Module 7: Primer on Buy-Sell Agreements
Part 1: Overview of Buy-Sell Agreements
Goals
Provide an exit strategy via options and triggers.
Maintain control of company.Establish future value of shares.Establish a market for shares.
Objectives of Buy-Sell Structure
• Control: Keep stock away from undesirable owners
• Fair Value: Establish fair mechanism for valuing stock of departing owner
• Transition: Assure smooth transitions of control and ownership issues as owners come and go
• Market: Assure “market” for shares at appropriate exit points
• Expulsion: Assure expulsion rights of group, if desired
• Source of Cash: Assure funding mechanisms and procedures
• Estate planning: Establish estate tax valuation
Mandatory Provisions
• Trigger event for mandatory purchase (redemption) or option (rt of 1st refusal);
• If Toiler, link between buy-out and voluntary termination of employment;
• Price or Formula for valuing shares;
• Process for resolving disputes.
• Uncontrolled
• Controlled
• Third party imposed
Death* Disability*
Voluntary sale of interest* Expulsion Employment termination
Divorce* Bankruptcy
*Most common
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
The Buy-Sell Triggers
Considerations
• Who is in the best position to buy?
• Whose interests are protected by the buy-sell: company or owner(s)?
• Are heirs likely to want to come into business?
• How do you define disability and does it apply only to toilers?
Special Rules for Estate Planning
Must be arms length business deal;At a fair value; andReasonable terms.
N/A if >50% of value owned by unrelated persons with comparable and mutual terms.
Price must be fixed or formula, estate has to sell at price; and corp. have right of first refusal.
Redemption vs Cross Purchase
• Company gets interest;
• Shareholders’ basis is unchanged.
• Treasury or repurchased.
• Company can deduct interest on installments.
*Preferred 1st Option
• Owners get interests• Stepped-up basis to
purchase price. • Lower capital gain on later
sale.
• Interest paid on installments subject to limitations.
*Preferred 2nd Option
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
Cross Purchase – Redemption Trade-off
Cross-Purchase Pluses:• Stepped-up basis to buyers• No AMTI life insurance issues• No state law redemption restrictions• No loan agreement or creditor restrictions
Redemption Pluses:• Easier – less cumbersome• Insurance structuring easier• Easier transfer-for-value issues• Deductibility of interest on installment payments• No need to get funds out of corp to fund buy-out
The Option Strategy – Not death trigger answer
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
Valuation Techniques
Third Party – Appraisal or Appraisal/Arbitration
Formula – Use modified book value.
- Focus on earnings (set cap rate)
- Discounted value of estimated future cash flows
- Asset market value - Combo formula
Costly, objective but uncertain.
May not reflect goodwill, current changes.
Best to use some combination of book and fmv.
Valuation Techniques
• Periodic owner agreement procedure – with back-up.
• Mixed formula – periodic agreement procedure.
Requires revaluation by shareholders. Need back-up if can’t resolve.
Three-tiers may be best if agreement is unlikely or difficult.
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
The Big Mistakes
• Misused Right of First Refusal
• Misused Showdown Clause
• Failure to honor unique rights – too much democracy
Precludes market for minority shares if company does not exercise.
Unfair advantage to deep
pockets. Best for golfers.
Big fish may have different interests than minority.
Big Mistakes
• Dumb payment terms
• Ignore the downside
• No anticipation of S Election Requirements
• Bad life insurance structuring
If no security is provided as collateral.
Who is stuck with debt after w/drawal.
Can’t make a transfer to ineligible shareholder.
Constructive dividend if obligation to owners but insurance is paid by corporation & beneficiary.
Buy-Sell Constructive Dividend Trap
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
CCorp
Cash or Property
ShareholderA
ShareholderB
Stock
Cross Purchase Obligation
ConstructiveDividend
Shareholder must buy, but corporation pays Constructive Dividend
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
Staged Exit ProcedureStage One: Shareholder gives notice, wants out per
price in agreement
Stage Two: Extended reaction period – others have time to secure funding to purchase or find replacement partner (3 to 6 months)
Stage Three: Negotiation period if Stage Two not produce solution (1 to 2 months)
Stage Four: Extended search period for acceptable replacement partner (2 to 4 months)
Stage Five: If still nothing, exiting partner has option to force sale of business. Any partner or group can buy. Tax-free structuring will be accommodated.
CWB Problem: Alton Inc.
• Alton Inc. provides take-out laundry services to hospitals and health-care providers in the Northwest. It is a C corporation with three shareholders, all of whom work full time for the business. The three owners have been "buddies and partners" since high school, but now they are all over forty. The business has 80 employees and continually grows. The owners have decided that they need some kind of "buy-out" agreement in case something happens to one of them.
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
CWB Problem 1: Alton Inc.
Triggers:
- Death: Insurance funded.
- Employment Termination: Installment, perhaps wrapped with owner deferred compensation. Amount reduced if no non-compete – goodwill presumed lost. (N/A in Calif.)
