Sunsetting Insurance Policies in Buy-Sell Agreements

A colleague of mine, Barry Thomas of Principal Financial Group, recently forwarded me some important information on buy-sell insurance policies. Barry's update highlighted some problems brought up in a recent Indiana court case, Hilliard v. Jacobs.

Hilliard and Jacobs owned a business together and as-is common they purchased life insurance policies on each other's lives. This is done so that if one partner dies the other will receive life insurance proceeds to buy the deceased's interest from his family. The only problem here is that Hilliard and Jacobs sold the business and no one did anything about the insurance policies.

We don't know the exact details, but it sounds like Hilliard's health started failing and, sensing the inevitable, Jacobs refused to exchange policies with Hilliard and kept paying the premiums. Hilliard sued, died, and his widow later lost the case. Jacobs collected $2,500,000 of life insurance. Fair? No. Legal? According to the court, yes. Indiana does not have an insurable interest requirement. Therefor Jacobs did not need to justify having an insurance policy on someone with whom he had no real ties, at least none that would indicate the need for an insurance policy.

The court told Hilliard's widow that there were two opportunities to do the right thing with the life insurance policies. First, the partners could have addressed the disposition of insurance policies in the buy-sell agreement. Second, there was a settlement agreement between the two partners at the time the business sold. Neither document made mention of what should be done with the policies once the business relationship terminated.

The lesson here is that we spend a lot of time encouraging owners to draft and fund buy-sell agreements, but rarely do we talk about what will happen to things like funded insurance policies if the relationship ends. It is easy to do at the outset, but as Hilliard proves it can be very difficult to fix later.

Five Reasons to Pay Yourself More (S Corp owner compensation strategies)

There is a lot of over-the-hedge tax strategy among small business owners. You know what I mean. Your neighbor who owns a painting company leans over the hedge and tells you he's paying zero taxes and you take his way of doing things and adopt them in your business. This happens quite often in the realm of officer compensation. S corp owners have the ability to limit the amount of payroll taxes they pay by reducing the salary they take out of the business. While good for cash flow there are a few reasons this may be a bad idea.

1. IRS is watching. S corporation owners are required to pay themselves a reasonable salary for personal services they perform for the business. If you don't IRS can come back and re-characterize distributions as wage payments. A host of underpayment and late penalties may follow. This is an area IRS has increasingly targeted for enforcement and even Congress is getting in on the act with recent legislative changes. It's better to have a well thought out and defensible compensation plan for the shareholders.


2. You may limit the amount you can contribute to retirement. Both defined benefit and defined contribution retirement plans are limited by the amounts you earn in wages. If your wages are too low you may be precluded from making contributions at the level that would be best for your financial plan.


3. You may sabotage your exit strategy. When someone looks at buying your business one of the first things they will use to torpedo your asking price is inadequate owner compensation. You at least want to have a debatable position rather than a scenario that is clearly flawed and gives the purchaser a clear point of leverage in the negotiations.


4. Inadequate officer compensation makes profit sharing muddy and confusing. The best profit sharing and incentive compensation plans use bottom line numbers from the financial statements. If you have to jump through hoops and explain why additional "below the line" adjustments are needed before you can communicate company profits you lose credibility with employees and make things more complicated than they should be.


5. Benchmarking becomes a black art. Similar to the problems created with profit sharing the presence of inadequate owner compensation in your financial statements makes it hard to compare your performance to peers or industry standards.

In the end inadequate shareholder compensation proves to be a nearsighted way to save a few tax dollars at the expense of sound business strategy.

Tech Friday - Taking the Paperless Office Mobile with Scanner PRO for iPhone

A couple of weeks ago I downloaded the Scanner Pro iPhone app from Readdle. I played around with it at my desk and then kicked myself for spending $6.99 on an app I probably wouldn't use very much. The app creates pdf documents using the iPhone camera and then gives you multiple options for sharing those documents including email, Dropbox, Google Docs, iDisk, Evernote, etc. However, I was comparing it to a Xerox scanner in the office and that wasn't a fair fight.

Recently my wife handed me some documents that she wanted me to take to the office, scan and email back to her. Instead I pulled out my iPhone, snapped four pictures, created two pdf documents and emailed them back to her, all in about 3 minutes. The quality is not great, but it is OK. CPA's and other professionals might find Scanner Pro invaluable in use cases where document information capture rather than document duplication is the goal. For instance, I had lunch with a client this week where he asked me to review his last pay stub for withholding sufficiency. Rather than bring the stub back with me I could have created a pdf on the spot and let him retain the original.

