Understanding Seller’s Discretionary Earnings

If you have acquired or sold a small company, or had one appraised, you’ve probably heard the term “Seller’s Discretionary Earnings”. Or you may be thinking “Earnings are discretionary? My earnings aren’t discretionary at all!” Let’s examine this often-misunderstood term, and how it compares to EBITDA, another common earnings measure.

What is Seller’s Discretionary Earnings?

Seller’s Discretionary Earnings (“SDE”) is a calculation of the total financial benefit that a single full time owner-operator would derive from a business on an annual basis. It is also referred to as Adjusted Cash Flow, Total Owner’s Benefit, Seller’s Discretionary Cash Flow, or Recast Earnings. Here at Exit Strategies, we prefer the term Discretionary Earnings or DE. For this article I’ll use the more common SDE.

SDE is most often used in the valuation and sale of “Main Street” businesses. While there is no precise definition of what a Main Street business is, it often refers to owner-operated companies with less than $5 million of revenue. Larger businesses primarily use EBITDA.


SDE = Adjusted EBITDA + Owner Compensation (one full-time owner)
Where EBITDA = net Earnings + Interest + Taxes + Depreciation + Amortization.

So SDE is always a larger number than EBITDA. This is a bit counter-intuitive for people used to working in the middle market. They usually think of EBITDA as the large number that things are subtracted from to calculate net cash flow. And wouldn’t SDE be similar to or smaller than EBITDA? A look back at the formula clears this up.

When applying price multiples for sale or valuation purposes it’s important to accurately differentiate between SDE and EBITDA. A mismatch between the earnings measure used and the multiple applied can result in significantly overvaluing or undervaluing a business.

Normalization Adjustments

Once we calculate EBITDA (or SDE) from a company’s profit and loss statement, we need to work through normalizing adjustments. We often break normalizing adjustments into two categories: discretionary items and non-recurring items.

Discretionary Items

Discretionary expenses are those that the business paid for but are really a personal benefit to the owner. Discretionary expenses exist because owners want the “tax benefit” of expensing these items. But they also want the benefit of adding them back into earnings when it comes time to value and sell the business.

Typical discretionary expenses are owner medical or life insurance, personal travel, personal automobiles, personal meals/entertainment, and social club memberships. To qualify as discretionary, each expense must meet all three of these criteria:

  1. Benefit the owner(s)
  2. Not benefit the business or its employees
  3. Are paid for by the business and expensed on tax returns and P&Ls

Whether an expense is discretionary or not isn’t always obvious:

Definitely AdjustDon’t AdjustGray Areas
Retirement plan contributionsNetworking group membershipsTravel (business and pleasure)
Home landscapingMarketing expensesContributions

Discretionary expenses are often the subject of debate between a buyer and seller. Buyers, of course, are risk averse and dubious about all these co-mingled expenses the seller claims are “not really expenses.” Items that fall in the gray area will require extra documentation by the seller and due diligence by the buyer. Certain items that a buyer might accept won’t be accepted by a bank. Generally speaking, sellers will benefit from stopping all commingling of business and personal expenses at least three years before they sell a business.

Non-Recurring Items

The other major category is extraordinary/one time income or expenses. Adjusting for extraordinary one time income and expense makes sense because they are not expenses that are indicative of the core business operations. Common examples are restructuring costs, costs related to acts of nature, asset sales, litigation expense and emergency repair costs.  One-time expenses are also scrutinized and debated. Did that bad debt really only happen once? Or is it likely to occur again in the future?

Why is this important?

In M&A transactions buyers are concerned about risks: What aren’t you telling them? How could this investment go bad? We often say that getting to a closing is about removing roadblocks in the deal – and often the biggest among them is reducing the buyer’s level of perceived risk. With that in mind it’s important to think about the line items that go into SDE well before you go to market and do your best to reduce any areas that might fall into the “questionable” zone. The cleaner your financials are the more likely you are to sell on the best price and terms.

For more information on the use of earnings and cash flow measures used in business valuation, or to discuss a current business valuation need, contact Joe Orlando at jorlando@exitstrategiesgroup.com.

