Understanding Business Succession Chapter 10: How Business Valuation helps sell life insurance

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1 Understanding Business Succession Chapter 10: How Business helps sell life insurance This is the tenth in a series of articles which will discuss how life insurance can be used in business succession planning. Be on the lookout for additional articles in the future. How much a business is worth is a matter of opinion By now you know that valuing a business interest is an art, not a science. There is seldom a single fixed value for a business interest. That value usually falls within a range. Points within that range reflect the personal perspective of those who are interested in that business interest. When an owner is looking to sell, he/she naturally wants the value to be as high as possible ( I wouldn t sell for less than $X, minimum! ); however when he/she wants to buy a similar interest from another owner, he/she wants the value to be as low as possible ( You want me to pay $X? That s highway robbery! It s not worth a penny more than $Y. ). A qualified appraiser often determines a value between these extremes by using valuation methods like those discussed in Chapter 8 in this series. Changes in valuation may help sell life insurance The value of a business is dynamic! It goes up or down from year to year for many reasons, including: its financial performance, changes in the market for its goods or services, changes in competition and changes in the economy. New life insurance sales opportunities may flow from changes in the business value. Consider these two possibilities: 1 Business Value Increases When a business value increases, there are several potential needs for additional life insurance coverage. First, if there is a buy-sell agreement in place, rising value generally means ownership interests are worth more; as a result, more money will be needed to purchase a deceased owner s interest. Second, if an owner s net worth is large enough to create an estate tax problem, an increase in the value of the business potentially increases the owner s federal estate tax liability. Because life insurance death benefits can be used to provide estate liquidity, increased estate taxes can lead to a need for more life insurance death benefits to pay those estate taxes. The value of a business should be re-assessed regularly. If its value grows, new life insurance coverage should be obtained to prevent the purchase obligation from becoming under-funded. When there is a gap between the life insurance coverage and the business interest s value, additional funds to complete the purchase will have to be found.

2 2 When business value decreases... there are potential opportunities for new life insurance sales. Business Value Decreases Even when a business value drops (as has probably happened to many businesses recently), there are potential opportunities for new life insurance sales. If there is no buy-sell agreement in place, this may be an ideal time to implement one. If there is an agreement, but life insurance has not been purchased to fund it, this may be a good time to purchase it. It may also be a good time to review both the agreement and the performance of all policies funding it. Businesses with life insurance policies funding their buy-sell agreements have alternatives to consider when the business value decreases. If business value decreases by 20%, it may be appropriate to reduce the buy-sell life insurance coverage by a similar percentage. Before reducing their life insurance coverage, however, the possible ramifications should be considered. If the drop in business value is temporary, the discontinued coverage may need to be re-purchased sometime in the future. Unfortunately, it s possible that new coverage may not be available. The owners would have to satisfy the insurer s underwriting standards and because they would be older, the cost of re-purchasing the coverage could go up. Unless they are quite certain that the business value will not recover, owners should think long and hard before reducing their buy-sell life insurance coverage. You may be able to help owners who want/need to reduce costs by conducting a thorough review of the current policies to make sure they still meet their objectives and are performing at an acceptable level. It may be a good time to scan the life insurance marketplace to see if more coverage for the same premium cost can be obtained. The life insurance market is a very competitive one. Insurers regularly re-design or re-price their products to attract new business. Business owners who are insurable at good rates may wish to see what new options may be available in today s life insurance marketplace. can accelerate voluntary changes in ownership Sometimes as part of a business succession or wealth transfer plan, it may make financial sense for owners to give away some of their ownership interest to other family members or to key employees. Owners who have decided to make such gifts should consider making them soon. Reductions in the value of many businesses could make these transfers attractive. If the business value is likely to recover in the near future, there may be a short time period during which gifts of ownership interests may provide some tax savings. Gifts of business interests that have lost value should not use as much of the owner s lifetime gift tax exemption and increases in value after the gift should avoid gift and estate taxes altogether. Transfers of ownership interests to family members or key employees create new life insurance sales opportunities. The new owners will need life insurance coverage for the purpose of the buy-sell agreement. They may also be key employees whose special skills, abilities, and contacts are important to business profits. The company may wish to purchase key person life insurance on them to protect itself should they die unexpectedly.

