ASPECTS OF PERPETUATION MANAGEMENT
by Catherine Oak and Bill Schoeffler
Most agency owners do not have a structured plan to perpetuate their lifetime's work-the firm. It would be safe to say that at least 90% of independent agencies or brokerages have not defined a strategy to buy out the majority shareholders, or even the stock of the minority owners, unless there is death or disability.
In the event of death or disability, most firms have a buy/sell agreement funded by Life insurance to finance the corporation's buyout of the owner's stock. Retirement is sometimes addressed in the buy/sell agreement, but cannot be funded by Life insurance.
Most buy/sell agreements that were established by the attorneys years ago have formulas for valuing the stock-instead of stating that an independent, qualified appraiser will be used for the valuation. We strongly recommend that owners do not tie their hands with a set formula because the current situation and level of profitability should be assessed, and liabilities that have become the firm's obligations should also be considered.
Determining whether the perpetuation plan should be an internal buyout of stock (using one or more perpetuation vehicles) or an external sale to a third party, should depend on whether viable perpetuation candidates exist in the firm.
PERPETUATION CANDIDATE CRITERIA
What should the criteria be for the ideal perpetuation candidate? That depends on the firm. However, in general, ideal candidates serve the two following purposes (and a good candidate serves at least one):
- They can oversee the management of the firm's major functions to make sure that profits are available to buy out the retiring owner's stock. The major functions are sales, marketing, service, claims, accounting, and administration.
- They can produce enough new business to help the firm grow to cover existing obligations and pay off the retiring shareholder(s).
Without a viable perpetuation candidate groomed by the time the shareholders are in their late 50s or early 60s, the firm will probably need to sell to a third party or find a viable merger candidate with younger owners.
SELL STOCK AT FAIR MARKET VALUE
Stock sold internally should be priced at its fair market value-at least at a price that most third parties would expect to pay. Unless there's some reason to discount the price of the retiring shareholder's stock (for example, a promise to a key employee, vested interest to be exchanged for equity in the firm at some future date, stock options to be exercised, and so on), owners deserve to sell their stock at a fair price.
PERPETUATION ALTERNATIVES AVAILABLE
There are a number of viable perpetuation alternatives. The key is to have the candidates groomed and in place in time to transfer market and key account relationships, as well as management responsibilities. If the candidates exist, various perpetuation vehicles can be used in combination or alone, depending on the owners' desires and the number of candidates.
Owners who sell their stock to an Employee Stock Ownership Plan (ESOP) have the most advantages, including:
- the lowest taxes for both the seller and the firm
- an ability to borrow money at a discounted rate from an insurance company or a bank (usually one or two points below prime)
- motivation and productivity that comes with vested ownership for all employees
- the sellers' ability to roll over their proceeds tax free if invested in marketable securities (if at least 30% of the stock is sold)
Other internal perpetuation alternatives exist, including gifting, employee purchase, deferred compensation, and stock redemption. Oak & Associates assists clients with a cash-flow analysis of the available alternatives and valuations.
If you're not ready to establish your perpetuation plan today, at least have a contingent buy/sell agreement with a friendly, respected competitor down the street in case the unexpected happens. The best time to establish a perpetuation plan is while the owners are still young. We recommend that owners also establish an annual business plan; the improvement in overall productivity and profitability will maximize the value of the firm. Owners can't afford to wait if they want to plan the perpetuation process properly.
Catherine C. Oak, CIC, AAI and Bill Schoeffler can be reached at Oak & Associates, P.O. Box 2047, Glen Ellen, CA 95442, (707) 935-6565, fax (707) 935-6515, E-mail [email protected].