Multiple Appraiser Valuation Agreements 

There are two types of appraiser valuation agreement (AVA). Multiple appraisers and single appraises, while the multiple appraisers (MAVA), are the most common.

How they worked

Usually the BSA calls for a 30-60-day window for the seller and buyer to attempt to agree upon a price.  Once the appraisal process is initiated, each party will select an appraiser.

The two will provide opinions of value conforming to the BSA.  If their value is within 10% of each other, then the final value will be the average of the two. 

If the two appraisals are more than 10%, they will agree on a third appraiser.  That appraiser will:

  1. Provide an appraisal is anaverage in the same way the other appraisers (reconciler)
  2. Provide an opinion regardless of theother two conclusions.

When BSA are triggered, the corporation and seller separate and go separate ways as there is different motivations. The seller wants the highest price, the purchaser, the lowest price.   A good reason why each party should reach an agreement on terms before there is a triggering event, where neither party will be as open minded as they were before a triggering event.

Even with appraisers it is possible that each side will be overseen by multiple sets of attorneys looking out for the interest of the various sides to the transaction.

  Thought Processes behind multiple appraisers’ agreements:   

Multiple appraisers are intended to bring reason and resolution to the valuation process. This does not always happen, because the parties have 30-60 window to get the appraisers and the evaluations completed.  This is more than enough time to irritate each other and taint the process, causing in some cases, the appraisals to be compromised.

Since most multiple appraiser agreements (MAA) base the third appraisal to be an average of the former two if within 10%.

Continue reading “Multiple Appraiser Valuation Agreements “

Life Insurance Proceeds In Business Valuations

If life insurance proceeds are considered as the funding vehicle, then the proceeds of the policy received following the death of a shareholder would not be considered a corporate asset for valuation purposes.(1)

It would be recognized that it was purchased for a specific purpose of funding the buy-sell agreement (BSA). IF it were considered a corporate asset, it would offset the company’s liability to fund the purchase of shares, added back as a non- recurring expense.

Treatment 1: (used as a funding vehicle, not a company asset)

Example: A company with a $10m value, has two shareholders, owning 50% of the company. The company holds a $6m life insurance policy on each owner (assuming no alternative minimum tax issues).

RESULTS: At Shareholder #1’s death, the company collects $6m of life insurance benefits. The surviving partner will receive $10m company value, and $1m of net tax-free proceeds, a total of $11m value. The deceased stockholder receives the $5m for the business.

Treatment 2: (A corporate asset)

Treating the life insurance as corporate assets for valuation purposes.

The proceeds are treated as a non-operating asset of the company. This asset along with other net assets, would be available to fund the purchase the of shares the of a deceased shareholder. Keep in mind that the expense of the deceased stockholder might be added back into income as a nonrecurring expense.  (2)

The treatment type can have a significant effect on the net position of a company or selling shareholder. There is also an affect in the ability of the company to purchase the shares of the deceased stockholder, and impact of the position of the remaining shareholders.

Company $10m, before $6m of life insurance. When you add the $6m into the value, the company value is $16m. The deceased shareholder entitled to $8m, the company pays $6m in life insurance proceeds and takes out $2m in promissory note.

RESULTS: The surviving owner, owns a company with 8 million and a note of $2 million.

Which treatment is fair? One owner ends us with $11m while the deceased owner, ends up with $5m. In treatment 2, the surviving owner has to carry a $2m debt to purchase the business. Two dramatic differences. A good reason, why the discussion should take place with your advisors.

More importantly, all parties should understand the ramifications of adding the life insurance proceeds in the valuation or using the life insurance as a specific vehicle to fund the BSA.

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1. Mercer: buy and sell agreements for boomers

2. Non-reoccurring expenses: Non-reoccurring expenses can be somewhat more complex. These are expenses which is  specifically  designated on the company’s financial statements as an extra ordinary or one time expense.  The company does not expect to continue the expense overtime, at least not on a regular basis. Non-reoccurring expenses can be somewhat more complex. 

The Interplay Between the Funding Mechanism And the Valuation? 

What happens when life insurance proceeds are part of the funding vehicle of a buy and sell agreement (BSA).    

 Example 

 When a stockholder owner dies and life insurance payments are made, is the valuation of the stock being redeemed as part of the value of the company?   

The way life insurance benefits are treated in the buy and sell agreement (BSA), could lead to different estate treatment and income tax.    In both areas, the results can be dramatic.     

 Does the agreement tell the appraisers how to treat the life insurance benefits in their valuationDoes the agreement provide for the company to issue a promissory note to a deceased shareholder, and what are the terms? 

 Keep in mind, the agreement is no better than the ability of the parties and/or the company to fund any required purchases at the agreed upon price.    An agreement that is silent on this issue is like not having an agreement.  