Manage Working Capital to Increase Business Value

As you likely know, working capital equals current assets minus current liabilities. Companies that have a high level of cash tied up in current assets (primarily cash, accounts receivable, and inventory) without similar levels of current liabilities are not as attractive as those who tightly manage their working capital. Buyers are often leery of businesses that require high working capital to sales ratios because as sales grow the company must continually invest more cash in working capital. Conversely, companies with low working capital can grow faster and return more cash to shareholders as they grow.

One Recent Example

We were recently retained to do a fair market value business valuation of a multi-state, value-added industrial distribution company for a shareholder buyout. The company was a profitable going concern. While it showed modest EBITDA margins, its working capital requirements were unusually high, primarily due to extraordinarily high accounts receivable and inventory levels.

A prior valuation done not long ago for a different purpose had relied solely on an Asset Approach method. Specifically they used the Adjusted Book Value (ABV) method where all assets and liabilities are marked to market. Thanks to the company’s high current assets combined with almost no current or long-term liabilities, the result was a high valuation number. As part of our analysis, we naturally considered the prior valuation. We wondered how valid its conclusion was from the perspective of a hypothetical buyer of a going concern business who would be concerned with future cash flows.

Following standard business valuation practice, we considered the three approaches to valuation: asset, market and income. The asset approach using ABV gave results marginally higher than the prior valuation while the market approach (comparable asset transactions method) values were slightly lower. However, when we analyzed the income approach using a single period capitalization method (SPCM), our result was substantially lower than the asset approach. Why? Because the SPC method is based on capitalization of net cash flow to equity holders, which considers changes in working capital that are largely ignored by the asset and market approach.

We were compelled to give some weight to the income approach results as we believe knowledgeable buyers of shares in the company would have a strong  interest in their expected return on investment. The result was a valuation conclusion somewhat lower than adjusted book value.

Theory Holds True in Practice

I want to point out that this affect of working capital on enterprise value isn’t just abstract financial theory. We regularly see it play out in actual M&A transactions where buyers have no interest in paying more for companies with higher working capital. And we often see sellers rewarded (sell for higher earnings multiples than their industry peers) for having proven that they can operate effectively with less working capital.

It is also interesting to note that in this case, should the owners of the company have tried to liquidate the company’s assets to generate cash, the net amount yielded would have been substantially less than adjusted book value. Given that the company had no plans to liquidate, we didn’t consider using a liquidation value.

What Companies Should Be Doing in this Area

Company owners and management should constantly reevaluate and consider modifying their accounts payable and borrowing practices, as well as focus on ways to reduce accounts receivable and inventory requirements. All of which will reduce working capital, generate cash, enable faster growth, and increase shareholder value. Sometimes this even means making tough decisions like firing a customer or replacing a key vendor.

For further information on how working capital affects enterprise value, or to have a business analyzed for sale, acquisition or exit planning purposes, contact Jim Leonhard, CVA MBA  at 916-800-2716 or jhleonhard@exitstrategiesgroup.com. 

One Business Appraiser that All Parties Know and Trust

Jointly retaining a single trusted business valuation expert in disputes over value is becoming increasingly common as owners seek ways to streamline the valuation process, protect their companies and control costs. Naming one appraiser in buy-sell agreements is also becoming more popular. In this slightly long-winded rant, I will discuss the pros and cons of using one appraiser that all parties know and trust, and explain why you should give serious consideration to this option.

Where My Thought Process Started

Exit Strategies has provided valuation services for many California companies going through involuntary dissolution processes.  Involuntary dissolution proceedings, per California Corporations Code § 1800 and § 2000, give minority shareholders who feel they have been victimized by those in control to force a liquidation or sale of the company, unless the corporation or its majority owners agree to buy them out at fair value.  CCC § 2000 stipulates that, “The court shall appoint three disinterested appraisers to appraise the fair value of the shares …”. Often, the judge in these cases requires that the appraisers work together to develop a conclusion of value.

What’s interesting to me is that in every CCC § 2000 case where I worked collaboratively with other competent appraisers from start to finish, we were able to reach agreement on a conclusion of value.  I’ve talked to several other BV experts who have similar experiences on such panels.

So, why do appraisers, working separately, reach different values?

