Building a successful business is difficult, and the first few years can be especially grueling. When first beginning any business, the owners’ focus tends to largely be on growth. After all, regardless of whether the goal is a sale to a larger firm or building the next Google, nothing happens without growth.
As a result, business owners devote an extraordinary amount of resources to the pursuit of said growth, and there’s little time or interest to worry about mundane thoughts like, “what if things don’t go as planned?” This lack of attention to contingency planning could be detrimental to one’s business if certain situations were to emerge.
For a hypothetical example, GuardIT (real company, fictional name) is a professional services firm that just lost an important client after two of the three owners had a falling out, followed by a very costly split. When Janet (part-owner) broke the news to her partners Mark (part-owner) and Kelly (part-owner), they realized that they had very little in place to handle unforeseen changes to the company’s structure.
Ownership of GuardIT is split between Mark (40%), Janet (30%), and Kelly (30%). They went into business together four years ago after some successful stints in the corporate world, and with their complementary skills and aligned vision, they figured they could build something unique. Today, GuardIT is doing well, they have established themselves as an innovative player, and business is flourishing.
Without losing sight of the need to ensure that the company continues to grow, the owners decided that GuardIT also needs to identify and prepare for the preventable threats to its long-term success. Their business advisor’s assessment is as follows:
GuardIT has three owner-employees. Janet handles the landing of the contracts, Kelly is in charge of project management and making sure the work gets done, and Mark is the numbers and compliance guy. There is no overlap in abilities on this team, and there is no strategy for finding or developing new Marks, Janets, or Kellys. Therefore, if either of them leaves, retires, moves away, or dies, the company is in trouble. Before growth in their company can happen, a foundation and safety net should be put into place.
This lack of contingency planning is the number one preventable threat for all businesses. As with most financial matters, it is best (and cheapest) to anticipate future concerns, as opposed to putting off difficult decisions and then scramble for a solution when something unfavorable happens. The contingency planning process starts with a buy-sell agreement, which dictates the rules of engagement for ownership issues. Not surprisingly, the best time to set one up is right away, before things happen.
What is a buy-sell agreement? It is a legal document that sets the rules for how ownership is re-allocated when someone can no longer or no longer wants to be an owner of the business. It acts as a blueprint for how the company will divide its assets and ownership in the event of an owner’s divorce, departure, or more extreme events like a death or disability.
Why do you need one? Here are some scenarios to illustrate a few of the risks:
● Mark divorces his wife Judy, and as part of the splitting of the marital assets, she ends up with half of his stake in GuardIT. As a result, Mark is now a minority owner (20%), and Judy (at 20%) is now his business partner.
● Janet passes away unexpectedly. As a single mom, her sons (12 and 9) are her next of kin and inherit their mother’s ownership stake in the business. Janet’s brother Tom is appointed as their legal guardian.
● Kelly wants to retire and would like to be bought out, retaining a 5% ownership stake and working for the company on a part-time basis, as a consultant.
There’s no right or wrong way to handle any of these situations. It all revolves around three things: the owners’ personal preferences, the availability of funds, and what the law states. Here are some accompanying questions that may be helpful to ask in these three scenarios.
● Do Mark and Judy want to be in business together?
● Would Judy prefer to be bought out? Is her price reasonable?
● Can the company afford to buy her out? What funding method?
● What happens if Judy’s price is not realistic?
● Could Janet or Kelly buy Judy out from personal funds and become a 50% owner, or does Mark get the first opportunity at buying out his former spouse?
● Who represents Janet’s children in the company?
● Does the company have the right to buy them out? If so, at what price?
● How will Mark and Kelly respond to a situation where they’re working more to essentially support a non-productive partner?
● How does the company value Kelly’s 25% considering her departure’s impact?
● Will she have to sign a non-compete agreement?
● Where would the money come from?
● What happens if she wants to retire and can’t be bought out?
This is just a preview of the questions that can be raised once any of the situations mentioned above occur. Other scenarios that haven’t been mentioned include an owner getting fired or disabled, losing their license, or filing for bankruptcy. Setting up your buy-sell agreement today allows you to prevent problems from getting too complicated and costly down the line. Contingency planning early on can help set up the ground rules of ownership of your company, as well as making it easier for owners to make those decisions when specific circumstances arise. As the saying goes, an ounce of prevention is worth a pound of cure.
Byline: Wilfrid Baptiste is the founder and principal of Financial Blind Spot. He helps businesses identify and fix blind spots in their financial plans.