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. Obviously, it 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.
Compounding 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:
(1) Fixed Price -- so much per share.
(2) Formula -- a mathematical formula such as "two times book value."
(3) Fair Market Value (FMV) -- for the percentage interest.
(4) Amount of Insurance -- simply pay the insurance, if any, to the estate of the decedent.
(5) 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 than ideal.
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.
By Tax and Business Professionals, Inc.
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