- Expulsion: Tough with only three. Require other two vote. Payout same as employment termination.
- Disability: Same as employment termination with non-compete.
- Bankruptcy, Divorce: Purely optional. Payout same as employment termination without non-compete.
- Voluntary Stock Exit: Min. vesting period. Employment remains. Staged exit program-installments. Pricing presumes no non-compete.
Lesson 2.2.2
Professional Service Organizations
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
Fragile Group Exit Protections
Key person disaster protection
Long-term exit notice to escape overhead and other burdens
The “Lights Out” option
The “Locked-In Equity” Option
Early transition financial payment requirement
Life and disability insurance to cover overhead, lost profits.
6 mo.-1yr. Notice
Mass exit option to liquidate
Equity in large asset preserved
Penalty for early departure
Scenario: A retires, B &C buy-in
• A has a successful practice, e.g, $1.4 million and turning away business.
• B &C want to take over practice, but have no money
• Execute promissory note payable monthly.• Payments made with after tax dollars.
Bottom line: B & C have a big debt on top of operating expenses.
Scenario: A retires, B &C buy-inAlternative: Keep as is, Wait until A dies.
1) Sub S election so pass-thru;2) Employment agreements for B & C;3) Salaries tied to productivity, bonus for
increase tied to benchmarks;4) A remains, and gets a draw with pre-tax
earnings. Taxed on distribution;5) Life insurance policy on A to fund buy-out at
death.
Module 7: Buy-Sell Agreements
Part 3: Funding Buy-Sell Agreements
Criteria for Funding
1. Provide liquidity for departing owner.
2. Offer financial security of payout.
3. Minimize risk to remaining owners.
4. Minimize tax cost for payment.
Strategy 1: Accumulate Earnings
Company funds
buy-sell K out of earnings.
Bottom line:
Should be used as a
Last Resort.
Exit is before saved enough.
Need $ for operations. Using after-tax dollars. Threat of AMT. May not be reasonable
business need.
Strategy 2: Death/Disabilty Benefit Insurance
Company takes out insurance on Toilers or Majority Owner.
Bottom line: Should be used by LLC or small
corp. where few shareholders of equal
importance, can corp. will redeem interest of departing.
Perk for employee. Protect business. Provide $$ to pay. Provide in Employment K. Base upon stock value, not
Owners’ need for cash. Decide cross-purchase or
redemption. Can’t transfer for value, unless sell
back to corporation. Can be administrative burden. Threat of AMT for corp.
Strategy 3: Cash Value Insurance
Company takes out insurance for death
only, but can loan for other triggers.
Bottom line: Should be used by LLC or
small corp. where few shareholders of equal importance; corp. can
redeem interest of departing.
May be subject to accumulated earnings tax.
Threat of AMT for corp. Limit on the interest a corp.
can deduct on loan up to $50K.
Must fund with after-tax $. Earnings accumulated is tax-
deferred.
Strategy 4: Split-Dollar Insurance
Company pays part of premium, employee pays balance.
Allocate proceeds based on who pays.
Bottom line: Should be used if perk to
employee and needed to fund buy-sell.
Tax impact based upon who owns the policy, the company or employee.
Employee-owned: Collateral assignment back to co. treated as below-market loan.
Company-owned: Endorsement back to employee treated as employee paid salary and co. gets deduction.
Death benefit does not reduce purchase price of interest.
Strategy 5: Retirement Plan Insurance
Company set up a retirement plan to fund future triggers. Plan
owns the insurance and pays premium.
Bottom line: Good for start-ups that have no money but potential
future income.
Upon death of insured, retirement account collects proceeds and uses it to buy interest.
Stock ends up in the plan, not corporation or owners.
Special rules apply to ensure it is a qualified plan.
Strategy 6: Installment Purchase
Company or owners buy back over time. Pay
interest on the installments.
Bottom line: Use with insurance to reduce cash burden on
company or other owners.
Eliminates accumulating funds issues.
Requires less cash, but family gets no lump sum unless insurance.
Fund death benefit with insurance and use for other triggers.
Secure not by stock. Interest paid deductible,
taxable to recipient.
Strategy 7: ESOP
Qualified retirement plan for employees that is
tax deductible by corporation.
Bottom line: Perk for employees and
low cost to company. Good for toiler with fewer employees to fund long term exit
strategy.
Allows accumulation for business purpose that is deductible by corp.
Defer tax on earnings. Can borrow funds from
company to pay before fully funded. Repayment is tax deductible.
Not a problem at death, but other triggers may result in capital gains tax.
Administrative costs.
Strategy 8: Supplemental Exec. Retirement Plan (SERP)
Non-qualified Retirement Plan that provides right in future
profits as tax deductible compensation by
corporation.
Bottom line: Perk for executives as deferred
compensation, used with another option.
Way to convert part of purchase price to tax deductible payments.
Should be used with another option.
Contract right to future profits in the form of deferred compensation.
Usually not fully funded. Payments deductible by corp.,
taxable to seller/shareholder. Only available to toilers.