Preface: A few common areas that can lead to disagreements in implementing a Buy-Sell agreement include: discounts in value for — tax-effects, minority ownership, key-persons, and marketability. Understanding these risk will help you develop a increasingly practical Buy-Sell Agreement. Handshake agreements work only among good friends, and good friends minimize risk for good friends (disagreements.) A written Buy-Sell agreement is a minimization of risk.
Wrapping-Up on Buy-Sell Agreements – What to Ameliorate Beforehand
In wrapping-up our series on Buy-Sell agreements, we will look at a few problem areas you should have an awareness of to refine your Buy-Sell agreement. Buy-Sell agreements are frequently required for transfer of interest from retirement, or life-changes, and less frequently for death or disability. For this reason, sellers and buyers will be inclined to make the process of an agreements practicality, complex. The following are common causes of disagreement in union on buy-sell transactions.
One complexity is the tax effect of value in pass-through entities. For instance, if your business is an S-Corporation and net income flows to your personal tax return, the cash flow value multiple of your business may be lower when the tax-effect of those earnings is calculated. For instance, if the seller’s K-1 has textbook consistency of $100,000 per year with a five year history, and the seller’s appraisal counsel says it should easily have a 5x multiple of earning value, $500,000. On the other hand, the buyer’s appraiser may tax effect those earnings for a 40% tax rate. Thus the value of business interest would be $300,000. These types of polarities should be ameliorated beforehand, with an agreed base-line appraisal methodology between all buy-sell members.
Some businesses still operate as C-corporations. Only C-Corporation need worry about the problem of appreciated assets. Here’s the concern – if your business has appreciated assets, e.g. real estate, or say investment securities, the book value, i.e. cost basis, of the investment, and fair market value of the investment may hold polarity. Let’s say that the C- Corporation has been in existence for 35 years, and hold a $500,000 book value real estate investments. The fair market value today, may be $2,000,000. The capital gain on sale of that real estate would be $1,500,000. With a combined corporate and state rate of say 45%+, appraisers values may vary from that inclusion of the embedded capital gain and net tax effect. For simplicity sake, if the real estate is the only asset in the business, the seller in the buy-sell agreement may think they are receiving too low of a price after the net tax effect and dividend tax effect are calculated into the appraisal, e.g. a 55% discount on the real estate. An understanding of value and price should occur with a base-line appraisal when the agreement is written or modified.
Marketability discounts, controlling interest discounts, or liquidity discounts on the appraisal calculation can lead to value polarity. These discounts can be 20% to 30% of the business value. Your buy-sell agreement should enumerate these discounts beforehand to minimize material variances in appraisals and buy-sell member expectations.
Importantly, key person discounts are the final material variance factor in appraisals and buy-sell member expectations. A key person is any person who holds key goodwill to the company in form of expertise, experience, network, and/or associated intangibles. A key-person discount can be as high as 25%. If you’re a key person and you think you will only be a buyer no need to worry. But that’s not always the case. If there is the possibility you could be a seller, you want this risk ameliorated beforehand to avoid or minimize the key-person discount on your interests appraisal.
Summary: A Buy-Sell agreement is a vital document to a multiple-owner business. Business appraisals have multiple value metrics that can create variances between buyers and sellers in a Buy-Sell agreement, i.e. entity structure, and price discounts. With this knowledge, you should have the tools to work with an advisor to modify or develop a practical buy-sell agreement for your business. Have confidence in your Buy-Sell agreement; work with a trusted advisor to ensure your agreement is practical, should it be implemented.