Buy and Sell Agreement – Page 2 – Your Business Worth

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 valuation? Does 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

Life Insurance: In 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.

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 stage. What 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?

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.

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.

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.

Why Use Non-Compete Agreements!

November 5, 2019November 5, 2019 by YOUR BUSINESS WORTH, posted in Buy and Sell Agreements, Funding your Buy and Sell, Income from your business, Inside Sale, Key People_Or Group, Selling Your Business, Uncategorized, Valuation, Value drivers, Working On Your Business

Non-compete agreements (NCA) represent a separate agreement. They could be in an employment contract, or as a separate article in a buy and sell agreement. Sometimes they are referred to as “Covenants not to complete. “

This is based on the possibility that an employee can do harm to a company upon termination. They could know sensitive information about the company’s operation, owners and employee’s personal information, special operations, and proprietary information to a competing advantage, along with so much more.

Picture a very long-term employee working side by side with the owners, for many years, and then leaving to work for the owner’s competitor. Certainly, there can be issues.

No compete agreements (NCA), can be used to retain employees also. It would be very difficult to change jobs within an industry or profession when the leaving employee is limited to compete in a geographic and specific industry for a period of time. However, non-compete agreements are hard to enforce, because in many instances the agreement has overreached and is very broad in the definition of industry and geographic coverage.

Continue reading “Why Use Non-Compete Agreements!” →

The Story! The Cost of Funding Your Buy and Sell Agreement! Options!

July 31, 2019July 31, 2019 by YOUR BUSINESS WORTH, posted in Buy and Sell Agreements, Executive Benefits, Funding your Buy and Sell, Income from your business, Selling Your Business, Uncategorized

The Story!

The Cost of Funding Your Buy and Sell Agreement! Options!

Over many years I have experienced many business owners in total denial about the cost of funding their buy and sell agreements, thinking they can come up with the liability when the trigger of death occurs.

The four listed ways are compared below.

Cash
Borrow
Sinking Fund
Life Insurance

Let’s take the one by one.

Cash: This is assuming the company has the cash at hand, idle. Rarely is this an option. Growing companies reinvest in their company and only keep enough cash reserve as needed.

Borrow: A company just lost a valuable member of the company. Most bankers would probably want to see how the company will fair after the death of a key person and would want to know how the liability which has just been created will affect the cash flow of the company before loaning more money. There probably is a good chance that outstanding line be pulled in by the bank (probably a covenant in the loan agreement).

Sinking Fund: Mostly just theory! In 48 years, I have never seen a company try to develop a sinking fund. If the company was putting money in the sinking fun, they are losing the opportunities this money could create by investing in the business rather than on the sidelines. Not reasonable as the actual amount of money needed is available should death occur prior to the target date of accumulation. The least appropriate method.

Life Insurance: At its simplest benefits, it is immediate, tax free and the funding level is immediately known. Also, the cost is only 17 cents on a dollar rather than the much higher costs of the other three options.

Summary: While we don’t know when a death or disabilitymay occur, the company should at least be prepared for this trigger. Today the price of life insurance is low-cost. There is no reason not to purchase at least temporary life insurance (10-30 years), such as term insurance. The cost of life insurance in the example is using cash value life insurance. Increased Sales To Fund Cost: Another measure of effectiveness of funding the buy and sell is to measure how much more in sales the company has to do to pay for the funding method.

Costs: Funding over 15 years.

Cash; 1,039,464 Loan: 1,306,085. Sinking Fund: 901,613 Life Insurance: 171,512

Also, what do you need to have in sales to pay for the method:

Example, with Life Insurance Cost, @20% profit, sales would be $857,560

With Cash: There would have to be $5,197,320

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Disadvantages Of The Buy And Sell Agreement! [i]

July 8, 2019 by YOUR BUSINESS WORTH, posted in Buy and Sell Agreements, Inside Sale, Selling Your Business, Working On Your Business

Certainly, having a Buy and Sell Agreement (BSA) has many advantages, many of which I have discussed in our past posts (May 2019, Advantages of Buy and Sell Agreements). However, I would like to go over the disadvantages of a BSA.

