answer: A lot!

So far, all our planning for Jim and Bob has been based on the assumptions that both will remain in good health and want to continue in the partnership until its agreed end date. Of course life isn’t always that simple!

To take just one possibility, what if either man is hit by a bus and dies?

Scenarios like this don’t just exercise the minds of the Bobs and Jims of the world either. Any person in a business partnership carries risks associated with their partners’ death, illness or sudden need or desire to get out of the business.

So the last key area for Jim (and Bob) to take care of is covering the three key risk areas. And that’s where insurance becomes critical.

The three key areas? They are:

 

Owners Risk

Consider this scenario. You’re in business with two other people, each of you holding a one-third share of the business. Let’s say it’s valued at $9 million and has $3 million of debt. Over summer, one of the partners is tragically killed in a diving accident.

Three months after the accident, his widow’s solicitor gets in touch. She has decided, as she is perfectly entitled to do, that she wants to sell her husband’s third share of the business – and quickly.

You have a major problem. You’re now faced with having to raise $3 million to buy out your partner’s wife (at a time when revenue is taking a hit). The bank considers you an unsafe risk under the circumstances. The only other option you can see is to let your partner’s widow sell to whoever else can come up with the cash, which means you’ll end up with a partner you might not want.

This is a classic demonstration of what Owner’s Risk looks like. And you’d be surprised at how few business owners appreciate the need to plan for it.

Fortunately for Bob and Jim, they did plan for it. Each took out an insurance policy on the other that provided enough money to buy the other’s share of the business if a tragedy occurred. The policy was sufficiently generous to also allow for a period of lost revenue while the business adjusted to the loss of a key partner.

They also put together a buy / sell agreement under which each partner agreed to buy the other’s share of the business in the event of death or irreversible injury or illness.

When Bob suffered a fatal heart attack in Year 5 of their agreement (he was only 37 and it came as a complete shock to everyone), Jim was devastated at the loss of someone who had become a very close friend. But thanks to his and Bob’s foresight (which came with more than a little help from the Maurice Trapp Group!), his retirement plans were not significantly disrupted. He bought Bob’s share of the business from Bob’s widow without digging into his own retirement fund (which had grown significantly thanks to Bob’s great management), and he then employed a manager to take care of the day to day running of the business. This, in turn secured a steady income stream for Jim on top of his retirement nest egg. While this wasn’t exactly the scenario he had planned, from a financial point of view, it was almost identical.

It is also important to not that Bob’s widow and two young children where taken care of through this arrangement.

 

Business Risk

Back now to the business partner killed in the diving accident. Your business partner. Once you get over the initial shock, you begin to consider the impact on your day-to-day business.

The first thing that strikes you is that this partner held the relationship with many of your top clients. With him gone, they’re now a target for your competitors.

What’s more, all your business plans are now in disarray. And the workload of the two remaining partners has doubled while you sort things out. And revenue has taken a hit, or will soon. (And that’s before any clients jump ship).

Then you look at your debt to revenue ratio. Up until now, the business has been growing, and you’ve been borrowing to fund that growth. For the next 12-24 months, however, business will now probably shrink. Covering your debt repayments is starting to look really tough

All of this is what we call business risk. It’s all the impacts on a business when one partner can no longer contribute. That can happen through death, injury, unforeseen family circumstances, or even a sudden urge for one partner to get out and live the good life at the beach.

And, once again, you’d be surprised at how many business owners don’t plan for it.

Bob and Jim did plan for it, in consultation with Maurice Trapp Group. So shortly after Bob’s death, Jim sat down with the bank and explained that he held an insurance policy that gave him the capital to buy Bob’s share of the business. What’s more, he told them, he also held a Revenue Cover policy that ensured that debt repayments and staff salaries would also be covered while the business got back on its feet. The bank was satisfied that its money was safe, and Jim didn’t take a financial hit from Bob’s sudden death.

Bob and Jim also took out trauma cover on one another, so that the business would be protected if either suffered a debilitating injury. As it turned out, this insurance was never needed. Had Bob not died so young, however, who knows what other surprises life might have had in store for either of them?

“Life is what happens to you while you’re busy making other plans”

- John Lennon

 

Personal / Family Risk

Every business owner – well, nearly every business owner – has personal life cover. When Bob and Jim stitched together their sale agreement, they wisely reviewed their respective insurances to make sure that whatever life threw at them, neither they nor their families would suffer financially.

When we sat down with Jim, it was clear that his insurance policies needed little changing. Bob, on the other hand, was severely under-insured.

He had a $500,000 Life Policy. And that was it.

In our initial discussion, he stated that he thought it should be bumped up to $1 million. Then we did some sums with him.

A million dollars, invested at 5% per annum, would return $50,000 a year – before tax. Did he think Alice could cover their $300,000 mortgage and still live on that, we asked him.

We could see him thinking. Then we asked about his one-year-old daughter, Ruby (he and Alice had just the one child at that stage. Jack would be born 18 months later). Who would mind Ruby if he died and Alice had to seek full time employment? Who would pay for her education?

It didn’t take Bob long to see that if his family was going to enjoy a similar lifestyle with him gone, $3 million cover was going to be needed. The good news was that given Bob’s age, the premiums were still relatively low.

We then looked at Bob’s other insurance. Did he have trauma cover, in case he was injured? What about medical cover for him and his family? Income protection, in case of permanent or long term illness?

Bob had never considered these things seriously before. He’d enjoyed great health all his life and believed he was more or less bullet proof. But now the stakes were higher.

Bob realised a couple of key things. First, with a young family to think about, it was irresponsible to ignore the potential impact of everything from illness to injury to death – or even something as mundane as a child needing major dental work.

What’s more, he was now entering a period where, if things went to plan, his net worth could grow exponentially, even while his income remained modest. If anything happened to him during this time, all his hard work could be for nothing. It was crazy, he said to us one day, to make the sacrifices he was making and to not provide financial certainty for everyone – including him – if life didn’t go exactly to plan.