Succession planning almost invariably focuses on planning for the death of a partner or other equity holder. But the greater risk for many business owners and their businesses is the risk of disability. The statistics are unexpected to most. Estimates are that 15% to 25% of people between the ages of around 25 to 65 will be disabled. There is more than a 25% likelihood that a 20-year-old will be disabled prior to their retirement. Practitioners need to focus clients on succession planning for disability and guide them to taking proactive steps to mitigate against what could otherwise be a disruptive event at best; calamitous at worse. Comprehensive disability planning includes preparing a plan for how the business can be transitioned during the disability of an equity owner, especially a key person. In addition to such management consulting type considerations, the governing document for the business (shareholders’, partnership or operating agreement) should address disability in a comprehensive manner that is tailored to the particular business, each equity owner’s role and importance to that business, and the financial realities involved. Consider the following:
√ Valuation:
If a long term or permanent disability is to trigger a buy out, what pricing should be involved in the re-purchase of the disabled equity owner’s interests? The value to be used must be determined simultaneously with consideration of the funding options so that whatever is agreed to will not create undue financial hardship on the remaining equity holders.
√ Funding:
Should disability buy out insurance be used? Is it affordable? While it is often advisable to encourage clients to price disability buyout insurance, in many instances they will object to the cost. Even if the cost is agreeable, often the payouts that are affordable to purchase will be less than most clients anticipate or believe appropriate. Weigh further saddling the business with additional payment requirements.
√ Senior/founder provisions:
If the patriarch of a family business or founding partner of a professional practice is disabled, should the same general disability provisions applicable to a new or much more recently admitted equity owner apply? Too many agreements provide for uniform disability definitions and provisions. The founding or senior owner may be an integral and valuable component of the goodwill and identity of the business and the business itself will benefit from continued association. That does not mean that compensation cannot be adjusted, but perhaps the relationship should not be terminated, or if terminated after a longer time frame. From the founding equity owner’s perspective it would seem rather unfair to be terminated in the same 90-day disability period as a newly minted owner. Importantly, senior members are often older and more likely to suffer a more significant health issue then younger members. A fixed time period does not account for that reality.
√ Prevent Gaming the Provision:
A common issue with disability clauses is preventing an equity owner from unfairly manipulating the formulas in the governing document. For example, if a shareholders’ agreement provides that an owner who is out disabled for more than 60 days must be bought out, the owner might return to work every 59th day. One solution to minimizing the risk of this type of abuse is to also include a band around this primary disability clause, e.g., in addition to being out for 60 days, if a shareholder is disabled and unable to provide services for 90 days in any 280 day period, that shareholder shall be deemed disabled. This would catch such a game.
√ Different Degrees of Disability:
Too many agreements assume that “disability” is a single point in time clearly definable condition. It is rarely so black and white. If an equity owner suffers an acute medical condition it might well be that after a period of hospitalization and recuperation that owner can return to full time regular work with the company. However, many medical conditions are chronic and will continue for the equity owner’s lifetime. If for example the equity owner is diagnosed with an autoimmune disease whose symptoms include severe fatigue. The equity owner may be able to continue working almost indefinitely, but with a reduced work schedule. The generic nature of most disability clauses does not generally facilitate this level of distinction, but it can be valuable to both the business and the key-person/owner. Give careful consideration to defining temporary versus permanent disability. If an equity owner has an acute medical condition and will require two months to recuperate, most businesses would not wish to force someone out for two months. But what if the recuperation period might be a year? What parameters make sense? In some instances there may be no need to differentiate; in others there might be. Permanent disability may trigger buy out of equity or removal of the persons name from the firm. Temporary disability may have less severe consequences.
√ Compensation and Benefits:
Merely addressing when a disabled shareholder should be required to sell equity to the entity or other owners is not sufficient. How should the salary and perquisites of that equity owner be reduced? Should the adjustments change over time? Many businesses will provide for the payment of a partial salary for a period of time then reduce the compensation to zero and sometime thereafter eliminate perquisites. What is affordable to the business? What degree of safety net do the business owners wish to provide each other in advance of knowing which of them may be affected? What changes should take place at what trigger points? Should equity owners be required under the governing document to purchase private disability income replacement insurance to lessen the financial burden on the business (and guilt burden on the other owners)? Should the payments by the business be tailored to mesh with the actual policies or the mandated coverage? What if the coverage changes or lapses?
√ Which Provision Governs:
Any comprehensive governing document may have a multitude of buyout provisions. Practitioners should review the trigger points and economic consequences of each of the provisions. For example, in a two partner corporation the shareholders agreement might include what is sometimes referred to as a “Dutch auction” or “reciprocal buy/sell.” This type of provision is designed to provide an exit strategy if the owners don’t get along and without the cost and complexity of a battle of the appraisers. This mechanism might work as follows: If partner A wants partner C out, partner A can trigger a reciprocal buy sell by setting a purchase price. Partner C then can either buy out partner A or if not done within some specified time period, then partner A must buy out partner C who must in turn sell. The same agreement might provide an optional retirement provision that permits a shareholder over age 52, for example, to “retire” and receive a payout of some percentage of gross over the next four years, and an additional payout of “capital” however defined. With these three provisions, if a shareholder aged 53 suffers a heart attack and will be out for some period of time, which provisions govern? Can the well shareholder force the application of the Dutch auction before the ill shareholder triggers the disability buyout? Can the ill partner choose to “retire” if that appears based on the economics of the business to provide a greater payment? All provisions must be coordinated to prevent a rush by one or the other partner to manipulate the terms of the agreement.
√ Multiple Events:
One of the most commonly overlooked issues in a business buyout agreement is the risk of multiple trigger events being operative at one time. One partner may die, another may retire six months later, and a third may become disabled. This might all occur within the same approximate time period. Can the entity afford to make the aggregate payments to each? The financial strain of multiple payments, if not properly planned for, could devastate the business. In some cases a ceiling on aggregate payments may be included in the agreement to avoid hardship to the entity (e.g., aggregate payments shall not exceed 20% of gross revenues in any year). Should ordering provisions be provided? For example, should whichever payment is triggered first govern priorities of payments? So that if a shareholder died, and then two months later another shareholder is disabled, the payments the corporation can make under the agreement are devoted to the deceased shareholder whose buyout was triggered first, and only what is left is then applied to the disabled shareholder’s buyout? Alternatively, payments can be prorated. The critical point is to address the issue of multiple events. During the period that buyout payments are made (i.e., those other than insurance funded payments) should existing partners have caps on salary or perquisites? If this is not done, the payments to the deceased, disabled or other terminated partners could be unfairly deferred.
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