When co-owners are united in striving toward common business goals such as growing revenue, building business value and increasing cash flow, the business dynamics can be wonderfully positive and strong. Contrast that bright picture with what can happen when the goals of the owners diverge.
As you read further, ask yourself if the real issue facing owners in our examples is the misalignment of goals or a lack of planning for the day one owner wants to leave.
Owner Disability and Other Lifetime Transfer Events
What happens when one owner of a closely held company wants or needs to leave the company, or sole owners want or need to leave theirs?
The reasons owners cite for leaving include everything from simple boredom to more dramatic and unexpected events such as the disability of an owner. As an example, let’s use an owner’s disability to illustrate some of the significant issues that arise when one owner needs to leave a company.
When a disability strikes, companies undergo both economic and operational hardships. More importantly, in the absence of a buy-sell agreement, the disabled owner’s income stream from the company usually evaporates. This is the problem Steve Hughes, one of three equal shareholders in a growing advertising agency, confronted.
At age 38, Steve Hughes had a stroke. As is the case with many stroke victims, his recovery was incomplete. Physically, he was the picture of health; his golf game even improved. However, he lost his ability to speak and read. Doctors told Hughes he would never return to work.
Hughes' firm had a buy-sell agreement, but it covered only a buyout at death and an option for the company to buy his stock if he were to try to sell it to a third party. It was silent on an owner disability or the more common situation of owners choosing to leave the company. This glaring omission left the company and Steve in a classic dilemma.
The company, or rather the remaining shareholders, wanted to purchase Hughes' stock so that its future appreciation in value, now due to their efforts alone, would be fully attributed to them.
Consequences for the Hughes Family
After the difficulty of the stroke and recovery period, the Hughes family was still in a difficult position.
Solving the Remaining Shareholders’ Problem
- The Hughes family soon realized that owners of stock in closely held companies rarely receive substantial benefits in the form of dividends or distributions because companies either accumulate or distribute (to active shareholders) profits in the form of salaries, bonuses and other perks.
- In short, the Hughes family would not get what it needed most – cash – to replace the salary Steve Hughes was no longer earning. His co-owners learned that their efforts to increase the value of the business would reward them and the Hughes family in equal measure.
The co-owners can buy Hughes' stock, but because they’d made no plans to do so, there are a number of obstacles.
- There is a difference of opinion between buyer and seller related to the value of Hughes' stock.
- The other two co-owners of the business want to pay as little as possible over as long a time period as possible because they or the company:
- will pay with after-tax dollars; and
- they want to preserve capital rather than spend it on a non-productive asset such as stock of the company.
- The Hughes family wants to receive full value for Steve Hughes' stock as quickly as possible.
Before Hughes' stroke, all co-owners were in sync. Hughes' disability, however, produced radically different owner wants and needs. To deal with this conflict, advisers must address four major issues with their owner-clients:
- Agreement on business value
- Funding for the buyout
- Agreement on payment terms for the buyout
- The income-tax consequences to the remaining owners on their payments to the departing owner
A buy-sell agreement drafted before Hughes' disability could have managed all these issues because all shareholders would have made the agreement when they shared the same ownership objectives. Also, they didn’t know who would be exiting first.
Solving the Problem
Hughes needs lifetime income for himself and his family. Even if the shareholders successfully resolve the buyout issues listed above, the underlying problem remains: How can Hughes maintain his former compensation level?
Let’s assume Hughes' pre-stroke, annual compensation was $250,000 and his interest in the company was worth $1,000,000. An all-cash sale might yield Hughes after-tax investment capital of about $800,000. Can Hughes expect a rate of return on his invested sale proceeds that matches his previous annual income from the company of $250,000 per year? The buy-sell agreement likely does not address this issue.
Many advisers believe their job is finished when owners sign a well-drafted buy-sell agreement. Hughes would not agree.
Had Hughes engaged in the exit planning process, he would have quickly realized that a sale of his ownership during his lifetime, or at death, would probably leave him and his family with a fraction of the income they are now spending. Planning would focus on closing this income gap using his employment and buy-sell agreements, disability insurance, the creation of a wage continuation plan and other appropriate means.
We realize that even well-drafted documents, such as buy-sell agreements, can create more problems than they solve. It is important to look at the specific provisions of the agreement and put them in context by looking at the big picture and all possible scenarios that may occur. In this case that means we carefully address all of the ramifications of both lifetime and death buyouts – for the business, the departing owners, and the remaining or surviving owners. We can talk with you about each scenario and the outcomes that you'd like to see, and then collaborate with your advisers to make sure that your agreements and planning are consistent with your goals.
The Cornerstone team includes former C-Level executives, successful entrepreneurs and advisers who offer unmatched experience in delivering advanced, custom-tailored, results-oriented solutions for business leaders. As a member of the Business Enterprise Institute (BEI), Cornerstone is an authorized distributor of BEI’s content and Exit Planning Tools. We developed the Performance Culture System™ to help clients implement best practices and drive high performance throughout their organization. For more information, visit www.launchgrowexit.com, call (910) 681-1420, or email [email protected].