I see three main reasons why Qualified (experienced and professionally accredited) valuation experts selected by opposing parties and working in isolation from each other are more likely to conclude different values for the same business:

  1. They have different facts. They ask different questions about the company, often of different people with different agendas, Then, using different information they arrive at different conclusions. Makes sense, right? Conversely, when appraisers receive the exact same inputs on a company, they are far more likely to produce similar values. If you hire multiple appraisers, be sure that they all get the exact same information.
  2. They head off in different directions.  Subtle differences in scope of work can have substantial effect on reported values.  Appraisers using different standards or levels of value are guaranteed to report different values.  It’s also common to see different valuation dates used.  Or, one appraiser reports a value of equity and another reports an undefined asset sale value. Often, the clients don’t even know this is happening.  And the appraisers don’t know because they are working in isolation. Such differences in direction are best identified and resolved in advance.
  3. Bias. Even though appraisers are supposed to be impartial, some succumb to pressure to deliver a result that favors the party that selected them or satisfies the attorney that hired or referred them. Exit Strategies’ professionals assiduously avoid letting bias creep into our valuations. (M&A advisory is a different story. There we absolutely advocate for our client.)

Now, CCC § 2000 cases are fairly infrequent, and usually the parties decide how many appraisers to hire. As this point you may be thinking, “wait a minute, doesn’t each shareholder need to have their own appraiser?” Let me turn that question around…

If a panel of appraisers working together generally see eye-to-eye, why have more than one?

The main argument for having multiple appraisers (besides putting more appraisers to work!) is that it can guard against an outlier opinion or one appraiser making an honest mistake. If you are careful in selecting the appraiser, however, you can mitigate these risks.

Cost is an obvious disadvantage to having multiple appraisers. Not only do the parties have to pay for 2 or 3 valuations, but appraisers generally charge more when they know they’ll be working in an antagonistic and uncooperative environment or when they know their report is likely to be challenged in litigation. The reason; more hours of work.

One very important disadvantage of hiring multiple appraisers is the deleterious effect it can have on shareholder relationships and the company itself. The perception of having an appraiser in their corner promotes divisiveness between owners. They become suspicious of the other expert(s). And doubling or tripling the number of information requests, interviews and follow up questions increases management’s workload, distracts them from running the business, and prolongs the valuation process. As the rift between owners grows and the company drifts, value erodes for all shareholders.

This seems to be a good point to summarize the advantages of a using single, jointly-retained business valuator — lower cost, less work and distraction for management, better shareholder cooperation, reduced likelihood that information will be withheld or biased, less danger of advocacy, and scope of work clarity. Next, let’s discuss how you go about selecting and working with a joint BV expert.

Keys to Success with a Jointly Retained Business Valuation Expert

  1. Get to know the expert. Establish trust between all parties and the appraiser at the outset. Start by requiring professional valuation credentials, several years of relevant BV experience and real-world business transaction expertise (not just financial theory). Ask around for recommendations. Jointly interview appraisers until you find one that you are all comfortable with.
  2. Correctly define the engagement, i.e. standard of value, subject interest, level of value, scope of analysis, type of report, valuation date, etc. Many buy-sell agreements and jurisdictions do not have well-defined valuation criteria. A trusted and Qualified BV expert can point out the various interpretations and work with the parties and their legal advisors to reach a consensus. Or the parties can have the appraiser produce multiple values using different interpretations, often for little extra cost.
  3. Require open communication. Set ground rules to involve all shareholders, and advisors (attorney, CPA, etc.) in some cases, in all communications with the valuation expert throughout the process. Shareholders should have access to all information requests and documents provided, be copied them on emails, be invited to fill-out and review questionnaire responses, be invited to all live interviews, presentations and meetings, and be given the opportunity to review and give feedback on a draft valuation report.

Getting to Trust an Appraiser

Successful jointly-retained experts have integrity and strong interpersonal skills. Get a sense of who they are by looking at their website and LinkedIn profile. Are they transparent and forthcoming with information? Can they write? Are they involved in their community and do they give back to their profession? Etc. Someone from a pure litigation support firm with little or no digital footprint probably isn’t right for this job.

In our experience, when we are jointly-retained, the parties are naturally more open and honest about company strengths/weaknesses, risks and future prospects. Separate experts rarely get the full access 360-degree view that a single expert with the support of all parties gets. In turn, they do better work and trust in them grows.