RESTRICTIONS ON ESTATE PLANNING

BSA can restrict ownership transfers and consequently management duties. These restrictions can be applied to you also. The restrictions could limit your personal planning by limiting your options for the ownership interests during your lifetime or at death. It may prohibit you from making gifts of your ownership interest to your family. Depending on your planning, your BSA could limit your plans to leave ownership interest to your family. The BSA may require your ownership interest to be sold at your death.

RESTRICTIONS ON FINANCIAL PLANNING

A BSA can restrict the persons to whom you could sell your ownership interest to and restrict when you can sell it. An example would be in a situation that you need to sell your interest because you’re in a financial bind. The BSA may require you to sell to your entity or your co-owners, who may not want to buy.

Special election to the defer federal state tax of deceased owners

This could limit an estate owner from using Code Section 6166 which is a way of paying your estate tax over a period of time, giving you the option of paying over a 15-year period, five years of deferral and a ten-year payout. A purchase from your estate could cause the loss of the right to defer the estate taxes.

A sale of Corporate interests may result in a loss of the entities corporate structure

This could limit the entities right to use its own loss carry back and carry forward losses on a significant change in ownership, which is possible without a well throughout BSA.

The cost of putting together a BSA

It takes time and money to put together a solid buy and sell agreement, Of course this is a disadvantage and it can be expensive, however, in order to have an optimal BSA, you will need to invest time and money. You will also need a competent council to prepare the necessary documents. This incurs costs. Being educated in this strategy is to your advantage when designing your BSA.

A poorly drafted buy sell agreement can be costly: By failing to carefully work out the terms of buy-sell agreement or by having mismatches between triggering events and the identity of the purchaser versus the funding source, a real mess could be created.

[i] Buy -Sell Agreements for Baby Boomer Business Owners Z. Christopher Mercer, ASA, CFA, ABAR

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

May 31, 2019May 31, 2019 by YOUR BUSINESS WORTH, posted in Buy and Sell Agreements, Income from your business, Inside Sale, Passive Ownership, Strategies of growing business, Valuation, Working On Your Business

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 3^rd
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.

Your Exit From Your Company!

March 29, 2018 by YOUR BUSINESS WORTH, posted in Buy and Sell Agreements, Company Wealth, Income from your business, Selling Your Business, Strategies of growing business, Uncategorized, Value drivers, Working On Your Business

I read somewhere that over the next number of years, at least one in every four small businesses will be sued or threatened with a lawsuit. The odds are great that it will come from within the company.

Will your death, disability, or withdrawal cause a dispute? In many cases it can come from not having communicated the exit or transition plan for the company.

Your Corporate Board of Directors

The Board of directors in your company is crucial to the short and long-term success of the company. The board helps in the avoidance and resolution of disputes. The board can help direct the company’s planning, officer selection and the compensation. The board can help in dispute avoidance, dispute resolution and overall corporate management.

Disputes, can come from compensation agreements, benefits, health co-pays, benefits paid. These are many other ares which a dispute can occur. The hope is that there is a board of directors to help with the resolution.

When the owner dies, becomes disabled or just wants out of their business, and there is no business continuation or a buy and sell, the risk of a dispute rises. A buy and sell agreement will establish the rules in the event a trigger that sets off a change within the business. Remaining partners will need to know what the value of the company stock will be sold for. The surviving family will need to know what the value of the business is and what the family expects to do with the company values. Without a solid written plan, there are unanswered questions and confusion. Continue reading “Your Exit From Your Company!” →

What If I Want A No-Sell Buy / Sell!

July 18, 2017 by YOUR BUSINESS WORTH, posted in Buy and Sell Agreements

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!

July 8, 2017July 10, 2017 by YOUR BUSINESS WORTH, posted in Buy and Sell Agreements

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;

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)
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?
Determine the conditions that cause the triggering events.
Determine the price (price per share) at the time of the triggering event.
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.
Define how the triggering event will be funded.
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.

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