 Life insurance  

 Generally, life insurance premiums are not deductible, and the pass through of non-deductibility can create pass-through income for the shareholders of S corporations, and the owners of partnerships and limited liability companies.  Knowing how to treat the life insurance premium for tax purposes would be important information for you.  We suggest you discuss this with your CPA.  

 Although the life insurance premium is not deductible, the death benefits generally are tax- free, notwithstanding the alternate minimum tax treatment for C corps.  

Keep in mind the funding mechanism is not actually necessary to define the engagement for valuation purposes and has nothing to do with appraisal standards or qualifications. It provides the funding for the company to afford the value, and to make sure the selling stockholder receives the value.  In essence, it’s the mechanism to fund the liability of the contract, or at least part of it.   

Wants and Needs of the Buyer and the Seller- The normal push and pull!  

The seller wants the highest price and the buyer wants the lowest price.   Without a doubt the best time to set the price would be prior to a triggering event, when both parties are in parity and neither is the subject of the trigger.  It is the best time when both parties will be the most reasonable in setting the rules of the agreements as they are both fair minded in the negotiations.   

 Funding Methods 

  1. Life InsuranceIn most cases life insurance will be the most inexpensive method for funding the death benefit part of the agreement, when comparing, self funding, and loans (including corporate promissory notes) to fund the liability, notwithstanding the ability to get a funding loan from a loaning institution.    In most of the comparisons I have done over the years, life insurance is the least expensive, most guaranteed, and the easiest method of funding for death benefit purposes. 
  1. Corporate Assets: They would have to be accumulated for this purpose, and would likely be included in the valuation, and also would be subjected to taxes during the accumulation stageWhat if the death of the stockholder occurred early after the agreement?  Would there be funds available to fund the liability of the agreement, as there would be a lack of time to accumulate the necessary net profits for the funding?   
  1. External borrowing: Depending on the company’s financial position, it may be possible to fund the purchase price by borrowing.  However, this should be negotiated in advance and before its needed.  Remember, the time to requests funds from an institution is when you don’t need them.  Also, on the other side of this funding element, is the possibility the loan covenant requesting the outstanding note balanced to be called in when there is a dramatic change in ownership and management.    The lending institution may be questioning the ability of the company’s future financial position and the ability to stay profitable.   
  1. Promissory Notes:  If this is going to be used, the terms of the notes should be in the agreement.  Although cash payments are preferable to the seller.   
  1. Combination of cash and promissory notes: Important to note:  Anytime capital is being used by the corporation, it is important not to unreasonably impair the capital of the business. Many state laws prohibit transactions that could impair capital and raise the question of insolvency.  

Without the mention of what funding mechanism is being used in the agreement to repurchase shares, lessens the value of the agreement.  Also, with stated funding, the economic or present value of the redemption price set by the agreement can significantly be reduced, because of inadequate interest or excessive risk leveled on the selling shareholder.   

  

Weak terms in the agreement of the funding mechanism diminishes the value of the agreement from the sellers prospective. However, terms that are too strong can taint the future transactions. What is clear is that it is essential for the parties to discuss the funding mechanism for the triggers of a BSA, keeping in mind both the sellers value position and the purchaser’s ability to fund the costs. 

Advantages Of A Buy Sell Agreement And Some Dynamics Of The Agreement!

It’s important to understand that every Buy and Sell Agreement (BSA) is different and has a separate purpose when put together and implemented. Because of the vast differences in BSA’s, using a standard form of BSA rarely accomplishes the needs and wants of the parties involved.

Each participant in the agreement has different purposes and objectives and looks at the transactions very differently. Neither party knows when the agreement will actually be needed, and what the triggering event will be. A triggering event could be death, disability, divorce, termination,  bankruptcy, and other defined events.   One thing that can is consistent in most cases is that when a triggering event happens, then each party becomes visionless to the other parties’ best interests, and only focuses on their own and best interests.

The two participants in a BSA are a seller and a buyer. They come in different forms, as individuals, trusts, or estates. Usually their purposes and objectives are very different, and there usually is a conflict between the parties.

While creating the BSA  the parties tend to be very fair before a triggering event. This is because everybody is in the same position and no one knows who will suffer the future triggering event. This is a positive viewpoint, as the parties are reasonable and objective about the possible and various scenarios. Everyone’s objectives are personal, and range from financial, tax, to personal protection for their families.  Having a designed BSA can offer the owners some satisfaction that their needs are documented and witnessed.

