Many buy-sell agreements are funded, in whole or in part, by life insurance on the lives of individual shareholders, who may be key managers, as well. Life insurance is a tidy solution for funding when it is available and affordable. It is important, however, to think through the implications of life insurance from a valuation perspective whether you are a business advisor, business owner, or a valuation expert.
The proceeds of a life insurance policy owned by a company naturally flow to the company. When this occurs:
- Should life insurance proceeds resulting from the death of a shareholder be considered as an asset to be used solely for the purpose of funding the repurchase liability created by a buy-sell agreement?
- Alternatively, should the life insurance proceeds be considered as a separate corporate asset, i.e.,as a non-operating asset, to be included in the calculation of value for the deceased shareholder’s shares?
This decision as to the treatment for any particular buy-sell agreement is one that warrants discussion and agreement while all parties to the agreement are alive. Absent specific instructions in a buy-sell agreement, business appraiser(s) may have to decide how life insurance proceeds are to be considered in their determination(s) of value. What they decide will almost certainly disappoint at least one side and may surprise both. Surprisingly, many buy-sell agreements are silent or ambiguous on this issue.
Let’s consider the two different treatments specifically, and then look at examples of their treatment and the differing impacts that the treatments have on all parties to a buy-sell agreement.
- Treatment 1 – Proceeds are a Funding Vehicle. The first treatment recognizes that life insurance was purchased on the lives of shareholders for the specific purpose of funding the liability created by the operation of a buy-sell agreement. Under this treatment, life insurance proceeds, if considered as an asset in valuation, are offset by the company’s liability to fund the purchase of shares. Logically, under this treatment, the expense of life insurance premiums on a deceased shareholder would be added back into income in the valuation as a non-recurring expense.
- Treatment 2 – Proceeds Are a Corporate Asset. This treatment considers the life insurance proceeds as a corporate, non-operating asset for valuation purposes. In valuation, the proceeds are then treated as a non-operating asset of the company. This non-operating asset, together with all other net assets of the business, is available to fund the purchase of shares of a deceased shareholder. Again, under this treatment, the expense of life insurance premiums on a deceased shareholder would logically be added back into income as a non-recurring expense for valuation purposes.
Obviously, parties to an agreement could make a decision for treatment of life insurance proceeds between these two extremes, but that is beyond the scope of our example.
An Example – High Point Software
The choice of treatment of life insurance proceeds can have a significant, if not dramatic, effect on the resulting position of a company following the receipt of life insurance proceeds and the repurchase of shares of a deceased shareholder. The choice of treatment also has an impact on the resulting positions of the selling shareholder and any remaining shareholders. Consider the following example:
- Harry and Sam own 50% interests of High Point Software, and have been partners for many years. Both are key managers in this small, but successful enterprise.
- The buy-sell agreement states that the Company will purchase the shares of stock owned by either Harry or Sam in the event of the death of either. The agreement calls for the company to be appraised by Mercer Capital (wishful thinking, perhaps, but I’m writing this example).