There is perhaps no better way to decide if you can trust someone than to work on a project together. If you know you’ll need an appraiser to set a share price for an imminent buy-sell transaction, don’t wait for the trigger event. Select an appraiser now and go through the valuation process together while there’s less at stake. You and your stakeholders will get to know the appraiser and the quality of their work. Further, the appraiser’s knowledge of the company and its industry will grow and they can probably recommend strategies to enhance the value of your company, which benefits all shareholders and more than pays for the extra appraisal.

What Business Owners Can Do

The next time you need an accurate unbiased business valuation or are preparing shareholder agreements, think about using a single Qualified BV expert that all parties know and trust.  Feel free to call us to discuss your needs and circumstances, or ask your attorney to contact us, in total confidence. We will let you know if we think this is a good option for you.

*          *          *

Valuations play a part in all strategic transactions, tax, and many litigation matters.  Al Statz is President and founder of Exit Strategies Group, Inc. which has four California offices and has been selling and appraising businesses since 2002. Al is an accredited business appraiser (ASA and CBA) and a Merger & Acquisition Master Intermediary (M&AMI).  For additional information or advice on a current situation, please do not hesitate to call Al at 707-781-8580 or Email.

Business Valuations Can Create Value, Not Just Report It!

I recently completed a valuation engagement for two shareholders of a California manufacturing company who were going through a buy-sell transaction. After the sale, the buying shareholder called to tell me how my valuation report gave him the confidence he needed to complete the purchase, take on debt, and revamp the company’s business plan. Besides making my day, his call made me think about why almost every business owner can benefit from a valuation.

When all aspects of a business are objectively analyzed by an independent, experienced business valuation professional who then considers each detail (after all, valuation is both art and science), applies real-world valuation approaches, and produces a well-documented report, you receive invaluable information for making important business and investment decisions.

If you’ve had your business professionally appraised, you know what I mean. If you haven’t, you are missing out on more valuable and actionable insights than you probably realize.

Why do business owners and others have businesses valued?

Some of the most common reasons include:

  1. To get an idea of how the market would value a business
  2. To create a process to increase a company’s marketability
  3. Click here for 50 Reasons for a Business Appraisal

For further information on buying, selling or increasing the value of a business, or business valuation or appraisal, you can contact Jim Leonhard, CVA MBA at 916-800-2716 or jhleonhard@exitstrategiesgroup.com.

Why You Should Know the True Value of your Business

The most common time to know the value of your business is when businesses are sold and ownership changes hands. As an owner, you might be retiring from business due to failing health, divorce, or other family changes and you want to know the value of your business to get a fair price. Another motive might be that you have to raise debt or equity financing to meet sudden cash flow requirements or expansion. In this case, potential investors will first want to verify the worth of your business. You might also want to take partners on board or add shareholders in which case the value of a share needs to be accurately determined.

Regardless of the company valuation methods calculation that you may choose, the true value of your business depends on a number of extraneous factors that may not be connected directly with your business. These range from the current state of the economy to the value of other businesses of similar ones operating in your area. For example, business valuation in the San Francisco area for your industry will be largely determined by the selling price of previous sales of similar types of business in the area.

One of the crucial things that should be kept in mind is that you should not value your own business but instead hire a professional firm to do it for you. The reason for this is that it will not be possible for you to objectively put a value on your own business. You will not have the necessary expertise or distance to step back and get an unbiased view. Hence, it is advisable to get the valuation done by an expert Certified Valuation Analyst (CVA) or the equivalent in your location.

We use a variety of business valuation methods to assess the value of your business.

  • Asset Based Method – Basically, this entails totaling up all the investments in the business. One is the net asset valuation method where the value of the net balance sheet value of liabilities is subtracted from the net value of assets. The second is the liquidation asset based method that estimates the net cash that would remain if all assets were sold and liabilities were deducted from the proceeds. This approach is suitable for a corporation valuation where all assets are held in the name of a company but not for sole proprietorship concerns where separating assets held in the owner’s name for personal or business use may be more difficult.
  • Earning value or Income method – Here, we estimate future cash flow levels of the company based on past earnings, taking into account unusual revenue and expenses and then multiply the normal cash flow estimates by a capitalization factor. Somewhat similar is the discounted future earnings method where the trend of future expected earnings is divided by the capitalization factor.
  • Market value method – This is done by comparing the value of your business in terms of size, scale and facets like turnover, revenue and balance sheet parameters with other similar businesses recently sold in your location. Here too, determining the price of a sole proprietorship concern is difficult as public information is not easily available for prior sales. We have access to various databases which can make this job easier.

