T. Ray Phillips Category

Buy-Sell Agreements Should Protect You, Your Co-Owners And Your Company

Wednesday, November 5th, 2014

Presented by T. Ray Phillips

Imagine, on the eve of your wedding, that you plan to divorce, on a friendly basis of course, in 15 years or so. During those 15 years, you will work diligently, and quite successfully, to build a business.

On the preordained day that your marriage ends, you announce that you are willing to give your soon-to-be ex-spouse one-half of your company’s business value—in cash. And you let your “ex” value your company because those are the terms of the agreement the two of you signed a year after you were married.

Sounds ridiculous, no? Yet, you may have done something quite similar (and similarly ridiculous) in your business with your co-owners.

Few owners begin working together with an expectation of future acrimony, much less litigation. Fewer still give thought to one day leaving the business—even on friendly terms. Indeed most exits are not precipitated by a disagreement among co-owners; instead owners leave for a variety of reasons and simply want to do so with their share of business value.

And remember, one day you will leave your business.

Over time, in business as in marriage, partners can grow apart. We’ve all witnessed the resentments, discord, and wastefulness of a friend’s or acquaintance’s needless nasty divorce. Business divorces can be equally unpleasant—with an added twist: One may be unable to leave the business, or force a partner to leave, without appropriate tax and legal planning.

When you or a co-owner wants out, what will happen? Chances are that when you turn to your company’s buy-sell agreement, you will find that it is woefully out of date. You may also find that it controls the terms of your (or any owner’s) exit from the business not only upon death, but also during lifetime.

If you haven’t looked over your company’s buy-sell agreement since you signed it, dust it off and check out at least four key provisions:

Lifetime and death transfers of ownership:
When must an owner sell, or offer to sell?
When must an owner (or the company) buy and when does it have the option to buy?
How will the value of the company and the value of a departing owner’s interest be determined?
Does the agreement mandate the use of an independently determined Fair Market Value at the time of transfer? If not, the valuation will favor you or the other owner. It will not treat you even-handedly.
What are the terms (length, down payment, interest and guarantees) of the buyout?
We generally assume that buy-sell agreements control the transfer of an owner’s interest when he or she dies or becomes disabled. Indeed, they do that. But they usually do much more and if you don’t appreciate how much more, disaster looms.

At his annual physical, Steve Hughes complained that he was bone tired. After a battery of tests, Steve’s doctor observed that, while there was nothing physically amiss, Steve did seem depressed. After some introspection, Steve was able to articulate that he had no interest in continuing as a partner in a successful CPA firm. Like many owners, Steve had lost the passion and commitment to the business that still stoked his younger co-owners. He decided to sell out before his partners demanded it.

Steve broke the news of his departure to his two partners and noted that their buy-sell agreement controlled only a buyout at death and an option for the company to buy Steve’s stock if he were to sell it to a third party. Attempting to sell a partial interest in most businesses to a third party is always a difficult proposition, but current economic challenges made that course of action impossible.

Steve and his partners were left in a classic dilemma: remaining shareholders want to purchase the departing shareholder’s interest so that future stock appreciation—due solely to their efforts—would be fully available to them. Conversely, because the profits of a closely-held corporation are either accumulated by the company or distributed to the active shareholders in the form of salaries, bonuses and other perks, the departing shareholder (now an inactive owner) rarely receives significant income in the form of distributions or dividends.

Naturally, Steve wanted and needed maximum value for his interest while his co-owners were convinced that the company’s cash flow could not support Steve’s buyout.

So, look again at your business continuity agreement: If you are the one leaving, is it as fair as it is if you are the one left behind?

When you sit for the first time across the bargaining table from your partner, you will want that table set with a fair valuation method, a thoughtfully designed lifetime buyout provision (that may well reduce the cash flow required for a buyout by 20 to 30 percent), and manageable payment provisions. Since it is exceedingly difficult to design these provisions when buyer and seller are at the bargaining table, agree to and document the valuation, cash flow, tax, and payment provisions long before potential discord or differences of outlook arise.

DISCLAIMER: The information contained in this article is general in
nature and is not legal advice. For information regarding your particular situation, contact an attorney or tax advisor. This newsletter is believed to provide accurate and authoritative information related to the subject matter. The accuracy of the information is not guaranteed and is provided with the understanding that none of the providers of this newsletter, including Business Enterprise Institute, Inc., is rendering legal, accounting or tax advice. In specific cases, clients should consult their legal, accounting or tax advisors.
The example provided is hypothetical and for illustrative purposes only.

