A Drop-Dead Plan for the Unprepared
In this article, Edward Mendlowitz shares his views regarding the importance of having a buy-sell agreement. He proposes a â€śdrop-dead planâ€ť or method that, while imperfect, addresses how owners can arrive at an initial value that does not necessarily require a Conclusion of Value, especially if the owners are not related. Significantly, Mendlowitz stresses the importance of securing an agreement that addresses major life events to get the process started.
Any business with more than one ownerâ€”a corporation, partnership or limited liability companyâ€”must have a shareholdersâ€™ partnership or membersâ€™ agreement (â€śbuy-sell agreementâ€ť). Such an agreement is effectively a pre-nuptial and/or will for a business and its other owners.
Imagine the complications, problems, issues, and controversies that arise when a part-owner dies and there is no such agreement. Other issues arise when an owner becomes disabled, imprisoned, files personal bankruptcy, or goes through marriage dissolution. All of these circumstances should be addressed.
Another issue that should be covered is an owner wanting to retire or leave the business. These are different situations. Someone may want to go to work elsewhere or start a competing business while a retiring partner usually wonâ€™t.
That being said, when understanding that there are many different variations of such agreement, three issues should be determined:
- The trigger points: What causes the buyout to become effective?
- The valuation: What price will be paid?
- Payment terms: Over how long a period will the payments be made?
The co-owners need to keep in mind that they could be on either side of the future transaction, and without an agreement, they may leave a mess for their partners and family.
It is best to have a comprehensive plan and agreement. Getting everything ironed out early on in the relationship is important and gets this â€śchoreâ€ť put aside. However, many owners of ongoing businesses have difficulty making decisions regarding the â€śsplit upâ€ť of their business, which is what occurs when one of the owners makes the decision to leave. So, the agreement never gets completed.
Now, we have to leave the ideal and proper thing to do and consider recommending a plan to a client that is less than perfect, but one that could unravel the problems that develop when a co-owner dies prematurely or becomes disabled to the exclusion of the other issues.Â From my experience with business owners, separating death and disability from the other issues removes a lot of complications and the difficult decision-making that covers all alternatives.Â It also can eliminate the need for a full valuation that most agreements would need. Â The limiting to death and disability makes it easier to get something done.Â Payment terms are also very important and need to be included.Â Once this is put in place, the other issues can be tackled and a comprehensive plan with the proper valuations put in effect.
This default plan for a buy-sell agreement would be to use the current â€śfair market valueâ€ť or other agreed-upon basis for valuing the company with future annual adjustments for increases or decreases in book value or other criteria. Payments should be made over a five- to ten-year period with interest at the then current applicable federal interest rate. I suggest that in a worse-case scenario, a new valuation be obtained every five years. Ideally there should be a new valuation, rather than a Calculation of Value, every two years. One further adjustment would be if the business is sold for a greater price within one year after the buy-sell transaction takes place. In that situation, the buy-sell value should include an adjustment.Â That is, the value should be adjusted to a pro rata portion of the actual sale price, and the payment terms will be consistent with the terms of that sale. There will be no downward adjustment.
Buy-sell agreement valuations also concern the IRS. The IRS routinely scrutinizes low values. This is done to make sure there isnâ€™t a gift element in the transfer. However, while the IRS looks at the values and compares them to â€śfair market value,â€ť that is not necessarily the proper standard since the valuations are not for cash payment and there are other elements removing it from FMV, such as a necessity to sell and buy because of the sudden trigger event causing the sale. This is a discussion for another time, but the main issue here is to protect the company, the buyer, and the deceased or disabled ownerâ€™s family, and that makes executing such an agreement a must.
Death and disability are also two situations that can be insured against, in most cases. Life and disability buy-out insurance can be looked into while you are have the agreements prepared and actually made part of the agreement.Â There are many different types of policies and funding options where the company has sufficient cash flow and owners are insurable.
Valuation for Drop Dead Buy-Sell AgreementÂ
Here is a method you can consider for valuing the business for a drop dead buy-sell agreement.
The big picture, and urgency, is the necessity of getting an agreement that covers death and disability of the co-owners. For that, a payment amount and terms need to be agreed to (understanding that either party could be on either end.). Â To accomplish this, the owners would need to arrive at a number that both think is reasonable. Not a number they would sell the business for, value a transfer to a successor or family member, to fund a retirement, or for the myriad reasons ownership would be transferred. The purpose of this agreement would be to avoid conflicts between the remaining owners and the family of the deceased or disabled owner and to allow the remaining owners a reasonable way to make the payments.
A simple method is for the partners to agree on an amount and terms they would be willing and able to pay and would feel comfortable for their family receiving. If asked, here the valuation analyst or business appraiser would serve as a consultant assisting in cash-flow modeling and payment terms rather than valuing the business using an appropriate standard of value.Â Keeping in mind the limited purpose of the agreement, this could be done relatively easy. The businessâ€™ attorney would prepare the actual buy-sell agreement.
To accomplish this, I do not believe they would need a formal Conclusion of Value provided the co-owners were not related. Â If the transfer is between relatives, a gift element or a tax-based transaction, they would need a Conclusion of Value for the fair market value prepared in accordance with IRS rulings and requirementsâ€¦but that is a different situation than I am discussing here. If for some reason the IRS challenges the value, and it is necessary, they can then get the formal valuation at that time. A tax challenge might affect the estate taxation, but it would have no bearing on the transaction between the parties. They can also add to the amount paid that an adjustment would be made if there is a sale to a third party at a greater price within one year after the buy-sell transaction.
I have seen too many situations where an owner died or became permanently disabled and problems arose along with excess costs that could have been avoided had they signed a buy-sell agreement.
Using this drop-dead plan, there would have to be representations and acknowledgements that the clients recognize that no valuation conclusions were provided and that they were strongly recommended to get them along with a comprehensive plan by the consultant, but declined.
Help make your clientsâ€™ lives less complicated and reduce stress and consternation; if they do not have an agreement, get it done, and use this article as a guide.
Edward Mendlowitz, CPA, ABV, CFF, is partner emeritus with WithumSmith + Brown, PC, in NewÂ Brunswick, New Jersey. He has over 40 years of public accounting experience. He is a licensed CertifiedÂ Public Accountant in the states of New Jersey and New York and is Accredited by the American InstituteÂ of Certified Public Accountants (AICPA) in Business Valuation and as a Personal Financial SpecialistÂ (PFS).
A graduate of City College of New York, Mr. Mendlowitz earned his bachelor of business administration degree. He is a member of the AICPA, the New Jersey Society of Certified Public Accountants (NJSCPA), and the New York State Society of Certified Public Accountants (NYSSCPA). In addition, he was a founding partner of Mendlowitz Weitsen, LLP, and CPAs, which merged with WS + B in 2005. Currently, he serves on the NYSSCPA Estate Planning Committee and was chairman of the committee that planned the NYSSCPAâ€™s 100th anniversary. The author of 16 books, Mr. Mendlowitz has written hundreds of articles for business and professional journals and newsletters. Mr. Mendlowitz can be contacted at (732) 828-1614 or by e-mail at email@example.com.
Image courtesy of Ambro/FreeDigitalPhotos.net