Disaster looms: Advisor education and business transition opportunitiesArticle added by Ed Morrow on September 8, 2011
Ed Morrow

Ed Morrow

Middletown, OH

Joined: October 29, 2005

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Business owners and professional practitioners focus on the everyday aspects of operation, and there are many challenges and economic changes to keep them occupied. That’s why they need a financial consultant whose job it is to assess these exposures, analyze and quantify the risks, develop creative solutions, initiate the legal documents required, and monitor the continuously changing company circumstances.

Bank loans threaten the growth of a business and the family of the principals. However, the extent of this hazard is generally not recognized by the owners of a business. Nor is it recognized by the family members who are assuming that the successful business will continue to provide for their financial security, income and health care needs.

This is an enormous market for financial professionals — one that has been largely ignored. Even the banks lending money to businesses have failed to capitalize on the opportunity.

Why a business needs loans

When a small business is first created, it is often a proprietorship or a two-person partnership. The capital contributions are from personal savings and a lot of sweat equity. As the enterprise grows, it needs more and more capital.

But small business owners cannot sell stock, float bond issues, obtain government grants or qualify for non-selective lucrative government contracts. They turn to family members and local banks.

Often there is a combination of loan sources. Well-to-do Uncle Jim may initially loan some cash, but often will endorse a loan made by a bank. When the business expands due to successful operations, intra-family loans become impractical. Bank financing is the only way to expand and fund the following:
  • Expanding inventory
  • Accounts receivable
  • New, more expensive equipment
  • Raw materials storage
  • Research and development
  • Royalties or licenses
  • Franchise down payments
  • Acquisition of other firms
  • Opening more locations
  • Marketing or package development
No one reads agreements

A business owner is so pleased to obtain critically needed funds from a bank that most details of the loan agreement are ignored. Focus is on just three loan elements:
  • Amount of new capital
  • Interest rate
  • Payment terms
The personality of the typical founder of a business or professional practice contributes to this customary failure to carefully examine all the terms of the loan. A typical founder generally has the following characteristics:
  • Visionary
  • Leader
  • Risk taker
  • Hard worker
  • Mono focused
Business owners want to expand their customer base, offer new products and/or services and occupy more territory. Professional practitioners want to see more patients or clients, delegate minor tasks to an expanded staff, acquire the latest technology, stay at the cutting edge of their professional and hope that a lawsuit does not jeopardize the practice.

What’s in the small print?

Every bank loan contains a few items easy to identify — the amount of the loan, the interest rate and the planned repayment such as “$4,800 per month beginning Aug. 15, 20XX.”

However there is extensive text in every loan agreement that includes warnings and loan default terms. The warnings are required since the borrower (and all guarantors) are giving up protections to which citizens are normally accustomed:
  • Right to written notices
  • Right to object or request court review
  • Possession of other assets and accounts
The warnings notify the borrower he or she has given up these traditional legal rights. Of even greater consequence are the various default terms. There are generally from 11 to 15 conditions in the very fine print of the agreement on all of the events which make a loan in default — regardless of whether or not payments have been made on a timely basis.
Here is what happens

Magnum Auto Parts was formed by Bill Smith and Tom Jones as a 60/40 partnership. Bill owned more because he contributed the starting customers and 60 percent of the capital. Later they incorporated and eventually they conveyed 10 percent of the stock shares to Sam Green, their leading salesman. Stock ownership is now:
  • 54 percent Bill, age 57
  • 36 percent Tom, age 44
  • 10 percent Sam, age 31
Bill has always handled bank negotiations for the enterprise. When the business started a new line for foreign cars, sales took off and more capital was needed for inventory, an extensive merchant website and purchase of new equipment. Carrying receivables became a major issue, since their customary terms to retail car service shops and distributors was net 90 days and payment from reliable customers often exceeded 120 days.

As they expanded, the loan balance reached $2 million and Bill’s wife Grace was required to sign the bank loan as a guarantor, along with Bill personally. They were happy to receive the much-needed money. Because this was perceived as “just a bank loan” rather than a “legal instrument,” they did not ask their attorney to review the agreement and explain the provisions.

Bill then had a stroke. The doctors do not offer any hope of recovery. The company has a funded buy/sell stock redemption agreement, but the value has not been updated. A current valuation of Magnum Auto Parts is now $3 million. But the agreement is insured for only half that amount — and the coverage on Bill is only $810,000 (54 percent of the outdated $1.5 million value).

The Friendly Financial Bank now declares the loan to be in default based on the “competency” provision, despite the fact that the company has never made a late payment. Friendly wants the full $2,000,000 loan balance paid in full — now.

