Succession in Small Business
by Gary L. Black

When you sit down with your business partner to discuss incorporation, it is essential that discussion include business succession.

Topics to consider should include the five “D’s”: Divorce; Disagreement; Disability; Death; and Debt.

In the majority of instances where a business gets incorporated, the lawyer issues some shares to the partners and recommends the establishment of a shareholders agreement or a buy-sell agreement, but such an agreement seldom gets done.  Too often, it gets put off to the future “when the business can afford it” or when “we’ve got more time.”

If you wait to enter into a shareholders agreement, “later” may spell “disaster."  Consider the following worst case scenario.

A (fictional) business called Phil and Fred started in the late 1980s.  It was incorporated on their accountant’s advice.  Year-end was approaching and the incorporation was put together quickly so that a dividend could be paid to each of them.  They got a legal bill and an accountant’s bill as well as a letter saying both Phil and Fred each owned 100 common shares in the Company.  Since then, the business has survived, and, in fact, flourished.  Despite minor differences from time to time, Phil and Fred have been able to come to agreement on any matter of importance.

However, Phil senses that things are changing.  Fred is now 50 years old, has recently let his sideburns grow, is unbuttoning his shirts to the navel, and sporting lots of gold.  He is getting telephone messages that he returns only in the storage room.  His wife of 25 years, Kooda comes to the office more and more and is asking the bookkeeper lots of questions.  Fred has two sons.  The dancer has no interest in the business, but the younger one, Slats, (who fried the tow-motor last summer) has been heard to say that he will be running the place some day.  Presently, Slats (a big kid) looks after the Company’s security.  Fred gave him that job.

Fill has a daughter who has two years left at business school and, recently, she has expressed interest in working with him.  To add to Phil’s woes, Fred recently returned from a “business” trip to Costa Rica where he contracted a rare virus.  Apparently, there is no cure.  He will lose his mind in six months and be dead in a year.

Phil’s concerns heighten when the Company’s lawyer advises that they never did finalize that shareholders agreement that he sent them shortly after incorporation.  In fact, no agreement is in place.  Phil is faced with the classic “deadlock” situation.

At this point, it is highly unlikely that Phil can hammer out an agreement to avert all of the obstacles that now face him.  In the absence of an agreement, any of the 5 D’s mentioned above may devastate or demolish a business.

1) Divorce

A spurned spouse will get instant attention if he/she claims an interest in the business or in his/her spouse’s shares.  To avoid this, a shareholder agreement may provide for an automatic buyout option in favour of the other partner at a predetermined price.

2) Disagreement

Normally, disagreements get resolved by discussion.  However, there should be some written mechanism to resolve differences outside the court system.  A shareholders agreement may resolve issue by mediation or arbitration or provide a shot-gun clause for the most serious situations.

3) Disability

This is often the most difficult topic to address from a number of levels.  For instance, disability is difficult to define in suitable practical legal terms; however, the partners should establish in a shareholder agreement the ingredients of a definition by considering how a disabled partner should be dealt with over the short and long term.  For example, they should ask themselves: Is some form of insurance adequate or should the healthy partner have the option or obligation to acquire the disabled partner’s interest?

4) Death

When a partner dies, a shareholders agreement should provide the method of dealing with his/her shares.  Should the surviving partner have the option to acquire the shares?  Or the obligation?  At what value?  Or should the deceased partner’s spouse or child be entitled to acquire those shares?  Should the Company purchase “key-man” insurance to provide liquidity during an adjustment period?  Should the partners cross-insure each other to provide ready funds with which to acquire the shares?  All of the questions should asked and addressed appropriately.

5) Debt

It is important to address how the Company will incur debt.  Will it do the borrowing or will the partners borrow personally and lend those funds to the Company?  If the Company does the borrowing, who will sign personal guarantees and what if those guarantees are unequal?

A more acute problem is the bankruptcy of a partner.  Since the Trustee in Bankruptcy of the bankrupt partner falls into the latter’s shoes, there should be a preset mechanism in place to deal with the disposition of his shares.

Final Thought

In light of the foregoing points and bearing in mind the 5 D’s, the lesson is that a well thought out shareholders agreement can take care of these issues before they occur.