It includes fictitious names and does not represent any particular person or entity.

To contact T. Ray Phillips Re: subject matter in this article, call
(317) 208-6312 OR e-mail trphillips@finsvcs.com

Please do not leave trade instructions over e-mail, as they cannot be processed.

Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS under circular 230, we inform you that any U.S. Federal tax advice contained in this communication, unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing, or recommending to another party any matters addressed herein.

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The Essential Business Ageement: A Business Continuity Agreement Among Owners

Saturday, April 13th, 2013

Presented by T. Ray Phillips

If you co-own your business, the business continuity agreement (or “buy-sell”) is one of the most important documents that you will sign. If you have a buy-sell that is out-of-date, un-reviewed or focuses on the wrong issues, it may well be worse than having no agreement at all.

Let’s start with a hypothetical case study that illustrates the importance of drafting a buy-sell agreement that anticipates and provides for all transfer events (lifetime transfers or death).

George Acme’s son-in-law, Tom Gardner, had been with George’s company for over 20 years. Tom had gradually assumed operational management, was the acting CEO, and had purchased 25 percent of George’s ownership over the years—mostly at a low value in recognition of his valuable services. Eventually, everyone acknowledged that Tom would one day own the company and carry on the fine traditions of Acme.

But that was before George died and Tom’s sister-in-law, Babette, became the executor of the estate. Babette told Tom that she would sell him the balance of the company—but at full fair market value and in cash—or she would sell the business to the highest bidder.

Only later did she realize that without Tom’s cooperation, the business was unlikely to sell. No buyer wants a disgruntled minority co-owner, especially when he’s the current CEO.

Tom and Babette disagreed about value, control and successor ownership. All these issues could have best been discussed and resolved before George’s death. Had Tom and George created a business continuity agreement, the business would have transferred at a fair price to the benefit of all concerned. Now, because the owners weren’t talking—except through their lawyers—it was unlikely that Acme could even keep its doors open.

Lifetime or Death Events

The business continuity agreement (also called a buy-sell agreement) controls the transfer of ownership in a business when certain lifetime or death events occur. Typically the “trigger” events include the death of an owner, and a sale and transfer of stock from one owner to another or to an outside party. Your buy-sell can also describe your agreement about how transfers will take place during the owners’ lifetimes such as an owner’s permanent and total disability, termination of employment, retirement, bankruptcy, divorce, and/or a business dispute among the owners.

Consider one example: Assume George didn’t die, but that one of the owners wanted to exit. How do they agree on value, buyout terms, or design the acquisition? Without a buy-sell agreement agreed to in advance, one owner’s desire to exit can transform longtime co-owners into adversaries. The buy-sell sets the valuation method, the terms of the purchase and outlines the tax planning.

In essence a lifetime buyout of an owner is similar in design and consequence to the sale of the entire company to a third party.

The value of the business, the terms of the sale (payment, security, etc.) will all be negotiated. In internal transfers, however, hard-nosed negotiation tactics and disputes about value and payments can quickly destroy friendships, company culture or even the value of the business.

The best way to avoid this is to agree in advance on the method of appraising value and payment terms when all of the co-owners are on the same page—looking out for the ultimate welfare of the company and not knowing whether they will ultimately be a buyer or a seller.

At each of these events, the business continuity agreement may require the business or the remaining owners to purchase the departing owner’s stock; or it may give an option to the business or the remaining owners to buy that ownership interest. Or it may give the departing owner the option to require the company to buy his or her ownership interest.

Remove the Guesswork
read full article »

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Fraud: Do You Know It When You See It?

Wednesday, January 9th, 2013

Presented by T. Ray Phillips

The subject of employee dishonesty is a delicate one. Owners generally want to trust their employees, and given all the other battles owners fight on a daily basis, they are often not as vigilant as they can or should be. Vigilance requires an investment of time and money in return for an uncertain payoff.

Here’s one example of a typical fraud scenario:

Lou Spencer’s CFO, Marty Jacks, had been with Lou’s company for 15 years. While Lou reviewed company financial reports and often the accounts receivable aging report, he let Marty handle the day-to-day financial operations. To say that Lou was surprised when one of his vendors mentioned that he’d run into Marty on the floor of a Las Vegas casino at 4:00 a.m. would be an understatement. As far as Lou knew, Marty spent every weekend at home or camping with his family.

Rather than confront Marty immediately, Lou casually asked his golf partner (a CPA who also happened to be a Certified Fraud Examiner) about employee theft.