I would like to see how Scanner Pro works with the new iPhone's 5 megapixel camera. If anyone wants to try it out and link to a review in the comments I would be greatful.

The Problem with Business Valuations and Investors

I have a client who thinks he needs a business valuation. In this particular case the client is courting an investor and he would like to go to the investor with a piece of paper that says "My business is worth $x. Therefor, you should pay me 10% of $x for a 10% stake in the business. There are several problems with expecting a business valuation to meet this client's need.

1. Valuations are expensive. Depending on the complexity of the organization valuations for small businesses can range from $5,000 to $30,000. CPA's will typically perform a calculation engagement or a valuation. In a calculation engagement the client brings all the variables and assumptions to the table and the CPA pretties them up in a nice report. Not very impressive. A valuation on the other hand examines the business from many angles to assess things like expected cash flow, risk and required ongoing investment. It is a lot of work and not surprisingly we like to get paid for it. So before you spend the money make sure it is going to fit the need you have.


2. Valuations are subjective. Something is only worth what someone else is willing to pay for it. A valuation is a third party's opinion about what someone else might be willing to pay. But until someone actually pays no one can really know what the business is worth. In other words, what I think about the value of the business is irrelevant if the investor has a different opinion.


3. Investors do their own valuations. Do you really think that someone is going to just take your word for it before they hand over a couple of hundred thousand or especially several million dollars? Don't get me wrong. They'll use your valuation...for scratch paper. Investors worth having will perform their own due diligence. They will build their own valuation models and they will test their assumptions against documents you provide. Why spend the money on something they will never use?


4. Valuations age quickly. One significant shift in your business, the loss of one major account, the departure of a single key employee can have dramatic effects on the value of your business and could invalidate a previously completed valuation. Negotiations with investors, however, can drag on for months or they can be over before your CPA cracks the file folder on your valuation engagement.

My suggestion for this client and others is this: learn how to fish. Have your CPA sit down with you at the whiteboard and run you through several valuation scenarios. The most difficult part of any valuation is assessing the risk, or "cap rate" that will be used. In the end the cap rate is less important than the required rate of return for the investor. If you can sit down with your advisor and forecast cash flows under multiple scenarios you can then have a meaningful discussion with your investor regarding the required ROI. Together you and your respective advisors can evaluate the business and the likelihood that the money the investor stands to give you will enable the company to deliver a return the investor can live with. And that is much more valuable than a valuation.

Open Letter to Would Be Entrepreneurs

Dear Entrepreneur-to-Be,

I am excited for you, I really am. I want you to succeed. It's just that I have been down this road before and experience has taught me to be reserved and analytical rather than enthusiastic and passionate. I don't want you to make some of the same mistakes I've seen repeated dozens of times by people with great ideas, some better than yours. I can almost see it coming so I want to warn you. I want to give you some advice. Take it or leave it, but please understand I only offer it because I care about you and I want to see your idea come to life in a magnificent way. There is a lot I would like to tell you and maybe we can talk at length some other time. But for now there are only two things I want to share because if you forget these two things you won't have a chance. 

1. Don't count on your idea for a paycheck. If you need a paycheck get a job. Your idea and dream to build a business is an investment. By definition that means you are going to give up some things now (time, money, freedom) in order to get rewards later. This is the biggest mistake I have seen your predecessors make. They need a check so they rush to market, or they appear desperate in front of customers or they beg others to invest in their new venture so they can keep paying their mortgage. Your startup is not supposed to provide you with a paycheck. It is supposed to develop a product that you can convince others to buy. All of its dollars need to be spent developing that product. If you take a paycheck you will be starving your product of the dollars it needs to grow into a business.


2. Sell something. Don't ask for money from investors or family members. Don't go out and rent space or design letterhead. Don't do anything until you have sold something to someone who doesn't know you and does not care about your family. Until you can sell something to a stranger you don't have a sellable product. Selling to friends and family is receiving charity. You might say, "But I need money to build my product." Bill Gates and Paul Allen did not have a product when they sold their idea for a product to IBM. If you cannot sell your product or your idea nothing else matters.

The world is full of people with great ideas who sit around designing their logos and floor planning their office space. They build beautiful web sites, spend money on nice business cards and network with their new peer group of "entreprenuers." Don't be them. Do the hard stuff. Go out and sell and do it because you love the product, not because you need a paycheck. If you do this I PROMISE I'll be jumping up and down with a smile on my face the next time we see each other.

Best,
Joey