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Module 7: Primer on Buy-Sell Agreements Part 1: Overview of Buy-Sell Agreements.

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Presentation on theme: "Module 7: Primer on Buy-Sell Agreements Part 1: Overview of Buy-Sell Agreements."— Presentation transcript:

1 Module 7: Primer on Buy-Sell Agreements Part 1: Overview of Buy-Sell Agreements

2 Goals Provide an exit strategy via options and triggers. Maintain control of company. Establish future value of shares. Establish a market for shares.

3 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

4 Mandatory Provisions Trigger event for mandatory purchase (redemption) or option (rt of 1 st refusal); If Toiler, link between buy-out and voluntary termination of employment; Price or Formula for valuing shares; Process for resolving disputes.

5 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 Enterprises www. drake-business-planning.com The Buy-Sell Triggers

6 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?

7 Special Rules for Estate Planning Must be arms length business deal; At a fair value; and Reasonable 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.

8 Redemption vs Cross Purchase Company gets interest; Shareholders basis is unchanged. Treasury or repurchased. Company can deduct interest on installments. *Preferred 1 st Option Owners get interests Stepped-up basis to purchase price. Lower capital gain on later sale. Interest paid on installments subject to limitations. *Preferred 2 nd Option

9 Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. 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

10 Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. 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.

11 Valuation Techniques Periodic owner agreement procedure – with back-up. Mixed formula – periodic agreement procedure. Requires revaluation by shareholders. Need back-up if cant resolve. Three-tiers may be best if agreement is unlikely or difficult.

12 Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. 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.

13 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. Cant make a transfer to ineligible shareholder. Constructive dividend if obligation to owners but insurance is paid by corporation & beneficiary.

14 Buy-Sell Constructive Dividend Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com C Corp Cash or Property Shareholder A Shareholder B Stock Cross Purchase Obligation Constructive Dividend Shareholder must buy, but corporation pays Constructive Dividend

15 Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Staged Exit Procedure Stage 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.

16 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.

17 Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. 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.

18 Lesson Professional Service Organizations

19 Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. 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

20 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.

21 Scenario: A retires, B &C buy-in Alternative: 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.

22 Module 7: Buy-Sell Agreements Part 3: Funding Buy-Sell Agreements

23 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.

24 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.

25 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. Cant transfer for value, unless sell back to corporation. Can be administrative burden. Threat of AMT for corp.

26 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.

27 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.

28 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.

29 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.

30 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.

31 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.


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