What a relief. You’ve finally got the financing together to fulfill your dream of company ownership, thanks to a Rollover Business Start-Up, aka a “ROBS” transaction. The million little tasks involved in running a business are at the top of your to-do list.
Here’s the Problem
Before you break open the champagne, if you are married and/or have a business co-owner, there’s one more thing to do, that is to address the big “what if” questions: What will happen to your spouse, your partner, and your company if some (unfortunately not uncommon) life event occurs, such as your divorce, your death, your permanent disability, or your termination of employment?
When one of the above events occurs, in the absence of any alternate arrangement, the law will automatically transfer ROBS shares to someone outside active employment with the Company. This is the ROBS succession problem, which can wreak business and legal havoc on all sides.
The Unthinkable
Think about it. You and your best friend go in together as 50/50 partners to start a ROBS company. You’re working hard, taking lowish salaries, and it’s paying off – the company is slowly but surely starting to grow. The sacrifice now will pay off later, when you sell the company at a marvelously increased value. For now, you both just keep on giving it 110% to maintain that good growth.
Then boom! Your partner suddenly dies. He is gone. In an instant, this horrible event triggers two things – (1) the company has suddenly lost a major contributor to its value, and (2) half of the company ownership is now in the hands of a person who has no role in the company, i.e., your partner’s designated plan beneficiary, probably his widow/-er.
What will happen now? As the new beneficial owner of half the company, the ROBS beneficiary has shareholder rights, but not necessarily any services to offer nor perhaps even any particular concern for the company’s goals. They may care only about their rights, given them under the terms of the ROBS plan document, to get their hands on their plan benefit; depending on how the document is drafted, the beneficiary could have a right to force the company to cash out the beneficiary’s ROBS shares immediately.
In such an awful scenario, could your young company find cash equal to 50% of its current value? How would you keep going after such an economic blow?
An ugly divorce could also create problems, as retirement plan assets are most likely on the table in any property settlement. A divorce decree could divide the ROBS shares without the company’s consent, adding a new shareholder to the mix; one who is not necessarily inclined to make life easy for the company or his/her ex-spouse.
Continuing the unpleasant thought experiment, how about the permanent disability of a ROBS owner, their voluntary resignation, or even an acrimonious termination of employment ‘for cause?’ While certainly unpleasant, these circumstances are not at all farfetched.
No Shareholders May Be Ignored
Like any corporation, a ROBS company exists to earn profits for its shareholders, and it is accountable to all shareholders. Even an “accidental shareholder,” such as a ROBS beneficiary, enjoys all the same rights as any other shareholder under state law:
- The company must operate in accordance with the corporate bylaws and all applicable state corporate and securities laws;
- The company must maintain accurate and up-to-date financial records;
In addition to the state corporate and securities law considerations, ERISA plays a large part in the shareholder rights of a ROBS plan participant/beneficiary. As the federal law governing retirement plans, ERISA imposes the following relevant duties owed by the company, and/or the plan itself, to the ROBS plan beneficiary:
- The Plan and the company must avoid conflicts of interest with one another;
- The Plan trustee (usually the ROBS owners) must put the Plan’s duty to provide benefits above all other competing interests.
These onerous and complicated duties are regulated and enforced by both the IRS and the Department of Labor.
Planning is the Best Solution
Fortunately, with a little planning, it is possible to minimize the financial impact of death, divorce and termination of employment.
Start with the Plan’s Distribution Provisions
The retirement plan document is the primary source of the rights of a plan participant, and of his/her successor or beneficiary. It should be drafted thoughtfully, with employer elections that anticipate the needs of the company in the event of an unexpected life event. Specifically, through the plan terms, the company can control two key aspects of the distribution of the ROBS shares– (1) the form of the distribution (i.e., cash or property), and (2) the timing of the distribution (i.e. when payment starts, and whether it may be all at once or in installments).
The plan elections made for a particular company may vary, depending on the needs and desires of each set of ROBS owners.
This is part one in a series of posts exploring the challenges and solutions for ROBS succession planning.