A truly heart wrenching part of my job is helping our members deal with the loss of a key employee, business owner and/or business partner(s). Particularly troubling is when I know the spouses and family left behind and they (their attorneys) reach out to us over estate settlement conflicts.
Here are some typical situations I run across…
- Scenario 1: Two partners form a company and immediately protect themselves with a buy/sell (member or shareholder) agreement defining what happens if one dies, becomes disabled, gets divorced, or simply wants out. Because the company is worth very little at the time, not much thought went into the valuation of the business, or funding the stock sale agreement. At the time, insurance seemed too expensive and unnecessary. Then the business grew, a valuation was done, and now – insurance seems like the best choice to fund a stock redemption upon a death of one of the partners. On the day of taking out the policy, the fair market valuation (FMV) exactly matches the insurance death benefit. As time goes on, there can be a huge discrepancy – perhaps the company is not worth what it once was, or the insurance death benefit is way below FMV.
- Scenario 2: The business grows and the two partners forget all about the buy/sell agreement. They purchase real estate – including the building where the company is located. The two partners offer stock to a third employee, then a fourth. An original partner now retires and the remaining partners buy him out. The new owners were issued stock certificates, but did not update the buy/sell agreement to match the insurance policy. Suddenly, one of the new partners dies, leaving behind a spouse and family. Because the original buy/sell agreement was never updated, the original document did not account for multiple partners. Some of our members believe they can fund a buy out or death settlement of minority partners without financial hardship by increasing their line of credit. But as we have recently learned, a recession can hit causing margins and profits to suffer, therefore limiting cash flow. In addition, banks have really cut back on the amount loaned without personal guarantees.
- Scenario 3: An estate attorney can challenge the valuations when the buy/sell specifies the lesser amount of the insurance benefit or FMV value at time of death is to be paid. The problem is that all a spouse remembers is their wife or husband coming home one day saying that “my business partner and I each took out a million dollar life insurance policy in case something happens to one of us.” They heard $1million and that’s all. They didn’t catch the part explaining that the actual payoff will be based on 4 times earnings averaged over a 3 year period and that the insurance (paid to the company) was only a means to fund that payout. It could be FMV but “not to exceed” the amount of the death benefit.
- Scenario 4: Most companies use life insurance to fund their buy/sell but never find time to evaluate the under/over funding based on current market conditions. More often than not, the owner/partner who passes is a leader in the company and the person who is the primary revenue generator, thus quickly reducing sales and the overall company worth. I’ve also seen partners whose medical history or age prevents them from obtaining insurance or have very costly premiums for one of the partners, so they take the risk of getting to retirement before death.
So how does your company buy/sell work and what valuation is used?
- I recommend you fix the stock value to the insurance death benefit and have that adjusted periodically to FMV.
- I recommend you name the corporation as the beneficiary and require the exact death benefit value to be paid out to the estate of the partner.
- I also recommend the language is very clear that the partner’s estate must accept that settlement amount without further legal action.
Plan for the future:
The whole point of this blog is to make sure the family comes first and your business affairs are always current. It’s responsible to set this up, but it’s even more responsible to evaluate and adjust your insurance and buy/sell agreements on a regular basis.
These scenarios bring about common considerations when setting up and reviewing your shareholder agreements, life insurance policies, and business valuations.
Consider the following items:
- Consistency with the terms and conditions of the buy/sell agreement and the death benefit of the insurance policy. If there are inconsistencies, the estate attorneys get involved and everyone suffers all over again. The settlement can drag on for months and at least one party will feel cheated on the actual settlement amount.
- The last thing you want is for your survivors to have to figure out what to do with an equity position in a business they’ve never worked in. You don’t want them to have to go through a valuation after you are gone. You don’t want them to have to hire another lawyer because of uncertain language on the fair market value vs. insurance benefit.
- Another harsh reality is the uncertainty over what happens with a partner going through a divorce, on disability, or when a partner simply chooses not to be active (abandons corporate duties) yet retains ownership. Specific language needs to be included in these shareholder agreements for these situations as well as an equitable dissolution statement and who can buy whom under what conditions.
Please make sure your business affairs are in order to keep have your family first if something should ever happen to you. Have your personal attorney help you and if they need a valuation have them contact me. CW