For further information on this topic or if you are looking for a business valuation, contact Joe Orlando at jorlando@exitstrategiesgroup.com. 

The Skinny on Valuation Report Options

Users of valuation services should know the most common types of business valuation reports: Detailed, Summary and Calculation of Value reports.*

Detailed and Summary Valuation Reports

Detailed and Summary valuation reports can only result from a full valuation analysis, not a limited scope analysis. A Summary report covers the same topics as a Detailed report but in less detail. Both sufficiently document the facts, data and information relied upon and the assumptions and analyses made, so that the conclusions reached can be clearly understood by intended users (shareholders for example) and withstand adverse scrutiny by the IRS, DOL, SEC, trier of fact, opposing expert or other third party.

For almost all business valuation engagements for tax, litigation or compliance purposes, BV experts conduct a full business valuation (aka appraisal) analysis and issue a Detailed or Summary report.

Calculation of Value Reports

In cases involving exit planning, buying or selling a business, or actual transactions between parties involved in a subject business and not at odds with each other, a limited scope Calculation of Value analysis and report may suffice. Even then, since these parties are not familiar with business valuation approaches, methods, procedures, assumptions, levels of value, rates of return, data choices, etc., a more comprehensive report can help curious users better understand the results. Calculations of Value (CoV’s) are less expensive than full valuations because they are less time consuming. CoV reports vary greatly in length and content.

Cutting Through the Fog

As professional appraisers, we want to be sure that the scope of work we perform is appropriate. According to the NACVA business valuation standards, “The form of any particular report should be appropriate for the engagement, its purpose, its findings, and the needs of the decision-makers who receive and rely upon it.” USPAP requires that an appraiser not allow the scope of work to be limited “to such a degree that the assignment results are not credible in the context of the intended use”.

Determining the appropriate scope of analysis and report for your needs and circumstances starts with a brief phone conversation with one of our valuation experts. See our list of topics for this initial conversation. Call us for a sample business valuation report.

Valuations play a part in all strategic transactions, tax, and many litigation matters. Al Statz is President and founder of Exit Strategies Group, Inc. which has four California offices and has been selling and appraising businesses since 2002. Al is an accredited business appraiser (ASA and CBA) and a Merger & Acquisition Master Intermediary (M&AMI). For additional information or advice on a current situation, please do not hesitate to call Al at 707-781-8580 or Email alstatz@exitstrategiesgroup.com.


* These terms are from the NACVA/IBA business valuation standards, effective June 1, 2017. Please note that ASA, AICPA (which publishes SSVS) and The Appraisal Foundation (publisher of USPAP) each use somewhat different terminology in their standards. The NACVA/IBA terms used here are generally understood by experienced valuation professionals following these different standards. Exit Strategies does not represent the AICPA, ASA, IBA, NACVA, or Appraisal Foundation and the views expressed here are solely our own and are not the official position of these organizations.

Protect your Trade Name and Protect your Business Value

From my experience as an M&A Broker, I can tell you that your company’s trade name will be a valuable asset to most prospective buyers of your business.  Your trade name, which identifies your company’s brand and distinguishes its reputation with customers and suppliers, is worth strengthening and protecting if you plan to sell your company some day.

It may surprise you that the name of your business, even if it’s not officially registered, receives some legal protection as a trademark. Protection for unregistered marks is based on common law and the federal Lanham Act. Generally the first documented use of a trade name within a geographic area receives some measure of protection.

But the value of your trade name can be threatened if you don’t safeguard it. When a competitor starts to use a name similar to yours it can cause confusion in the market place and impact your business. For an asset as valuable as the name of your business, it’s wise to proactively protect it.

