BEGIN WITH THE END IN MIND:

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BEGIN WITH THE END IN MIND

• Structuring Effective Buy/Sell Agreements

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Its hard to make predictions, especially about
the future

• --Yogi Berra

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Objectives of a Buy/Sell Agreement

• Provide a smooth transition for a change in
  ownership
• Allow an owner to liquidate an ownership interest
  in the event of death, disability, termination
  of employment, retirement, bankruptcy or divorce
• Provide assurance to the remaining owners that
  the interest being sold will be transferred to an
  acceptable owner
• Set forth detailed payment terms that are not
  detrimental to the remaining owners or
  disruptive to the business
• Provide procedures for business valuation
  questions
• Provide a valuation of a deceased owners
  interest for estate tax purposes

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Therefore,

• By agreeing in advance upon a method for a
  smooth transfer of ownership, the owners should
  prevent potential problems and reduce the
  likelihood of litigation and friction between the
  parties

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The Buy/Sell Agreement Should Specify

• The type of agreement
• Triggering events that cause the buyout
• Definition of valuation date
• Method for determining the purchase price
• How the purchase obligations will be funded
• The existence of non-compete agreements
• Transfers of ownership interests that are
  permitted and prohibited

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Types of Buy/Sell Agreements

• Redemption acquisition of interest by the
  company
• 2. Cross-Purchase acquisition of interest by
  the other owners
• 3. Hybrid allows flexibility, with the company
  having the first option to acquire the interest,
  then the other owners having the second option

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1. Redemption Agreements

• The business is obligated to purchase the
  ownership interest
• Easy to administer
• Typically funded by life and/or disability
  insurance
• Insurance proceeds are free from income tax
  (except C-corp. may be subject to AMT)
• If the ownership interest is a controlling
  interest, insurance proceeds are included in the
  decedents estate

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2. Cross-Purchase Agreements

• Ownership interest is acquired by the other
  owners
• Difficult to administer, especially multiple
  insurance policies with differing premiums
  (younger, healthier owners may have to pay higher
  premiums for older, sicker owners)
• Insurance proceeds are tax-free to the other
  owners, not subject to corporate AMT
• Deceased owners family gets a stepped-up basis
  in the ownership interest

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3. Hybrid Agreements

• Generally, the business has the first option to
  acquire the ownership interest
• If the business does not exercise its option,
  then the other owners have the option of
  acquiring the interest
• This structure allows maximum flexibility

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Triggering Events

• Death or disability define disability
• Retirement how to fund, since life insurance
  wont be applicable?
• Divorce, loss of professional license or
  bankruptcy other owners can compel a sale
• Sale to a third party right of first refusal

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Valuation Date

• Date of Death
• Previous Fiscal Year End
• Previous Quarter End

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Standard of Value

• Fair Market Value this is the only standard
  acceptable to the IRS for gift and estate tax
  purposes
• Fair Value (no discounts for lack of
  marketability or lack of control), fairer to the
  first to die
• Other book value, intrinsic value, investment
  value (define as no less than the value as
  finally determined for estate tax purposes)

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Level of Value

• Clearly define whether the value determined under
  the agreement will be based upon a pro rata share
  of the entire business, or upon the value after
  discounts
• Discounts for lack of control (50 or less
  ownership) generally range from 14 to 45
• Discounts for lack of marketability on
  non-controlling interests are added on top,
  generally ranging from 35 to 50

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Level of Value Makes A Big Difference
Value of Business 4,000,000
Interest Being Valued 25
Pro Rata Share of Value 1,000,000

Discount for Lack of Control -30
700,000
Discount for Lack of Marketability -40
Value of Interest After Discounts 420,000
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Valuation Methods

• Negotiation
• Formula
• 3. Independent professional valuations

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1. Negotiation

• Saves on professional fees
• The owners may know the value of their business
  better than anyone else
• The owners also know their objectives best
• May not be fair if one party to the negotiation
  is not as knowledgeable
• The owners may not be able to agree on a value
• In cases of controlling interests, the IRS is
  unlikely to regard a negotiated value as binding

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2. Formula Approach

• Avoids the cost of a professional appraisal,
  although an appraiser should be consulted in
  designing the original formula
• The most common formula approach uses book value
  or adjusted book value
• Different types of businesses would require
  different formulas
• It may be difficult to design a formula that
  would fairly capture the value of the business if
  the business changed significantly
• Rarely results in a true fair market value when a
  transaction ultimately occurs

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3. Independent Professional Valuations

• Most likely approach to achieving a fair and
  accurate outcome
• Can be costly, but updated valuations should cost
  less than the first valuation
• Appraiser should consider asset-based,
  market-based, and income-based approaches to
  value
• May use one appraiser, or may use several
  appraisers
• The agreement should provide the process and
  criteria for selecting a qualified appraiser

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Appraiser Qualifications

• Valuation professional should have some business
  appraisal credential
• Institute of Business Appraisers CBA
• American Society of Appraisers ASA
• American Institute of Certified Public
  Accountants ABV
• National Association of Certified Valuation
  Analysts CVA
• Accountants or CPAs may not be qualified unless
  they have earned one of the designations above
• Real estate appraisers are probably not qualified
  to appraise an interest in an operating business

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Funding Mechanisms for the Buyout

• (Unfunded or underfunded buy-sell agreements may
  be worse than none at all)
• Life insurance source of cash, cash value is a
  business asset
• Corporate funds, in redemption cases
• Personal assets, in cross-purchase cases

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Payment Terms

• Should give the Company an adequate amount of
  time to pay without jeopardizing its financial
  health
• Interest rates should be tied to market rates, so
  that the seller is treated fairly
• Should provide the seller with adequate
  collateral
• Should require the buyer to meet certain
  financial criteria, such as minimum working
  capital, a minimum current ratio, or maximum
  debt-to-equity ratio. If these criteria are not
  met, the entire amount becomes due and payable

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Potential Tax Pitfalls

• A value determined under a buy/sell agreement may
  be legally binding on an estate for transaction
  purposes, even though it may not be binding on
  the IRS for estate tax purposes. Thus, an estate
  could suffer a whipsaw effect whereby it pays
  on a substantially higher value than the amount
  the estate actually receives.
• See IRC Chapter 14, Section 2703 the buy/sell
  agreement must not be a device to transfer value
  for less than full consideration.
• See IRC Section 302 be careful that the
  redemption is not treated as a dividend taxed at
  ordinary income rates.

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Summary

• Review and update Buy/Sell Agreements (or
  buy/sell provisions) for your clients on a
  regular basis
• When it comes to valuation issues, one size does
  not fit all
• Consistent and regular use of independent
  appraisals allows the owners to discuss and
  analyze a value that has been developed through a
  valuation philosophy

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