3 1 Minneapolis Star Tribune, As Workloads Go Up, Worker Loyalty Falls, Survey Finds, March 30, Center for Work-Life Policy, Sustaining High Performance In Difficult Times, by Sylvia Ann Hewlet, Laura Sherbin, Peggy Shiller & Karen Sumberg, September, 2009 Table A A future event which could threaten business value Smart business owners hope for the best, but they plan for the worst. They develop contingency plans to protect themselves and their business if unexpected events occur. A potential future event which most businesses owners should plan for today is the possible loss of one or more non-owner key employees. They may be hired away by a competitor or they could leave to start their own businesses. Ask this question: What would happen to the value of your business if one of your key employees left and took one of your major clients with him? The risk of losing a key employee is very real. On March 24, 2010, Modern Survey published a report showing a precipitous decline in U. S. workers psychological investment in their organizations. While the economic recession may have temporarily motivated employees to put forth extra effort on the job, the data from this study suggests U.S. workers may have hit their breaking point. Don McPherson, a founder of Modern Survey said, Some people have been asked to do too much for too long What I m predicting is that when opportunities happen, some of these experienced people will leave for other opportunities. Some of these companies will have to go through the expensive process of hiring and training new people. 1 A study by The Center For Work-Life Policy concurred: How is top talent dealing with this onslaught? In a word badly. In focus groups conducted for this study, senior executives talked about being angry, anxious and deeply stressed. Troubled firms are finding that precisely the wrong people (top performers with other job options) are heading for the door. 2 Other studies/surveys reporting similar findings are listed in Table A. Losing key employees may trigger several problems. First, replacing a key employee can be expensive. A recruiter may have to be hired and the replacement may command a higher salary and benefits or need extensive training because of the uniqueness of the business. It may take some time before he/she can perform at the same level as the old key employee. Second, when a key employee leaves, he/she may take some valuable and important customers with them to the new business. This can be a business disaster, particularly when business is slow. Valuable revenues could be lost. New clients will have to be found to replace the lost revenues. Attracting new clients can be time-consuming and expensive. After working so hard to stay afloat during the recession, it could be devastating for a business to lose key employees and important clients just when the business climate may be starting to improve. A study published by the Center for Work-Life Policy entitled Sustaining High Performance in Difficult Times reported that between June 2008 and December 2008, the number of employees expressing loyalty to employers plunged from 95% to 39%. The number trusting their employers fell just as dramatically, from 79% to 22% over the same time period. Surveys in mid-2009 continued to report similar disenchantment and mistrust. A survey by the Conference board reported that the majority of Americans are unhappy with their jobs. The survey, published on January 5, 2010, found that only 45% off those surveyed said they were happy with their work. This is down from 49% in Results for the current survey were lower across the board; workers in every age group and income level showed a drop. Almost 25% said they didn t expect to be at their current job within a year. A joint survey conducted by Robert Half International and CareerBuilder reported that 53 percent of workers surveyed plan to make a career change once the economic recovery is underway. In a survey conducted by the Society for Human Resource Management and CareerJournal.com., 83% of employees stated that it was extremely likely or somewhat likely that they would look for a new job when the economy and the job market improve. A study published in the Academy of Management Journal in 2009 found that after a round of layoffs, voluntary attrition spikes by as much as 31%, and precisely the wrong people those who have the strongest track records and brightest employment prospects are most likely to leave.