In California, any company doing business in the state under a fictitious name must register that name in the county where the business operates. Once registered, you as the owner will be able to sign contracts and engage in financial transactions under the fictitious name (also known as Doing Business As or DBA). California follows the first use rule when determining the ownership of a trademark. Fictitious name registration can also be useful to document how long you have been using your business name, in case it’s ever contested. However, fictitious business name registration does not necessarily protect your trade name throughout the state or in other states where you are doing business.

Registering your business’ name as a trademark at the state or federal level is the surest way to shelter it from unauthorized use and provide assurance to potential acquirers that they too would be able to benefit from the goodwill that the name generates.

The Secretary of State maintains the trademark registry for the State of California. Registering your trademark at the state level is generally easier and less expensive than a federal registration. However, there are some real benefits to registering through the United States Patent and Trademark Office. Federal registration is a more robust protection because it:

  • Makes it easier to bring infringement matters to federal courts
  • Increases remedies for trademark infringement
  • Has priority over state registration. If a federally registered trademark was in use before a state registered trademark, the federal registrant can stop the state trademark owner from using the mark. If the state mark was in use first, the mark’s use may be restricted to the state where it was registered.

Possibly the most attractive benefit of registering a trademark at the federal level is that after five years of not being challenged the trademark can become eligible for “incontestability”. Incontestable trademarks are, under normal circumstances, immune from being challenged.

To protect the value of your trade name (and your brand) it is worth considering federal trademark registration, especially if you plan to sell your business someday.
Most businesses also have an online presence. It is equally important (and in some cases far more so) to protect your trade name through marketing channels on the web and social media. At minimum you should acquire through Google or GoDaddy any domain names associated with your business.

Even if you don’t choose to utilize them, many owners will also want to claim their trade name and related monikers in Facebook, Instagram and other social media sites frequented by their clients. As with trademark registration, when you are looking to sell your business a prospective buyer will appreciate that you have diligently protected your business’ trade name and that you can transfer those protections as an asset of the sale.

For more information on protecting and maximizing the value of your business in a sale, email M&A broker Adam Wiskind at awiskind@exitstrategiesgroup.com or call 707-781-8744.

Please note that this article does not constitute legal advice on your situation! For legal advice, please contact an attorney with appropriate experience. If you need a referral to an attorney we would be happy to provide a recommendation.

What are the current expectations for interest rates?

One of the important factors that effect business value is macroeconomic conditions which include interest rates and the cost of capital. Business owners who want to know what is going to happen to interest rates should be aware of new leadership at the Federal Reserve.

On February 5, 2018, Jerome “Jay” H. Powell took the oath of office as the new Chairman of the Board of Governors of the Federal Reserve System, succeeding Janet Yellen.

The Federal Reserve System (“the Fed”) is the central bank of the United States. It performs five general functions to promote the effective operation of the U.S. economy and, more generally, the public interest.

One of the Fed’s functions is to conduct the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy. The Fed sets the federal funds discount rate to influence the interest rates banks and other lending institutions charge to business and consumers.

What does the change in leadership mean for interest rates and the economy? The new chairman is stressing continuity as he takes over as Fed chairman, which suggests the central bank will keep gradually raising interest rates in 2018, unperturbed by recent market volatility and signs of firming inflation.

Interest rates have been at historical lows since the Great Recession but are expected to continue gradual rising toward more long-term historical levels. For business owners, knowing where interest rates are headed can help in planning both ongoing operational financing needs and in understanding buyers cost of capital. If you are a business owner considering selling, now is a good time as expectations are for continued growth in the U.S. economy, and interest rates are at historic lows.

For more information on the effects of interest rates and macroeconomic conditions on business valuation and M&A activity, Email Louis Cionci at LCionci@exitstrategiesgroup.com or call him at 707-781-8582.

Does My Buy-Sell Agreement Establish Value for Estate Purposes?

Al StatzBuy-sell agreements that contain a clause that values stock at less than fair market value can be disregarded for tax purposes. It is important to consider the requirements of Internal Revenue Code (IRC) Section 2703 when developing an estate plan involving business interests in which 50% or more of the stock is family owned.

Section 2703(a) states that a shareholder agreement (entered into after October 8, 1990) that allows for the acquisition or transfer of property at a price that is less than fair market value will be ignored for estate and gift tax purposes. With respect to buy-sell agreements, Section 2703 provides that such agreements will set the value of shares for estate tax purposes if the agreement is binding in life as well as at death and results in the shares being transferred at fair market value.