The CPA listed more ways to steal than Lou could imagine, but Lou did remember:

Creating fictitious vendors or employees.
Stealing inventory.
Giving oneself undisclosed and unauthorized pay raises.
“Lapping” or taking payment from one customer and applying it to another’s account.
The CPA explained to Lou the three conditions present in any fraud situation: motive, opportunity and rationalization.

“Has anyone run into financial difficulties?” he asked. “Maybe a sick kid? The unemployment of a spouse or even the readjustment of payments on a home loan?” Lou could not think of anyone in those situations.

Lou understood the “opportunity” factor immediately. He admitted that because he trusted Marty implicitly he was not reviewing every report carefully. Marty certainly had opportunity.

Rationalization: Lou was fairly confident that his employees—including Marty—were satisfied with their salary and benefit packages. Except for an occasional afternoon of golf, Lou believed he worked as hard as any of them.

The CPA suggested that before acting, Lou retain a fraud analyst to conduct a fraud audit. At a minimum, Lou should review his financial statements and this time, rather than focus on the decline in revenues, look for any anomaly or anything that “bucks the trend.” Lou returned to an empty office to do exactly that.

What Lou discovered caused him to call his golf buddy to schedule a meeting about a Fraud Deterrence Audit. Lou swallowed hard as he signed an engagement letter for an audit that would cost his $20M company between $20,000 and $25,000.

After several weeks of review, the CPA laid out the situation for Lou. Marty had a gambling habit (motive). Over the past 18 months, Marty had set up numerous bogus vendor accounts and had siphoned off almost $1 million to these accounts (opportunity). When Marty started pulling small amounts of cash out without Lou noticing, Marty decided that since Lou didn’t miss the cash, Lou could do without it (rationalization).

Armed with the facts, Lou fired Marty. There was no way to recover the money, so Lou and the Fraud Examiner concentrated instead on ways to prevent this scenario from reoccurring.

We asked Edward Bortnick, a CPA, Certified Fraud Deterrence Analyst and Certified Financial and Forensic Accountant, and Certified Valuation Analyst from Rockville, Maryland for his best fraud prevention advice.
read full article »

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The Road to Irrelevance: Transferring Your Responsibilities to Management

Friday, December 7th, 2012

Presented by T. Ray Phillips

Longtime readers of these articles know that one of our favorite instructions to business owners is: Make Yourself Irrelevant!

Newer readers may find that recommendation off-putting so let us explain. Unless your business can run without you, your business has little value to a prospective buyer.

If making yourself irrelevant is the goal, how do you do that?

In our experience, owner irrelevance doesn’t happen by accident or overnight. It is the result of careful analysis and action.

Analysis

In those rare moments when owners think about their key employees running their companies, they often put on their rose-colored glasses. They expect, that with a few tweaks, their employees can easily run the show.

To those owners, we recommend: Take a trip for a few weeks, preferably to a remote island with no cellphone service. When you return, you will be in a better position to coolly assess your employees’ performance.

Don’t be surprised if you find that:

There is no leader on your management team. There isn’t one person with the charisma or personality to inspire both managers and employees.

There is no decision maker. When disputes arise among managers, there is no one or no mechanism in place to resolve them. In fact, this vacation exercise often illustrates that the members of your management team don’t even respect each other.

You have created a work (or learning) environment very different from the one you experienced as you gained management experience. Most owners acquire their skills through trial and error. When (not if) they made mistakes, they fixed them and moved on. But these same owners unintentionally create a “no error” environment for their key employees. If key employees make a mistake, they are fired. Is it any wonder that management teams are replete with “yes men” rather than creative, entrepreneurial do-ers?

Action

After unpacking and dumping the sand out of their suitcases, how can owners address these issues and work toward owner irrelevance?

First, accept the challenge. It isn’t the management team’s job to fix the problem. It is yours. We encourage you to contact us for help in creating an action plan, but the job of becoming irrelevant is yours alone.

Second, make a list of all the activities that are involved in getting orders in and your product or service out the door. If you need help with that list, we can help as well, but the point is to write the name of the person responsible for managing that task next to each activity. One owner who employed Vice Presidents of Operations, Manufacturing and Sales, found that he was responsible for 94 of 136 tasks. That owner was far from irrelevant.

Third, consider hiring an industrial psychology firm to assess members of your management team to see if they possess the intangible skills necessary to run your company. If you learn that members do not have these skills, you may choose not to devote the time and effort necessary to train them to assume the technical responsibilities of their positions.

Fourth, once you’ve determined which employees have what it takes (or you have hired new people) to run your company, you must create a training plan that includes three important characteristics:
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