Business owners should be aware that banks may not be able to provide credit and offer support in the frosty economic climate making business protection increasingly important, writes Jerry Bayman.
A recent report has claimed that a third of small to medium-sized enterprises are failing to find affordable credit. A bold statistic, but one that raises the question of what can go wrong with businesses when creditors lose confidence in them?
It does not seem to take much to get banks running for cover with the current fragility of the banking system, and businesses need to think carefully as to how exposed they are.
The loss of a key worker, either through death or serious illness could be the factor that brings that exposure about.
The temptation for businesses to cut back on what they see as unnecessary expenditure is obvious but if a company is telling an adviser it cannot afford cover, then it is also saying that in the event of losing a key person that it has no cash reserve to fall back on.
Relying on the bank to pick up the consequential cash shortfall in this current fiscal crisis could be a dangerous assumption.
The bank will be looking at all sorts of issues. What does the order book look like, will customers be lost, and assuming there are also debtors, will they be slow to pay? What does the company's liquidity look like and if cash flow is threatened, how much increased borrowing will be required? The amount of security in place will also be evaluated, so do not be surprised if they start to look for personal guarantees and second charges if further funding is required.
This latter requirement should sharply focus directors' minds. Losing a business is bad enough, but at least limited liability businesses ring-fence indebtedness. Personal guarantees mean you stand to lose everything.
It would have been fair to say 18 months ago that banks would have been much more inclined to provide support to allow the business to recover, but in the current environment the risk of the bank pulling in its security is becoming more likely. This is the reality of their difficulties in lending money.
The solution is that businesses should be their own bankers. Key person cover means they become self-funding.
Facing facts
Another objection advisers might hear is that ‘it will not happen to us'. Well it might. Intermediaries have seen all the statistics on an individual dying, but the odds of losing any key person from within a business need to be examined. So in a business with four key directors the odds are a lot shorter. According to Munich Re's 2007 analysis of this issue, the chances of one male in a group of four 30-year-olds dying during their working life is 29%. The chances of the same person getting a critical illness soars to 68%. Statistics for females of the same age are 23% and 59% respectively.
Do business owners really want to play with these odds?
Theoretically, any business is susceptible. Bright Grey recently wrote about the case of Carter and Carter which collapsed after the death of its chief executive officer. That was a £500m public limited company (plc). However normally an intermediary would be directed to the SME market, as they will tend to have the biggest need.
This is because, firstly, they are less likely to have a ‘substitutes' bench'. These businesses tend to have key people such as managing directors, technical, finance or sales directors who, although part of a team, spend much of their time working within their own speciality. Unlike plcs, they often do not have a succession strategy - there is no substitute sitting in the wings to take over if the key person falls ill.
So the job of the adviser is to provide one, in terms of money to pay for a replacement and by actually sourcing the substitute. For example, through its Helping Hand facility, Bright Grey will provide a temporary replacement within 48 hours of losing the key person and then help with finding a full-time replacement. There is no additional charge in the policy for this.
Another problem is dealing with the loss of the business owner. SMEs are usually owner managed private companies, so there is no exchange to sell the business share on. Who will want to buy them when the business has just lost a key person, especially if the shareholding was a minority one carrying little or no control in the business?
Usually the articles of association will lay down a succession path, the usual clause is a pre-emption agreement. This gives the surviving shareholders first refusal to buy the shares but this makes the assumption that they have the money to do it, which in many cases will not be the case. If the bank is going to fund anything it will be the company's cash flow - not buying shareholdings.
For a majority shareholding, this could be devastating for the survivors as the estate could then sell the shares to a competitor, depending on the articles. For a minority shareholder, there is probably little the estate can do except sit on the shares until the company is sold or a dividend is declared.
Likewise a partnership may have similar clauses in its agreement, assuming it has an agreement. Do not forget that under the Partnership Act 1890, the death or retirement of a partner will result in the partnership being dissolved and most probably the assets having to be paid out to the estate.
A hard place
There is also the question of what value is put on shares? In most articles and agreements it is down to the business' accountants, yet, accountants that insurers speak to are increasingly unwilling to get involved in this process as they end up caught in the middle of the surviving shareholders looking for a bargain and the estate looking for full value.
There is also the question of impartiality. If the accountant is between the remaining shareholders who they will no doubt continue to act for, and the estate which they will have nothing more to do with, professional as they may be, can they be seen to be impartial?
And does the accountant give a pre-death value or a value discounted due to the death of the key person? Do they give the same value per share for a controlling share or do they discount this down for minorities?
Certainty and a business will are required. This provides two things:
Firstly, an agreement that shares can be bought from and sold by the estate should either side wish this to happen, and at a pre-agreed value - the cross option agreement. Secondly, an appropriate life and possibly critical illness policy to provide the cash.
The problem with most articles and partnership agreements is that they attempt to achieve this but rarely do and, in particular, they ignore the fact that these transactions require hard cash.
At this point, most inexperienced intermediaries will ask: ‘What do I need to know?'
Protection providers speak to many advisers, both with corporate clients and those that are looking to find them, but in both cases they can become daunted by the learning curve they need to take. There is no point pretending it is simple, but it does have the attraction of rarely changing unlike the merry go round of pensions legislation. Advisers who want to move into this market should be prepared to commit to serious training and self study - it is not something they can learn in an hour-long seminar.
However, providers have highly experienced business protection specialists to provide training for those that are serious about it. Bright Grey offers intermediary and advanced master-classes but advisers need to be prepared to put a day aside plus further study if they are serious, .
Reading around the subject is also necessary. Do advisers know the basics of business taxation such as the difference between capital and trading income? Do they know the difference between gross and net profit? The PFS/CII AF2 Business Financial Planning manual is a good start and many providers have technical reading material available. It would also be a wise idea to get some good books on business structure.
The other issue is of course where to find the clients?
Jerry Bayman is national partnership manager, corporate protection, at Bright Grey
