By Maurice Walch
Typically, when there are a number of shareholders in a company, if a partner/shareholder leaves, the remaining shareholders will buy out the departing partner’s interest. Effectively, each partner has a potential unfunded liability as they will need to come up with the cash for their portion of the buyout. Alternatively, the company may be designated as the planned purchaser of the departing shareholder’s shares. In this case the company has the liability and must ensure it’s funded.
There are only three ways a shareholder will leave a company; death, disability, or retirement. Each of these situations has its own unique features and challenges, but the common denominator is the requirement to fund the purchase of shares from a shareholder.
The funding alternatives are as follows:
1. Cash – as funded by partners and/or the company;
2. Debt – partners and/or the company may borrow the necessary funds;
3. Insurance – in the case of death or disability, insurance can be purchased to cover the potential liability; and
4. A combination of the above.
When we rank the three basic funding alternatives from a cost perspective, debt is typically the most expensive financing method due to the interest charges. Cash is usually the second most expensive as the cost to purchase is generally 100 cents on the dollar. Insurance is the most cost effective method of financing, should the need arise, as the cash outlay will be a fraction of the purchase price. Most buy sell agreements will contemplate the use of a combination of these options as it depends on the scenario for which the funding is required.
Cash can be used in all three of the potential scenarios of a departing shareholder. Due to the cost, however it is generally best used in the scenario of retirement. If the shareholders of a company know that there is a target date that each partner will retire, the company might establish a savings fund with the specific purpose to purchase the shares of retiring shareholders. Saving in advance takes advantage of compound interest or growth to help fund the buyout and therefore reduces the net cost.
Debt is frequently used for financing the purchase of shares in all three scenarios. This becomes the go-to option when there was not enough advance notice of retirement or when no plan was in place at all to deal with the death or disability of a shareholder. Be aware that the assumption of debt being available may not be correct. If the departing shareholder is the driving force of the company, bankers may not finance the purchase. If debt is available, the terms may not be acceptable to the spouse of a purchaser as personal guarantees may be required to put the financing in place. It shouldn’t always be assumed that all potential stakeholders will fall in line.
Insurance can be deployed as the financing method when death or disability occurs. From a pure cost perspective, insurance is typically the most cost effective alternative. For example, if a female aged 55 put a life insurance policy in place for $5 million. The annual cost of insurance would be about $12,000/year (average of top five life company quotes). If she died in the fifth year, the company would have spent $60,000 in premiums to receive a $5 million benefit. This represents a 320 per cent rate of return on the investment. Not a lot of investments provide that kind of return. Insurance can also be purchased to protect the shareholders in the event of the disability of a shareholder and the results are similar.
Ultimately, the challenge is to find the financing solution that best suits the shareholders and the company. The best solution is one that balances three key metrics:
1. What is most cost effective method of financing?
2. What is the most tax effective solution?
3. What is fair for all parties?
When I work on funding buy sell agreements with my clients we never “let the tax tail wag the dog.” However, in the event of the death of a shareholder, life insurance is not only the least costly method of financing the buyout, but it can also be a powerful tax planning tool.
An attractive feature of life insurance is that the death benefits paid to a company create credits for its capital dividend account (CDA). This is a nominal account that allows the company to pay out a tax-free dividend to the shareholders for any amount over the adjusted cost base of the policy. This is a bit of a moving target, but if our 55-year-old woman lived to age 85, and the company still owned the life insurance, the credits to the CDA would be around $5 million. Not only will the company have the cash to purchase the departed shareholder’s shares, the surviving partners may have up to $5 million in tax free income they can draw from the company.
The primary objective of funding the buy sell agreement is fairness for all the stakeholders. This includes the business owner and the business itself. The business is an entity with rights and responsibilities and one of those responsibilities is the equal and fair treatment of each of its owners. Fairness as a goal is achieved when fair payment is made when payment is due.
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