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Two Key Components to Your Buy/Sell Agreement

Admin - August 15, 2019 - 0 comments

There are many items that a business owner considers, Not Urgent, but Important.  When you own and operate a business, your Buy-Sell Agreement is probably the last thing on your mind.  It’s something your advisors drafted years ago and it hasn’t been on your horizon since.  However, your Buy-Sell Agreement will eventually become Urgent and Important; you just can’t predict when that moment will occur.

Let’s address two key areas that will have a significant affect on the value that is determined under the provisions of your Buy-Sell Agreement.  They are a) the standard of value, and b) life insurance proceeds.

Value to Whom?

Your buy sell agreement must address the standard of value that will be applied to the valuation.  The standard of value addresses the question, Value to Whom?  The most widely recognized standard of value is fair market value.  Fair market value applies to most federal income, estate, and gift tax matters.  However, under the fair market value standard, it is appropriate to consider discounts for lack of control and lack of marketability.  Many business owners are not aware that, under the fair market value standard, their non-controlling ownership interest will not reflect their proportionate share of the entire entity, but rather a reduced value, due to discounts for lack of control and marketability.  In fact, in my experience, most business owners view the value of their ownership interest from an investment value or strategic value standard, that is, the value from the perspective of a particular investor or strategic buyer.  Investment value and strategic value are typically higher than fair market value because it represents the value to a specific buyer, who typically will pay more due to synergies with an existing, complimentary business operation.  There is no right or wrong answer on whether your Buy-Sell Agreement should be under a fair market value, investment value, or strategic value standard.  But when an agreement does not address the standard to apply, it forces the business valuation expert to make that decision for you.  To avoid any confusion, your agreement should specify the standard of value to follow, and whether the ownership interest is, or is not, subject to discounts for lack of control and lack of marketability.

Life Insurance Proceeds

If a Buy-Sell Agreement contains a mandatory redemption, there may be life insurance payable to the company upon the death of the insured owner. This provides a source of working capital for the Company at a time when they will be facing additional costs and dealing with the predictable distractions that such an event can cause.  In addition, life insurance proceeds are often designed to provide liquidity for the owners’ estate and heirs in exchange for the decedent’s ownership interest.  From a valuation perspective, when the company is the beneficiary of the policy, it can be treated either as an additional business asset, reduced by the redemption liability; or, as a separate funding mechanism and not included as a business asset.  Let’s take a look at an example under each method and see how it affects the surviving owner and the estate:

Life Insurance Proceeds-Funding Vehicle
Company Estate Surviving Owner
a Ownership 100% 50% 50%
b Entity Valuation 5,000 2,500 2,500
c Insurance Proceeds 2,500 2,500
d Repurchase Obligation (2,500) (2,500)
e Post Buy-Out Value 5,000 5,000
f Increase in Value (2,500) 2,500

The above illustrates that if insurance proceeds are equal to the redemption amount, there will be no change in the post buy-out value.  If life insurance proceeds are greater than the redemption, there will be a value increment to the survivor, and if insurance proceeds are less than redemption, there will be a value decrement to the survivor.

Let’s contrast the above analysis with the result that would occur if the life insurance proceeds were included as a business asset, thereby increasing the decedent’s buy-out value by 50% of the proceeds;

Life Insurance Proceeds-Corporate Asset
Company Estate Surviving Owner
a Ownership 100% 50% 50%
b Entity Valuation 5,000 2,500 2,500
c Insurance Proceeds 2,500 1,250 1,250
d Post Life Insurance Value 7,500 3,750 3,750
e Repurchase Obligation (3,750) (3,750)
f Post Buy-Out Value 3,750 3,750
g Change in Value (1,250) 1,250

As indicated above, by treating the life insurance proceeds as a business asset the post buy-out value is lowered by 50% of the proceeds, which are transferred to the estate.  Under this situation, the estate reaps the benefit to the detriment of the surviving owner(s).  What each owner needs to realize is that under this scenario, additional funds, above and beyond the life insurance proceeds, are required to fund the buy-out.  This means the surviving owner will need to borrow funds or deplete existing working capital to fund the buy-out.  However, this could be an overwhelming burden for the surviving owner, considering that at this point in time, the company is most likely experiencing additional costs and distractions in dealing with the loss of an owner and key employee.

There is no right or wrong answer on how life insurance proceeds should be treated in the valuation.  Each owner must comprehend the ramifications of their agreement so that they can have an intelligent conversation on the pros and cons of each option.

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