Objectives of BSA

  • To provide a predetermined roadmap for the business based on a triggering event which may call for the sale of a participant’s ownership interest.
  • To provide a guaranteed buyer for the owner’s business interest and to create a market for that interest.
  • If funded through life insurance or some other means, the BSA will provide liquidity for the payment of the business interest and help the estate pay for the estate taxes and other settlement costs of the deceased owner’s estate.
  • Can avoid an impasse between the parties in the event of a triggering event.
  • To protect the company and surviving shareholder from subsequent competition, should a terminated owner wish to sell to a 3rd
  • To avoid potential conflicts between the surviving owners and the deceased owners’ heirs, by creating a roadmap through the agreement at the owner’s death.
  • Can level the playing field for the estate or deceased owner’s as the agreement gives the deceased owner a say on how settlement of their interest will be to their heirs and estate. Especially, when the surviving family have little knowledge of the business entity.
  • Establishing the price and method of valuing the interest, establishing the terms of payments, and providing a method of funding for the payment of that purchase price.
  • Can create job stability for minority owners and key non-owner employees.
  • Can establish the value of the entity for tax purposes.
  • Can preclude owners from selling their interest without the consent of others thus avoiding the third-party ownership or voting percentages.
  • The agreement can restrict ownership to people who are actively engaged with the entity of full-time basis.
  • Can improve the credit worthiness of the entity.
  • Can avoid transfer violations/Licensing requirements.
  • Avoid transfers to individuals that would terminate the S corporation status.
  • Can dictate discounts for lack of marketability (minority interest discounts).
  • Can provide for voting agreements where necessary.
  • Can dictate what happens to in force life insurance policies on the terminated or surviving owners.

These are only a few of the many reasons for a buy and sell agreement, and the advantages of funding the agreement.

 

What If I Want A No-Sell Buy / Sell!

There are business partners who at their death, want their family to continue to own their shares even though the family member will not be actively involved with the business.   We see this with businesses that are expected to grow significantly. Each owner wants their family to share in the future growth even if they should die prematurely.

A no-sell buy/sell agreement has a fairly simple structure. The management and the voting stock all remain with the surviving owner. The deceased’s ownership interest remains with his family. We take each owner’s interest in the business and divide into voting and nonvoting stock. Upon the death of one of the owners, the deceased’s voting interest is bought by the surviving owner per the terms of the buy/sell agreement. The non-voting interest of the deceased owner remains with his family. This way, if the business does grow significantly, the family of the deceased will share in the growth. The control of the business remains in the hands of the surviving owner. The family of the deceased owner has non-voting interest in the business only and cannot expect to see any money out of the deal unless, and until, the business is sold. Continue reading “What If I Want A No-Sell Buy / Sell!”

Characteristics Of An Effective Buy –Sell Agreement!

Creating a buy-sell agreement requires foresight about what could, might and will happen to the business if certain situations occur to the equity owner’s/stock holders of the company. This article looks at some of the important elements of the buy-sell agreement (BSA).

First of all, what is the purpose of the BSA?  Simply, an agreement between, interest holders, and the corporation as to what will happen to the company and interest holders should there be a disruptive and harmful occurrence in the future.  These are called triggers; death, disability, divorce, departure (voluntary and non-voluntary), bankruptcy, retirement, and others.

It is important that the agreement be entered into when parties are aligned and before triggers events occur.  It usually is a time when the relationship is aligned for the good of the interest holders and the company.  In short, they usually are of the same mindset that any of the triggering events could happen to them in the future,

This is a time where advisors should encourage interest owners to complete and sign the BSA, as it is the best time when their attitudes are in synch concerning future event happenings.

Interest owners know that when there is a trigger event, each party will have a different perspective as to outcomes for each person.   Terms and pricing transactions can become difficult or impossible to achieve if the issue was dealt with without an agreement in advance.

 Some of the characteristics required in the agreement;

  1. It should be in writing and signed by all parties. (good time to have spouses sign as to their witnessing and understanding of the agreements, although they are not signing as a party to the agreement)
  2. Trigger events should be defined and funding and price adjustment; Each event should be discussed as to what will happen as to the price, and the terms. Also, the definition of the trigger event should be in the agreement.  Example: definition of disability? What happens if a person is fired? What happens if a person decides just to leave?  What happens upon a divorce, or bankruptcy, retirement, or death?
  3. Determine the conditions that cause the triggering events.
  4. Determine the price (price per share) at the time of the triggering event.
  5. Methods of Valuation
    1. Fixed price; usually never updated with changing markets, and company condition.
    2. Formula: with all the variables of economic conditions, company conditions and market conditions, it is hard to find an accurate formula for any given company or industry.
    3. Single Annual appraisal (updated annually or bi annually); Suggest the initial pricing of the company by a single appraiser, and then update yearly or every other year.
  6. Define how the triggering event will be funded.
  7. Creating a buy-sell agreement takes future thinking by all the interest owners. There is always the “what if’s” of the future, but owners need to be aware of them and protect themselves.

The BSA is the most important document owners of a business can have.  They must have one.  Without it, there are no instructions as to what will happen, how much they will pay, and how to fund it.  There ends up being chaos, arguing, and lawsuits, not to mention the costs of fighting in the courts.

(Some great resources:  Buy-Sell Agreements for Closely Held and Family Business Owners by Z. Chris Mercer, and Buy and Sell Agreements, Paul Hood)