Death and Family Security

In the first article in this series, we met Ralph, an owner who died with an up-to-date estate plan, but absolutely no coordination between that plan and his business Exit Plan. After Ralph died, his business failed, and his estate was bankrupted. We recommended that Exit Planning Advisors ask owners—and see that they answer—four questions, the first of which is:

If I die tomorrow, can my family maintain the lifestyle I want for them?

Let’s assume for a moment that one of your owner/clients exits—during lifetime or at death—receives, in cash, the full fair market value of his or her ownership interest. When that happens, will the owner’s family (and owner, if he or she is still around) be able to continue to enjoy its current lifestyle?

Let’s further assume that your client’s ownership interest is subject to a current, fully funded buy-sell agreement.

  • It requires that, should an owner die, there will be a mandatory sale of a deceased owner’s interest at full fair market value.
  • The purchase price is fully funded with life insurance.
  • The thinking goes as follows: Should a co-owner die, the mandatory sale makes the decedent’s family whole; in fact better than whole because we have replaced a closely-owned business interest (an illiquid asset) with cash. What more can an owner want?

    But Wait: There’s More!

    Owners generally want to continue their current standard of living after they exit, and will not exit if it means living on less income. To generate the desired amount of post-exit income owners must substantially grow business value and cash flow. If owners don’t survive until their exits, there is usually not enough business value to maintain their desired and existing lifestyle. This is true even if their buy-sell agreements are fully funded and use formulas that properly value their businesses.

    The Nub of It All

    There is a second consideration: Even a fully funded buy-sell agreement that pays a decedent owner’s family full value for his or her ownership interest does not provide enough investment capital to replace more than a fraction of the owner’s current income, not to mention the extra cash flow normally retained in the business or invested in other assets. Blame the Headwinds [1] and the increased disparity between the valuation of closely-held businesses (usually an EBITDA multiple of between three and five) and low-risk investments (U.S. ten-year Treasury bonds currently yielding 2%).

    I’ll use Jack (a fictional client) to illustrate the problem of dying in return for “only” fair market value for an ownership interest.

    Will and Jack were equal co-owners of Will & Jack’s Dispensary, a relatively new Colorado-based business worth, according to a recent appraisal, $5,000,000. Will and Jack each received annual salaries of $375,000. The business had an additional $1,000,000 of EBITDA that the owners retained in the business to fund its healthy growth.

    One dark and stormy night, lightning fatally struck Jack. His estate received $2,500,000 from Will—the full value of Jack’s ownership interest and for which Will had an insurance policy on Jack’s life for the full purchase price.

    Before Jack’s death, he and his family (a wife and three children) lived on Jack’s salary. After Jack’s death the $2,500,000 of sale proceeds generated about $100,000 to $125,000 each year (a four- to five-percent return).

    Even though Jack’s estate received the full value of his interest in the business, his family’s income plummeted by two-thirds (from $375,000 to $125,000). Again, place the blame for the difference in the income to Jack’s family on:

  • The Headwind pushing against investment returns
  • The disparity between the income that a business produces for its owner and that of investments of an equal value.
  • Let’s Not Forget EBITDA

    There is one more income-related asset that disappears at death—your now-deceased client’s share of the EBITDA. If your client’s business was successful, it likely had significant EBITDA. In Jack’s case, his share of the EBITDA was $500,000 a year. In growing businesses (like Will and Jack’s) that EBITDA is largely retained by the company to fuel growth. Even so, it adds to the value of the company and increases the capacity of the business to increase revenue and EBITDA in future years. The loss of EBITDA can be significantly greater than the loss of an owner’s income and, at an owner’s death (and transfer of ownership) that EBITDA now belongs to the successor owner.

    In sum, before his death, Jack and his family enjoyed income and cash flow of $875,000 per year. After Jack’s death, although his family received full fair market value of Jack’s ownership interest in cash, their available income plummeted to $125,000 per year.

    Lifetime Exit Planning, unlike buy-sell planning for owners, deals with this dramatic reduction in the income available to an owner’s family at the owner’s exit. We design exit plans based on securing the owner’s financial security goal by the owner’s planned departure date. If death intervenes, it is vital to provide that same level of financial security to the owner’s family.

    Simply having a buy-sell agreement that correctly establishes a current value for the company will not provide the level of financial security the departing owner’s family needs. Owners must undertake, with your help, the estate planning necessary, using tools (such as life and disability insurance) that provide income protection if they die before their planned exits.

    [1] Headwind 1: Long-term, mediocre investment climate; Headwind 2: A flat economy; Headwind 3: Higher taxes due on sale proceeds