Understanding buy-sell agreement payouts
By Mike Benes and Keith Krueger
Sept. 9, 2002
In a previous column, we discussed establishing a stock value for a buy-sell agreement. Once you have that basic value, you must determine if it is different under various scenarios such as death, disability, termination, retirement or divorce. You may want to consider applying different payout factors or schedules to the value depending on the circumstances causing the buyout.
In the case of death, the stock would be purchased at 100 percent of the value established by the agreement. The payment would usually be in a lump sum, as it is often funded by life insurance. If the life insurance proceeds didn’t provide for the full payment, the remaining amount could be paid over five to 10 years under a note bearing reasonable interest. Generally, the life insurance proceeds aren’t included in the value of the stock since the purpose of the insurance is to help fund the buyout.
Total disability would be treated the same as death — purchase at 100 percent of value. Since there often isn’t insurance (although disability buyout insurance is available), payment is usually made over five to 10 years under a note bearing reasonable interest.
Partial disability is more difficult and often isn’t addressed in buy-sell agreements. The disabled stockholder could keep his stock, have a different role at the company and be compensated based on that new role. It would then be important that all stockholders be fairly compensated so that any net-income loss of the company is really just that. As you know, in growing construction firms, the owners often undercompensate themselves to help the company grow. That creates problems on an equity basis if one or more of the owners is essentially a passive investor.
The agreement could instead specify a complete buyout at 100 percent of value if partial disability occurs. The difficulty is defining what is partial disability. In addition, partial disabilities are sometimes only temporary, and the person recovers.
Termination can be voluntary (the stockholder wants to leave) or involuntary (the other stockholders want him to leave). Usually the payout is over five to 10 years under a note bearing reasonable interest. Often, a discount factor — 60 percent or 80 percent of the value established in the case of death — is applied to the value.
Why the discount? When it’s voluntary, the discount may be to compensate for the cost of finding a replacement. Or possibly it’s to compensate for the fear of the unknown, such as why the person is leaving or what that person knows that others don’t. Often, the discount may be done primarily as a deterrent to breaking up the group or as an incentive to stay for the stockholder going through a "What am I doing with my life?" stage.
A discount of the value under an involuntary termination makes less sense, since the other stockholders want him to leave. Possibly it’s a way of saying "you didn’t do your part in creating the equity or value in this company." It would be better to address performance problems earlier and through compensation than to have it be part of a buy-sell agreement.
The one termination where usually there isn’t any discount involved is retirement. A buy-sell agreement should establish minimum-age and notification requirements so that retirement of a stockholder can be accomplished in an orderly manner with the retiring stockholder receiving full value for his stock.
Divorce often isn’t addressed in a buy-sell agreement. However, since Wisconsin is a community-property state, the stockholders’ spouses own half of the stockholders’ respective stock unless there are agreements to the contrary. It would be wise to address the issue because the last thing you would want is someone’s ex-spouse as one of your new "partners." The best solution is to have all spouses also be part of the buy-sell agreement. The spouses agree to sell any stock interest they may acquire through divorce to the existing stockholders at 100 percent of the established value.
A good buy-sell agreement not only establishes a methodology for valuing the stock, but it also provides the rules for how the value is to be adjusted and paid out under various scenarios. Better to set the rules up front and avoid fighting later.
Mike Benes and Keith Krueger are the principals of Benes & Krueger SC, an accounting firm specializing in construction and providing audit, tax, claims analysis and management consulting services. For further information, contact the firm at 262-542-1200.