Volume 10 Issue 1
Sell It For What???
© by Tax & Business Professionals
Remember our last newsletter
about the LONG TRIP TO TIBET? In that edition, which dealt with business succession, we
intentionally skirted the subject of setting the price for the mandatory sale of an
owner's interest in a buy-sell or a redemption agreement.
One of the essential
ingredients of such arrangements is that the surviving owners (or the business) be
obligated to buy, and the terminating associate or deceased owner's estate be obligated to
sell, his or her interest.
can be hard to deal with the estate of a deceased associate or a disgruntled former
associate. Setting a fair and
enforceable price today is important.
these problems is the timing of events. None of us knows when an event, such as death, will occur. This lack of
predictability is why the IRS will honor a properly drafted redemption agreement.
O.K. you say,
But what is the best way to set the price for my stock? What's fair for everyone involved?
Generically, the methods of setting a price could be:
- Fixed Price - so much per share.
- Formula - a mathematical formula such as "two times book value."
- Fair Market Value (FMV) - for the percentage interest.
- Amount of Insurance - simply pay the insurance, if any, to the estate of the decedent '
- Some Combination of These Methods.
Each of these methods of shaping a price has strengths and weaknesses:
Fixed Price - The problems of a fixed
purchase price are obvious. While a fixed price per share may be fine initially,
conditions change over time. If the business succeeds, a fixed price set five or ten years
ago will be inadequate. Conversely, If those initial rosy expectations are never met, the
estate of the first to die may receive a windfall. Potentially worse than a windfall may
be litigation between the estate of the decedent and an impoverished business over the
business's inability to pay the fixed price.
Formula - In theory, formulas seem ideal since
they have the advantage of being adaptable as times change. In reality, formulas suffer
the same deficiency we all have - the inability to predict the future. No price formula
could have foreseen the success of Microsoft or the virtual demise of Lotus. This does not
mean that all formulas are flawed, but there are situations where any formula may be less
Fair Market Value (FMV) - FMV works this way: the decedent's
interest, 25% for example, is multiplied by the entity's FMV, and the decedent's estate
gets 25% of FMV. "Fine," you say, "but who determines FMV?'' There is the
rub. If, as is likely, there is disagreement over the FMV, then a "tie-breaker"
type mechanism can be used. If the appraisers for the decedent's estate and the business
disagree, a "tie-breaker" provision would specify that these appraisers pick a
third appraiser whose decision will be binding on both sides (buyer and seller).
The Insurance - Some redemption agreements
provide that the decedent's estate will receive the proceeds of insurance policies
in consideration for the stock of the decedent. If the insurance is adequate, then the
estate of the decedent can be well compensated and the business will have paid only the
amount of the insurance premiums. But if the business prospers and the principals forget
to buy more insurance, this will not work. The failure of the business to pay the
insurance premiums or the demise of an insurance company can also be problems.
Combinations - It is possible
to combine a number of these approaches to overcome their individual weaknesses. There are
so many ways to engineer a buyout price that if we attempted to cover them all, this
newsletter would turn into a book. Rather than attempt to cover the plethora of
possibilities, let's look at a popular approach.
Suppose a new defense contracting company, StarBurst, wants to create a stock redemption agreement. Let's
further assume that one "right" contract could put StarBurst in the "big
time." The company is wheeling and dealing, bringing in new employees, but still
hasn't yet reached stardom, although there are reasons to think it may.
StarBurst could structure its stock redemption agreement by providing that the price for the stock of a deceased
stockholder will be the greater of $300 per share or the proceeds of insurance
policies on the life of the deceased stockholder. Using this method the decedent's estate
gets the larger of the two figures.
Fine, you say, but what if StarBurst goes big time and both the $300-per-share price and the insurance are
woefully inadequate? In that event, a good mechanism to use might be a provision some call
a "kick-out." The "kick-out" provision might state that if the
per-share price has NOT been updated in the last two years, then instead of the insurance
or the per-share price, FMV will be used. The kick-out provision is an attempt to address
the problem created by the common habit of putting the stock redemption agreement in a
drawer and forgetting about it, usually until someone dies.
There are many ways to structure this type of agreement. None will be perfect for all circumstances, but
frequently even a poorly drafted agreement is better than none.
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