Also, the buy-sell agreement must meet these requirements:

  1. It is a bona fide business arrangement.
  2. It is not a device to transfer property to members of the decedent’s family for less than full and adequate consideration.
  3. Its terms are comparable to similar arrangements entered into by persons in an arms­-length transaction.

A buy-sell agreement is deemed to meet the three requirements if more than 50% of the business enterprise is owned by individuals who are not members of the transferor’s family.

 A business owner’s estate plan and succession plan can be interrelated in other ways as well.  Exit Strategies does not provide tax counsel, but we connect owners with competent tax professionals.  Our accredited business valuation experts appraise privately held businesses and fractional interests for buy-sell, tax, exit planning and many other purposes.  Contact Al Statz at 707-781-8580 with any questions or to discuss a current need. 

How Would Your Company Survive Without You?

If you are like many business owners, you tend to get caught up in the daily demands of your business: managing sales and production, costs, and the bottom line. What about preservation and protection? Perish the thought, but what would happen to your company if it was unable to carry on due to your death or disability?

These concerns may seem like, and may in fact be, remote possibilities. However, by putting them off, you may be placing the future of your business, and its shareholders and their families, at risk. Once death or disability strikes, it will be too late to plan. Your company’s continuing operations could be severely damaged, permanently affecting your family, partners, employees, and others who may depend on it for their livelihood. If you’re like many business owners, you may assume that, if disaster struck, your family could simply sell the company. But, to whom would they sell and at what price? And what if otherwise capable buyers did not have sufficient cash for the purchase? A buy-sell agreement helps provide answers to these and many more questions.

What is a Buy-Sell Agreement?

Briefly, a buy-sell is a legal contract that guarantees a buyer for your business, and provides a means of funding the purchase. You typically negotiate a buy-sell with partners, shareholders, the management team, or key employees. The agreement commits them to buy out your share of the business if you die or become disabled. The process for valuing the company is agreed upon up-front, when the deal is struck. Life insurance and disability insurance are often used to provide the necessary funding.
Your family benefits by automatically having a cash buyer for the business. Your buyer benefits by being able to continue operations without fear of interference from outsiders who are unfamiliar with the business.

The Basics of Setting One Up

An insurance professional usually plays a key role in structuring a buy-sell. Ideally, your representative should have extensive experience in business succession planning. You may also require legal, tax, and accounting assistance, depending on the complexity of the agreement.
In many cases, funding a buy-sell agreement with both life and disability insurance may be the best way to proceed. The life insurance policy can either be term or have a cash value component. A term policy provides the largest death benefit for the least cost; however, it will only cover the buy-sell itself. If you want the insurance to provide other benefits, such as supplementing your pension or providing funds to buy out a partner, you will need a cash value policy. Disability insurance is particularly important, since the chances of becoming disabled are statistically greater than the chances of dying before age 65. However, insurability will depend on your occupation, health, and age.

One Company’s Approach

Consider the benefits of a buy-sell agreement, in the following hypothetical example. Barbara Smith, Mary Jones, and Tom Altuve are partners in a computer services company. Barbara owns the majority interest, while Mary and Tom are minority shareholders. Recognizing the importance of guaranteeing the company’s long-term survival, they consult an insurance professional, who, over the course of several months and with assistance from the company’s lawyers and accountants, develops a buy-sell agreement.

Twelve insurance policies are written to fund the buy-sell agreement, two life and two disability insurance policies per partner. Both life insurance policies are payable to the business. One policy will provide funds to buy out a deceased partner’s interest, while the other will pay the costs of recruiting a replacement. Of the two life policies, one is a term policy, while the other is a cash value policy. The cash value policy can be used to provide supplemental pension income in the event the partner retires. Of the two disability policies per partner, one is payable to the partner, while the other is payable to the company. The partner’s policy will provide him or her with income in the event of disability; the company’s policy will provide funds that can be used to buy out a disabled partner’s share.

Clearly, a buy-sell agreement can be complex and does not come cheaply, since it needs to be tailored to your company and your shareholders. However, it may help you sleep more easily at night, knowing that your family, and others who depend on your business, will continue to benefit from the company you worked so hard to build.