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1 C a s e S t u d y 1 Buy-Sell Way Out of Whack Valuation We recently worked with two partners who owned a private business. These two had started the business from scratch and over the years had built the business into a multi-million dollar venture. They had been offered $75M by an outside strategic buyer the year before and decided not to sell. As part of our ongoing engagement with the business, we set a priority to review corporate documents, including the buy-sell agreement. Both partners assured us that the buy-sell was up to date and in great shape, since it had been reviewed only five or six years prior. We found a few things during the review but here was the major issue. Valuation: The company had a value formula that was based on a 3.5x multiple of EBITDA. The advantage to this is that the valuation would increase with the growth of the business without having to adjust the buy-sell. The disadvantage was that the multiple was way out of whack. They had just been offered a 5.74x multiple. And they turned it down because they felt it wasn t high enough. The difference: buy-sell price $45M. Fair market value - $75M. Had there been a death, one partner would have lost $15M. The other would have gained $15M. Does it really make sense to set and forget with regards to your most important asset?

2 C a s e S t u d y 2 Buy-Sell Funding Mismatch We recently worked on a buy-sell case involving three partners. They had a buy-sell agreement with a common redemption agreement. This meant that if one of the partners died, the company would buy out the shares of the deceased partner. The problem: Each partner personally owned the insurance on the other partners and there was nothing that required a partner to deliver cash to the company so that the company could fulfill their obligation to buy. In this case a partner died and one of the remaining partners refused to give the death benefit to the company. This left the company short of cash, the estate of the deceased short of cash and one partner way ahead of the game. The case is slowly working its way through the courts with claims, cross claims and counterclaims. With luck, everything will be resolved within three to four years. Until then, only one of the three partners is in a good position, and all three (including the estate) are in serious litigation with pretty large legal fees and lots of frustration. Unfortunately, this was not a case we got to review in time. However it shows how important it is to do periodic reviews to look for issues like this that can create huge problems where none should exist.

3 C a s e S t u d y 3 The Buy-Sell Agreement that Creates Capital Gains Tax For No Reason In one recent case we reviewed a buy-sell that had been drafted several years earlier. The company had four shareholders and the advisor recommended to the shareholders a redemption style agreement. This would make it much easier for everyone to administer the life insurance on the four shareholders (Four policies instead of 12) and also made it easier from a premium point of view. All of the shareholders were different ages and different underwriting classes so they all had differing premiums due. Having the company own the policies made sense since the company could also pay all of the premiums. In this case the company was a C corp. Insurance paid to the company on the death of an owner was to be used to buy out the deceased shareholder. The problem is that when the company buys the shares of a deceased shareholder, the remaining shareholders do not get an increase in basis. This can cause an unnecessary capital gains tax to be due should the remaining shareholders sell the company at a later date and can easily be avoided. Owners of S Corporations should also be wary since S Corporation redemptions usually waste basis, again making higher capital gains taxes a real possibility.

4 C a s e S t u d y 4 Right of First Refusal Gone Wrong In this case, Dave and Harry had been partners for years. Harry decided he wanted to retire and give the stock he owned in the company to his son, Jason, who was working in the business. Dave had no problem with that. He thought Jason was a little bit unreliable but remembered when he was young and thought everything would work out. Harry passed away shortly after retiring and Jason told Dave that he wanted to cash out. Dave said he had no interest in buying Jason s shares and told him he should work harder in the business. Jason went to one of the business s competitors and entered into a deal to sell his shares to the competitor. When Dave found out, he went ballistic. He knew that once the competitor got involved, he would learn everything there was to know about the business including confidential information concerning suppliers, customers, pricing, intellectual capital and more. Dave went to his lawyer who looked at the buy-sell agreement and found that it was a bare bones internet agreement which did not prohibit a shareholder from selling their shares for the best price on the open market. Dave was stuck. He ended up having to bid against his competitor which drove the price of Jason s shares well above market. This was a problem that could easily have been avoided.

5 C a s e S t u d y 5 The Buy-Sell Agreement that Cost the Company Money XYZ, Inc. was a manufacturing company that required a lot of capital to operate. Over the years it had been a good customer of the local bank, on both the deposit and loan side. In recent years, the manufacturing company had come under pressure from overseas competitors and the bank had been bought out by a regional bank that was not interested in lending to manufacturing companies. The bank attorneys started looking for ways to terminate the revolving line of credit, but the agreement was pretty favorable to the company and no outs were found. Then one of the shareholders wanted to retire. Per the terms of the buy-sell agreement, the company bought the shares of the retiring partner and issued an installment note to the partner to pay for the shares over a five year period as called for in the company s buy-sell agreement. This gave the bank the ammunition they needed because this additional debt, though totally manageable by the company, was prohibited in the loan covenants without the banks prior permission. The lender used their leverage. They told the company that they could either pay off the loan or alternatively, sign new loan documents with a higher interest rate and much less favorable terms. The business had no choice but to agree to the new provisions, which turned out to be very expensive to the company.

6 C a s e S t u d y 6 The Golden Goose Leaves Several college students work together to build a new computer program. Two of the three have the idea and appear to be very smart marketers. The third is an expert computer coder and can make almost anything happen online. The three work together for a period of time until the coder realizes that without him, the company is nothing. He starts working on his own to develop his own program that mimics in many ways the original idea. Then he starts building enhancements to his program, leaving the old program to stagnate and die. His original partners are cut out and the coder goes on to make billions. One problem: no buy-sell with provisions that restrict a partner from competing with the company for their own personal gain. In addition, no provisions to prevent a partner from diverting business opportunities from the company for their own personal gain. Of course some might recognize the scenario from newspapers, movies or books, since this is basically the accusation that Cameron Winklevoss and Tyler Winklevoss leveled at Mark Zuckerberg, founder of Facebook.

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