At a recent presentation to business owners, an owner told me the following: Despite the economy, his business hasn’t lost a beat. The company is doing better than ever. Yet he had a business appraisal done and his business is worth less than it used to be. How can that happen?
This business owner is the victim of a buyer’s market. The recent economic downturn has not only hurt the profitability of many companies; it has also limited the number of viable buyers for businesses. Less liquidity, less financing and less demand translates into lower values and fewer parties able and willing to buy businesses.
Private business owners, whether selling internally or externally, must act now to review their business values and buy-sell plans, and to adjust their exit plans. Failure to do so can mean delayed retirement, unfulfilled estate plans and unnecessary business failures.
The current economy can be a two-edged sword of opportunity for owners who get ahead of this issue and a potential disaster for those who don’t. One potentially effective way to get ahead of the issue is to perform a buy-sell review.
What is a buy-sell review?
A buy-sell review entails more than having an attorney review the language of a buy-sell agreement. There are 3 key elements to a review. First, the business must be valued. Second, there should be a review of existing agreements that involve the disposition of the business. Finally, a review needs to be made of the funding for the exit plan.
The object is to determine if the designated business value is accurate in this changed economy. The agreement is reflective of the intended exit plan and the funding is in place to make the plan actually viable. Failure of any one of these elements can mean failure of the entire exit strategy.
In an environment where business and asset values are lower than in past years, a buy-sell review can be a particularly important business planning step. The economy-driven changes in valuations can cause unwanted outcomes such as:
? Overpaying for a partner’s ownership interest;
? Inability to buy an interest because of reduced credit lines
? Insurance that is misaligned to the buy-sell terms.
Further, as exemplified by the business owner quandary mentioned above, the economic conditions may have changed an otherwise valid valuation or buy-sell agreement. For example, consider a business owner who had a $5 million estate when she set up her estate plan 3 years ago. On the advice of her attorney, she set up a bypass trust for which the federal estate tax exemption ($2 million at the time) would pass to her children; the remainder would pass to her husband.
The increased federal estate tax exemption and a lowered business value may cause this well crafted plan to fail under current conditions. Assume that her business (and estate) is now only worth $3.5 million and the federal exemption has risen to $3.5 million. If she were to die this year, all of her estate would go to her children, disinheriting her husband. This is an unintended outcome, in part caused by a significant change in the value of her business. A buy-sell review can help avert this outcome.
Kick-starting the exit plan
By gathering the appropriate documents and working with the business owner’s other advisors, the insurance professional can be the spark that lights the review of the owner’s exit plan. If necessary, the business will be revalued, the agreement reviewed and the funding revised.
A business valuation is the cornerstone of the exit planning process. Without an accurate idea of the true value, the exit plan is more theory than fact. Typically a business valuation includes several formulas, some based on assets, some on earnings, and some on industry benchmarking.
Once a range of values is determined, the owner can work with advisors to determine which value to use for buy-sell agreements, executive benefits and family transfers. The business valuation can also help the owner assess shortfalls in the family’s finances and explore ways to increase the value of the business for a future sale.
Buy-sell agreement review
Next, existing buy-sell arrangements should be reviewed. The agreement may be a standalone document or part of a business operation document, for example an LLC formation agreement. Aside from the legal aspects, the review allows the advisor to see if the document aligns with the owner’s exit planning expectations.
Among the questions to be asked: Does the value stated in the agreement accord with the business valuation? Is there a disposition of the business in the event of a disability? Is the definition of disability the same as any disability insurance funding? Are all the intended buyers and sellers parties to the agreement? Have spouses signed off on the agreement? And does the agreement coordinate with the planned-for funding?
Without adequate funding, a buy-sell agreement is an expensive piece of paper. Funding may come in various forms, but it is important to determine the sources in advance and put them in the agreement. Funding can come from earnings, financing, tax savings or be pre-funded in the form of life insurance.
Even if life insurance is in place, it is not enough to confirm that there is adequate coverage and assume the review is complete. The review should determine if the policies are properly held (for example, cross-owned for a cross-purchase plan) and adequately funded.
Are they the right policies for the plan? Do they address both living and death-time transfers of the business? In sum, will the funding plan help make the execution of the buy-sell agreement successful for the business, the owner and other interested parties?
Assuring a Successful Exit
Virtually all business owners have been affected by the economic downturn. A buy-sell review is a coordinated process that should be performed currently in order to help assure a successful exit from the business.
Steve Parrish, JD, CLU, ChFC, RHU, is a national advanced solutions consultant with the Principal Financial Group, Des Moines, Iowa. You may e-mail him at [email protected].