Understanding Your Buy-Sell Agreement – Part 5
Written by Dalton Hopper, CVA, CFE
This is the last article in our series discussing the valuation aspects of buy-sell agreements. We have discussed what is included in a buy-sell agreement and how, when, and who should be involved in valuing the business or interest. Finally, we must discuss one of the most often used funding vehicles used in a buy-sell situation: officers’ life insurance.
While the death benefit amount of life insurance is often used to fund the purchase of the decedent’s interest in the business, the ownership arrangement and the ensuing treatment of life insurance can be crucial to a fair determination of value for both the business and the owner’s estate.
While a complete, in-depth discussion is beyond the scope of this article, buy-sell agreements can be structured as redemption agreements, under which the business entity is purchasing the interest of the departing owner or, as cross-purchase agreements, under which the remaining owners buy the interest of the departing owner. In some cases, a hybrid agreement of the two types of agreement might be structured. The owner of insurance acquired to fund a buy-sell agreement may differ depending on the type of agreement. Special purpose insurance LLCs might also be present in some buy-sell arrangements.
The discussion below applies to redemption agreements.
Let us imagine that Bob and Sam own 50% of Hardware Store, Inc. (Company). The buy-sell agreement states that the Company will purchase the shares of Hardware Store, Inc. from the owner’s estate in the event of either owner’s death. The Company owns a life insurance policy of $6 million on the lives of each owner. Let’s say that BMSS was engaged to determine the value of Hardware Store, Inc. and found that the Company was worth $10 million.
In this instance, two scenarios should be considered. One, the life insurance proceeds are not considered non-operating assets of the business and the Company simply recognizes a liability for the purchase of the decedent’s shares at half of the Company’s value ($5 million). Under this example, the former owner’s estate would be paid $5 million for his 50% interest in Hardware Store, Inc. and the Company would hypothetically gain $1 million, which could then be used to support the Company as it replaces its former owner.
However, in the second situation, the life insurance proceeds are considered a non-operating asset of the business and the former owner’s estate is paid $8 million (the originally determined $10 million plus the $6 million life insurance proceeds divided by 2 for the 50% interest in the business). Under this example, the Company must pay an additional $2 million above the amount of the life insurance proceeds to the estate. The additional $2 million could be paid in the form of a note payable to the estate or could, ultimately, force the closure of the business if the business is unable to make payments.
With these two scenarios, it is clear that the treatment of life insurance proceeds is crucial to all parties involved. While both situations are possible and reasonable, which situation demonstrates the intent of the owners? Owners should decide how to treat the life insurance proceeds within their buy-sell agreement now, because if left unaddressed, there could potentially be issues down the road at a time when the family is grieving and the business is struggling to continue operations without a crucial owner.
If you have not read through your business’ buy-sell agreement lately, now is the best time to dust it off and make sure you understand it. When it comes time to buy out an owner, serious disputes about value can erupt. To help business owners and advisors of closely held businesses avoid this potential conflict, BMSS can step in now and work with the owners to put an effective valuation mechanism in place—before it becomes operative.
If we can help you understand your buy-sell agreement and the impact it may have one day, please don’t hesitate to reach out to us at (833) CPA-BMSS or visit our website.
The information provided in this series does not, and is not intended to, constitute legal advice; instead, all information and content in this series are for general informational and business purposes only. Please contact your attorney to obtain advice with respect to any particular legal matter, including a comprehensive discussion of other provisions that might be advisable in a buy-sell agreement.