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1 BEGIN WITH THE END IN MIND: Structuring Effective Buy/Sell Agreements

1 BEGIN WITH THE END IN MIND: Structuring Effective Buy/Sell Agreements

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Page 1: 1 BEGIN WITH THE END IN MIND: Structuring Effective Buy/Sell Agreements

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BEGIN WITH THE END IN MIND:

Structuring Effective Buy/Sell Agreements

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“It’s 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 owner’s 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

1. 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 decedent’s 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 owner’s 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 won’t 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

1. Negotiation

2. 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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