If Bill dies soon, the company group life insurance of $100,000 will go directly to Grace. The $810,000 would go to the corporation and the bank wants that — plus the balance of the loan — $1,190.000. The bank takes precedence over the non-trusteed buy/sell agreement.

The company does not have the $1.2 million. All of its money is tied up in the business.

Since Bill’s stock will not be redeemed, Sam and Tom are devastated to learn they will not become the sole shareholders as they had expected. Grace still has controlling interest. They like her well enough, but realize she has no business experience.
Grace had been under the impression she would be paid 54 percent of $3,000,000 or $1,620,000 plus the group coverage of $100,000. She believes she can count on the earnings from $1,720,000, which at 5 percent would provide her an income of $86,000.

She does not have the amount the bank is seeking — $1,190,000. There is a residence with a small mortgage and some inherited farm land, but no cash and very little securities. She asks Tom and Sam, “Where is Bill’s salary check, and are you going to continue us on the group medical plan?”

The bank is not very happy and is seriously and secretly considering attaching all the other company accounts — such as payroll, credit card receipts and a small reserve account — which it can do instantly, without notice.

Employees are getting nervous because they have heard about the non-paid bank loan, and they are spending as much time on gossip as on their work duties.

Sam, who is a great salesman, is considering a position with a competitor and his first move would be to solicit all the customers of Magnum Auto Parts. Tom is under a lot of stress and his former jovial personally has disappeared.

What’s the solution?

Can this disaster be solved today? The answer is no, unless the sky starts dripping a lot of 100 dollar bills. Could it have been solved a month ago while Bill was in good health? Yes. What would have been required?

1. A regular, periodic recalculation of the business valuation would have pointed out the shortfall. The business could have adjusted the buy/sell agreement to the current value of $3,000,000. The existing life coverage could have been leveraged to start the additional insurance required. This would solve the problem for Tom, Sam and all the employees.

2. The company could have covered Bill, Tom and Sam for critical illness in the amount of $1 million each — for less than $1,000 per month. As soon as Bill’s stroke was diagnosed, the company would have received the $1,000,000, which would have temporarily funded payment of Bill’s salary to Grace and continued medical coverage.

3. The Friendly Financial Bank could have been requested to modify the loan terms in exchange for a full assignment of a new life insurance policy on Bill. Modestly improved terms would have provided the cash flow for the required $2,000,000 of coverage. The bank loan would be paid in full upon Bill’s death.
Had this been done the following would have been the result:
  • Grace would have the full income she expects. The company could have provided short term medical protection under an employee agreement.

  • Tom and Sam would now be the full owners. Based on prior share holdings, when Bill’s shares are redeemed, Tom will own 78 percent and Sam will own 22 percent of the shares.

  • Sam would own 22 percent of a company worth $5,000,000 (since the bank loan had been fully paid) — for a grand total of $1,100,000. He’s not going anywhere now.

  • Friendly Financial Bank would be happy to have been paid off in full. In fact, it would now be willing to consider some new financing for Magnum Auto Parts.

  • Because there are no bank loan payments to be made, the company will instantly be more profitable.
Ignoring reality

Business owners and professional practitioners focus on the everyday aspects of operation, and there are many challenges and economic changes to keep them occupied. That’s why they need a financial consultant whose job it is to assess these exposures, analyze and quantify the risks, develop creative solutions, initiate the legal documents required, and monitor the continuously changing company circumstances.

Forward to the past

Many years ago life agents took LUTC and CLU courses to learn the problems faced by the owners of small businesses. LUTC equipped them with marketing techniques and basic analysis tools. CLU offered risk assessment, tax background and calculations for business valuation.

But today, they are not having the same impact. Advisors should take it upon themselves to get the education and all the tools to achieve success in this underserved and highly profitable market.

The owners of businesses and professional practices are accustomed to payment of fees to respected advisors. Their wide circle of associates makes them superior sources of referrals. They represent the ideal client — one with growing needs, one who can be seen during the daytime, one who is comfortable paying a fee and one who can and will offer a flow of referrals.

Consequences

Since the end of World War II, there has been a steady shift of employment in America. There has been consistent growth of employment in the government sector and in the number of retirees. However, the private sector drives the economy of the U.S. as it does in every other country.

The percentage of employees working for large companies has steadily declined, while the percentage of those working for small and medium sized companies is constantly increasing. The future of our economy and our society is that these businesses continue to thrive. Never before has there been such a strong need for financial consultants.

As a business grows, its financial exposure compounds. The owners or executives are attentive to business and marketing risks, but often ignore opportunities to assure business continuity. In the next 15 years, nearly every business owner currently age 55 will have to consider a business transition — stimulated by disability, death or retirement. The opportunities are enormous.

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