4 Carrots and Sticks A carrot and stick approach could potentially keep key employees from leaving for greener pastures. Carrots are strategies designed to motivate them and create loyalty. Sticks are strategies designed to make leaving more difficult and less desirable. Carrots Carrot strategies include: (1) formal recognition of the contributions and sacrifices they ve made to keep the business going, (2) a heartfelt Thank You for their service to date, (3) a tangible reward for their efforts and (4) new financial incentives to continue their high level of performance in the coming years. A life insurance-funded executive benefit could potentially provide all four of these carrots. It could provide recognition, a thank you, an immediate reward and the financial incentives necessary to keep key employees on board and committed for the coming years. Executive benefits such as a 162 Bonus Plan, REBA (Restricted Executive Bonus Arrangement), Split Dollar Loan, 401(k) Look-Alike Plan, or a NQDC/SERP plan could be customized for each key employee. As they remain productive and feel appreciated, their skills could produce the revenues needed to pay the costs of the benefit. Executive Benefit Ladders Life insurance-funded executive benefits may also be structured as a related series. The benefits can be designed to build on each other over time to provide greater incentives to participating key employees. Such arrangements are known as executive benefit ladders and they may be attractive to businesses because the costs can start out low and increase as business cash flow permits. Also, the benefit may potentially be changed over time and become more valuable the longer the key employee stays with the business. In fact, increases in the key employee s productivity could possibly provide the revenues needed to pay for the benefits. Sticks Sticks are strategies that place a cost on a key employee s departure from the business. One example is a restriction in a 162 Bonus Plan that prevents the key employee from accessing life insurance policy cash values without the written consent of the employer. This type of restriction converts the arrangement into a REBA (Restricted Executive Bonus Arrangement). Another commonly used restriction is a provision in an employment agreement which requires the key employee to repay bonuses received if he/she leaves the business prior to a specified date or before retirement. Another useful stick is a non-compete agreement. This is an agreement (or part of an employment agreement) in which the key employee agrees not to solicit the business clients for a specified period of time (usually not longer than one year) and within a specified geographic area. A non-compete agreement helps protect the business client base and puts employees on notice that they won t be able to just walk out the door with the business client list. Non-compete agreements may also be effective in retaining key employees because their inability to take customers with them may decrease their value to competitors. Because the rules for non-compete agreements vary from state to state, a knowledgeable attorney should be engaged to draft the agreement. Some states have laws that prevent the enforcement of non-compete agreements unless the employee receives something of value ( consideration ) in return for making the noncompete promise. A life insurance-funded executive benefit created as a carrot may provide the consideration needed to satisfy this requirement. Linking the executive benefit and the non-compete agreement could potentially provide the best of both worlds. The executive benefit can provide recognition for the employee s efforts, incentive to continue topnotch performance and the value needed to make the non-compete agreement enforceable (assuming the agreement is drafted to comply with all applicable state laws).

5 Conclusion Many businesses have lost some of their value over the last two to three years. Wise advisors may be able to use this fact to produce life insurance sales. This is a good time to talk to business owners about reviewing their buy-sell agreements and the life insurance funding them. This is also a good time to discuss wealth transfer planning with business owners who are concerned about estate liquidity and making gifts to keep their business in their family. Finally, it is a good time to discuss locking in key employees and motivating them to remain committed, highly productive business assets. With well-designed life insurance policies, you may help your business owner clients accomplish each of these objectives. The Voya Life Companies have created a platform to help make Business Succession sales easier for you. To learn more, access the Business Planning Microsite at or Voya for Professionals at VoyaProfessionals.com or try any of the following introductory materials: Buy-Sell Planning Producer Guide (#117671) Buy-Sell Planning Consumer Overview brochure (#117672) Key Person Coverage Producer Guide (#140184) Key Person Coverage consumer brochure (#139985) Executive Benefit Ladders consumer flyer (#155302) Executive Benefit Ladders Producer Guide (#154592) The next chapter in the Understanding Business Succession series will cover Entity Purchase. For more information on business succession planning, contact your Voya Life Companies Representative or call Sales at , Option 4. These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax advisor. The Voya Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws may change and the strategies suggested may not be suitable for everyone. Clients should seek advice from their tax and legal advisors regarding their individual situation. Life insurance products are issued by ReliaStar Company (Minneapolis, MN), ReliaStar Company of New York (Woodbury, NY) and Security Life of Denver Insurance Company (Denver, CO). Within the state of New York, only ReliaStar Company of New York is admitted and its products issued. All are members of the Voya family of companies Voya Services Company. All rights reserved. CN /01/2014 Voya.com