The Private Capital Market® Business Buy/Sell Insurance Series

Thomas E. Vass, Business Insurance Advisor

More Than A Difference of Opinion

The owners of a company sometimes have a difference of opinion over the direction or strategy of a business. Sometimes the difference involves mundane matters like installing a new piece of production equipment, or obtaining a business loan to finance growth.

In many cases, the differences of opinion about the company can be ironed out between the original owners because when they started the company they shared a common business philosophy, and that common understanding allowed for compromise and rational deliberation.

When one of the original owners dies, that common understanding evaporates, and the surviving owner begins to comprehend that overcoming a difference of opinion about the business with the widow, or the former spouse, involves a lot more complexity.

The widow or former spouse may have inherited the ownership interest when the shares passed through probate, or through the courts, if the owner did not have a valid will. Many times, the original owner prepared a will with the first wife as the primary estate beneficiary, but failed to modify the will after the divorce.

The original owner then finds herself reluctantly in business with the surviving widow, or inadvertently, with the former first wife.

When the widow becomes an owner, there is an unanticipated divergence in financial interests between the surviving owners and the surviving spouse of the deceased owner.

The surviving original stockholders are mainly concerned with increasing sales and using profits to grow the business, but the surviving spouse is interested in obtaining income from the business.

One method the surviving spouse can obtain income from the business is in the form of dividends taken from profits, or sometimes in the unhappy case of taking them from business capital accounts or retained earnings, if there are not any current profits to pay dividends.

If the widow or former spouse happens to be the majority owner, and votes for a dividend, then the dividend must be paid, no matter whether the company has profits or net revenues.

The profits usually had been used to finance business operations or fund future growth, and with mandatory dividends, those former uses of capital are foreclosed.

This conflict leads to more than a difference of opinion between the surviving owners and the surviving spouse. It can lead to the forced liquidation of the company.

Financial Issues For Minority Shareholders After A Death of the Original Owner

Because a corporation operates under the principle of majority rule, the holders of a majority of shares with voting power often can use their power to further their own interests and to deny minority shareholders three basic expectations:
(1) a lucrative job,

(2) a meaningful role in management, and

(3) a proportionate share of earnings.

The issues are perfectly symmetrical for a former spouse or widow who winds up as a minority shareholder. The original majority shareholders can deny the former spouse a stream of income from dividends and preclude the sale of the company, or even the sale of the minority shares to an outside buyer.

This use of majority power is often called a “squeeze-out.” A “squeeze-out” is an action taken by majority or controlling shareholders in an attempt to reduce or eliminate a minority shareholder’s interest in a closely-held corporation.

Common squeeze-out techniques include:
· Refusal to declare dividends

· Refusal to distribute earnings as bonuses or retirement benefits

· Siphoning off earning through exorbitant salaries and bonuses

· Termination of employment (the functional equivalent to a denial of dividends or any return on investment)

· Removal as directors or officers (or effectively depriving minority shareholders of any active voice or meaningful role in the management and operation of the corporation)

· Deliberate withholding of information or manipulation of company books and records

· Usurpation of business opportunities and misappropriation of corporate assets

Squeeze-out techniques are used by majority or controlling shareholders to “lock-in” a minority shareholder for two reasons:

(1) to force a sale of a minority interest at less than a fair price and

(2) to “freeze out” the minority of a fair return on investment.

Legal Protection of the Minority Shareholder Interests

Many state have passed laws that offer a minimum set of rights for minority shareholders. Among the rights usually proscribed by general stature are:

· The right of minority shareholders to inspect corporate books, papers and records at certain times and places.
· The right to attend and vote at corporate meetings with notification of such meetings given to the minority shareholders.

· The right to take part in the election of a board of directors

· The right to bring derivative suits against corporate managers for breaching their fiduciary duties to shareholders.

· The right to delay or block mergers, consolidations, or reorganizations if the minority shareholder rights are impaired and a court agrees with the minority shareholder.

· The right of appraisal of the value of the business and the minority shares, and payment in the event of a fundamental corporate change, such as a merger.

· Pre-emptive rights, which allow minority shareholders to maintain their relative equity in the company when new shares are issued.

In addition to the general statures, the state and Federal courts have generally moved in the direction of expanding minority shareholder rights. Sometimes, the courts even order the company or original owners to buy out the minority shareholders.
Obtaining A Well-Crafted Buy-Sell Agreement That Is Coordinated With The Estate Settlement Plan

A much better financial outcome than reluctantly going into business with the former spouse and learning about her minority legal rights is to retain a business attorney to craft a buy-sell agreement, before the original owners die or become disabled.

The provisions in the business buy-sell agreement must be legally coordinated with the provisions of the owner’s estate settlement plans, especially the part about dealing with former spouses that may still be beneficiaries in prior wills.

Children from prior marriages must also be included in both the business buy-sell and the estate settlement plans, or the original owners may find themselves reluctantly in business with those children.

In the case of very small, closely-held companies, the same attorney who drafts the business buy-sell agreement may also draft the family estate settlement plan and will.

In the case of larger private companies, usually it is a good idea to obtain two different attorneys to handle the two distinct sets of issues involved in the business buy-sell and the estate settlement.

Funding the Business Buy-Sell and Estate Settlement Plans With Two Sets of Life Insurance Policies

In many court cases involving the fair treatment of minority shareholders, following a death of the original owner, the judge will attempt to find the fair value of the minority shares.

Rather than have a judge issue a ruling on business value, a better idea is for the original owners to agree upon the fair value of the business, and put that value, or the formula, in the buy-sell agreement. That agreed upon value becomes the starting point for determining the amount of life insurance to buy to cover the smooth transition of ownership after a death.

The insurance for funding the buy-sell agreement is completely different than the life insurance that is used in the family estate settlement plan. The life insurance for the estate settlement is usually designed to benefit the surviving spouse and all the children from all the prior marriages, so that everyone feels like they were treated fairly.

In many cases, the death benefit proceeds from the estate settlement plan are owned by a family trust. The trust usually has provisions spelling out when and how the children and surviving spouse are paid the death benefit, including provisions about not interfering with the future of the business.

The attorneys who draft the buy-sell agreement and the estate settlement plans must work together to make certain that the beneficiaries of all the different life insurance policies are correct.

After that legal work is complete, then both the business and the family can buy the right type of life insurance policies to fund all the agreements and plans.

Otherwise, the owners may reluctantly find themselves in business with former spouses, surviving spouses, and wayward children from different marriages.

Can I Help You Implement A Buy-Sell Agreement?
Thomas Vass is an independent licensed insurance agent, located in Raleigh, N. C., with a special focus on helping small companies implement buy-sell agreements. He works with the company’s other business professionals as a part of an advisory team that provides advice to business owners on getting the right buy-sell agreement in place. After the legal and tax issues have been solved, Vass provides advice on the right types of life insurance and disability income insurance to fund the agreements for a smooth financial ownership transition. Contact Vass 919 975 4856.

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Thomas E. Vass, 6001 Waters Way Dr. Raleigh, N. C. 27606 919 975 4856

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