Taming the Planning B.E.A.S.T

Part I – Buy-Sell Planning

By: James M. Duggan

The B.E.A.S.T. is always lurking – will you be its next victim?

As entrepreneurs maintain a primary focus on running a successful business, proactive planning understandably gives way to the demands of the day. Unfortunately, the failure to proactively plan in the following areas can have catastrophic consequences for the entrepreneur:

B Buy-Sell Planning – An absence of thoughtful buy-sell planning can lead to loss of value, litigation, and failed transition for your business interests upon a wide range of trigger events.

E Estate Planning – An improper estate plan can lead to public disclosure of private information, faulty disposition of assets, tax inefficiency, and creditor exposure.

AAsset Protection – All that you have worked for can be lost in a lawsuit if your business and personal asset structures are not properly insulated from creditors.

SSuccession Planning – Failing to establish the best-suited individual(s) to succeed you for both the business and your personal wealth usually leads to material dissipation of each after your death or disability.

TTax Minimization – Tax-inefficiency can lead to income and estate tax burdens in excess of 50%; maximize what you keep.

Each area of the planning B.E.A.S.T. is important in its own right, as the failure to properly address any one of the foregoing elements can lead to unexpected loss, if not ruin. This article will serve as the first of five installments in which each component will be reviewed for your benefit. Not surprisingly, we start with “B”….

Above all, the goal of Buy-Sell Planning is certainty. You have the ability to prescribe the rights and obligations of the owner(s) of a business as well as the terms upon which the ownership interests may pass. Uncertainty can lead to impasse, litigation, lack of leverage in negotiation, and lost enterprise value.

You may create a separate Buy-Sell Agreement (“BSA”), or you may insert Buy-Sell Planning provisions into broader shareholder agreements, operating agreements, partnership and joint venture agreements, and bylaws. Your circumstances will dictate which is the best path for you to take. Aside from certainty, reasons for a BSA include:

1.  Restricting certain transfers. The entrepreneurial venture is usually a small business enterprise as well as a privately held entity. Consequently, restrictions on transfer are often necessary to protect the company and your objectives. For example, a transfer could be prohibited and declared void in all respects if it is made to a transferee that: a) would violate an entity’s existing S corporation election, b) is not your descendant, or c) is not consented to by a stated voting percentage, including unanimous. This type of provision ensures the ownership interests never end up in the wrong hands, as defined by you.

2.  Creating a class of “permitted transferees.” While restrictions may be necessary, it may also be desirable to create a class of potential transferees who may receive ownership interests without any prohibitions. Generally, this class of “permitted transferees” may include existing owners, your descendants, an estate planning trust for your benefit, any entity controlled by you, and perhaps key employees.

3.  Clarifying the appropriate “trigger events.” At the core of the BSA are the various trigger events upon which the buy-sell provisions take effect. Most commonly, the BSA will deal with the contingency of the current owner’s death. The BSA creates a binding obligation for the estate of the deceased owner to sell, and the prospective purchaser to buy, the ownership interests of the deceased owner.

And while planning for death is the most common driver to the BSA, there are a variety of triggers of equal, if not even greater, importance. They include:

  • Disability
  • Voluntary transfer
  • Involuntary transfer
  • Retirement
  • Resignation (before a specified retirement age)
  • Attainment of stated return or economic threshold
  • Divorce
  • Bankruptcy
  • Loss of professional license
  • Termination
  • Dispute
  • Passage of a stated period of time
  • Conviction of a crime
  • And anything else that fits your circumstance

Each of the foregoing should be considered and discussed in detail to determine how best each contingency should be handled. The BSA is necessary not only to identify each trigger, but also to outline the purchase right/obligation at the time. It is likely that the various triggers will actually be treated differently.

4.  Providing a guaranteed market for ownership interests. Given that your entrepreneurial enterprise is almost certainly a private company, you are illiquid. You are in a different position than a public company in that you have a very limited pool of potential purchasers. The BSA allows you to overcome your illiquidity obstacle by identifying the class of purchasers and contracting in advance for the ultimate purchase of shares upon the specific trigger. The BSA, in effect, provides a self-created exit strategy.

5.  Establishing the optimal valuation method. As a private company, it can also be difficult to readily value your business. The BSA allows you to pre-determine the valuation methods to be applied at the time of purchase. Multiple methods can be used:

a)    Agreed Value – an amount that is stated in the BSA and adjusted annually thereafter in the company record book;

b)   Agreed Formula – this can be an industry norm or customize formula to be applied at the time;

c)    Appraised Value – using one or more third party appraisers to independently value the business using their professional valuation approaches;

d)   Insurance Proceeds – this method simply pegs the value of the interest to the amount of insurance proceeds received upon the death or disability of the owner; and,

e)    Any combination of the above – you can combine the approaches using a “greater than” or “less than” standard. An example would be to purchase shares upon the death of the owner for an amount equal to the greater of the insurance proceeds received or the agreed formula value.

6.  Establishing the ultimate purchase price and payment terms. Establishing the price is not necessarily the same as the valuation exercise. While the price may equal the valuation, it can also be adjusted from the valuation derived depending on the nature of the departure. For example, a discount could be further applied in the event of a “bad” trigger (e.g., divorce or criminal conviction), or a premium applied in the event of a “good” trigger (retirement after many years).  Also, the payment terms can be altered based on the nature of the trigger. A “bad” trigger may be paid out over a long period of time, with little money down, and a low interest rate, while a “good” trigger may be paid out over a shorter period of time, with significant money down, and a high interest rate.

7.  Assisting with tax planning. The BSA can be structured generally as a “redemption” in which the company buys back the interests, or a “cross-purchase” in which the other owners or successors buy the interests directly. For tax planning purposes, the cross-purchase method is favored as it gives the purchaser a “step-up” in basis on the received ownership interests. With a redemption, the company makes the purchase; the remaining owner(s) have an increase in the value of their respective interests, but no increase in basis since they did not pay anything. As a result, upon subsequent sale to a third party, the taxes will be greater after a redemption and less after a cross-purchase. The BSA can also be structured to have the best of all worlds by giving both the company and the other owners the option/obligation to make the purchase.

8. Avoiding litigation. Litigation arises when two or more parties have a dispute that they are unable to resolve without resorting to the courts. By providing the clear rights and obligations in advance of any trigger, you are able to provide a blueprint as to what the outcome must be, thereby avoiding costly litigation. You family and successors will indeed thank you for this.

Although it may not be easy contemplate all the triggers that may apply to your entrepreneurial venture, a little effort now can provide certainty, avoid heartache, and maximize your purchase price down the road.

By:  James M. Duggan, MBA, JD

— Taming the Planning B.E.A.S.T. – Part II – Estate Planning

— Taming the Planning B.E.A.S.T. Part III – Asset Protection