Life Insurance is a Valuable Financial Tool as a Business Transitions from one Generation to the Next
Jack and his sister Jill sat in front of me looking expectant. Jack still had the bandages on his head from the nasty fall he had taken a couple of weeks ago, Jill showed signs that she had taken a tumble too.
Jack and Jill were planning on buying their parents out of the family business, Hill Water Company Limited. Their parents, apparently concerned with the recent injuries, had asked me about protecting the note they were taking back as part of the sale of the shares to their children. I had suggested that we look at insurance to protect the parents if something happened to Jack or Jill. Life insurance was an obvious answer but critical illness insurance was also up for discussion.
It not unusual for parents to take some of the sale price of the business back, as a promissory note when the children buy the business. Often the terms depend on how successful the parents have been at diversifying assets outside the business. I never recommend 100 per cent financing by the parents, the children should have some investment or personal obligation through a loan and the parents should take some of their equity out of the business. However, the note payable to the parents can result in tax efficient cash flow in retirement and may provide some contingent control to the parents if things don’t work out the way everybody hopes.
Insurance on Jack and Jill will provide some guarantee that if something happens and either of the siblings cannot continue in their role, their parents note can be paid off reducing both the risk to the parents and reduce the cash flow required by the company to pay the monthly payment.
“Nice to see you’re recovering from the fall Jack” I said, “How are you feeling?”
“OK” he responded, “It’s nice to be back to work”
“Well part of your work, as you and Jill take more responsibility in the business, is to understand the risks and obligations of managing a family business. Your parents have spent many years building the business from scratch to the great business it is now. They are ready to step back from the daily operations and be mentors and strategic counsel to you two. This is a difficult phase for them as it is in any family looking at transition.” I paused to confirm I had their attention. After several months of working with the family I had their trust, Jack and Jill were clearly listening.
“The monthly payments on the note your parents are taking back as part of the sale of the shares to you represent an important part of their monthly cash flow in retirement. If something happens to either of you, as key people in the business, that could put the company in financial difficulty and put their note at risk. To protect against that, we should look at insurance. Life insurance in case we lose one of you and critical illness which frankly protects against a greater risk, that you become seriously ill and cannot work for an extended period.”
“Today we will talk about how much insurance you should have, the process we go through when the application is submitted and how much the insurance will cost. We should meet with your accountant to review who should own the policies and how to pay for them, there may be other reasons for insurance that we can incorporate in our application process.”
“Dad always said we will be stewards of the business, taking over from our parents and growing it for our kids” said Jill pensively “I guess this is where we start to acknowledge that”.
“I like that attitude” I smiled back, “But don’t lose that entrepreneurial flair.”