Value of Future Payments

If you own a business, odds are the business represents a sizable portion of your estate. Therefore, planning for the orderly disposition of the business is an important planning consideration.

The most basic element of the plan involves the use of a buy-sell agreement. It is astounding how many business owners do not have a buy-sell agreement. Even more amazing is the numbers who have one, but have no method to fund it. Let’s take a look at the rationale behind a funded buy-sell agreement.

Creates a Market

Most businesses are closely held. A person can’t call their stockbroker and buy shares in the business. Essentially, there is no market for the business.

If the business is a sole proprietorship or one-man or one-woman corporation, who is going to buy the business when the owner dies? In rare cases, a family member may be able to step in and successfully continue the business. Most of the time, the businesses simply closes its doors.

If the business owner is a partner or minority shareholder in a corporation, where is the financial motivation for the other owners to buy a minority interest? A buy-sell agreement among the person’s partners, or one involving one or more key employees for the sole owner, creates a market for the business.

Avoids a New Partnership With the Heirs

In my experience, there is no quicker way to get a male business owner’s attention with respect to business succession planning than to ask two questions.

“Do you and your partner have a buy-sell agreement?”

“No.”

“If your partner died, would you like to be in business with his wife?”

Silence.

When a partner dies, and the dust settles, generally one of two things happens. The wife calls up her husband’s partner and asks where her paycheck has been for the last month. The partner has to explain that her husband’s salary was a result of his active participation in the business, not tied simply to the fact that he owned stock in the business.

The second possibility is the wife, who has no experience or participation in the business, takes over her husband’s position.

A buy-sell agreement avoids both of these scenarios.

Sets the Price

Assuming buyers surface, what is the value of the deceased owner’s interest? If the seller is the deceased owner’s family, they want as much as they can get. The remaining partners want to pay as little as possible. Oftentimes, the dollar amount is far apart.

By setting a price that everyone is happy with while living, there is no haggling over price at death. In addition, this “pegs” the value of the business for estate tax purposes. In the absence of an agreement, the estate lists a value on the estate tax return, if one is required. The IRS often comes back with their valuation opinion: a much higher amount. What ensues is a back and forth argument, involving attorney’s fees and stress. Some of these cases have dragged on for as much as ten years.

Converts an Illiquid Asset to Cash

A properly funded buy-sell agreement instantly converts bricks, mortar and steel into cash. This provides funds for the heirs to pay obligations and taxes. Cash can be invested to generate an income; cash is easily divided among heirs.

Funded With Life Insurance

Assuming that a buy-sell agreement has been drafted, the next question becomes, “Where will the funds come from for the obligation now mandated by the buy-sell agreement?” There are three typical choices.

1. Pay cash. This is only an academic choice. Most businesses don’t have cash in these amounts laying around.

2. Buy out over time. If the business interest is worth $500,000, the arrangement is to pay, for example, $50,000 plus interest over 10 years. Negotiations could be tough. The family wants their money as quickly as possible; the remaining owners want to string it out for as long as possible.

This option is expensive. It requires the survivors to pay principal plus interest. The payments put a mortgage on future earnings and have to go through the tax wringer. The result is paying much more than a dollar for each dollar of business interest purchased.

3. Fund the agreement with life insurance. This is the “discounted dollar” method. Money is available immediately to fund the agreement, and the total premiums on the policy will come nowhere near the amount received.

If you own a business and do not have a buy-sell agreement in effect, call your life insurance agent, attorney and accountant. Set up a meeting, come up with a value, have an agreement drafted, and fund it with life insurance. You have probably spent a lifetime putting your business together. Now allocate a couple of hours toward keeping it together for your heirs and circumventing a myriad of problems.

Stock valuation models are methods to value stocks. Everybody knows the stock price but only few understand how much it worth and the other investors do not even care. The reason can be due to different strategies, do not know how to value stock or just do not care how much it worth as long as the price increase the next day. If you are one of the intelligent investors, consider these valuation models in your next purchase.

Discounted Cash Flow (DCF)

This is probably the most common model that you ever heard when it comes to stock valuation. However, I found it a bit tough to do it. Simply because the discounted cash flow model have to consider revenue growth and the escalated cost at the same time, which can be too difficult to estimate and forecast as an outside investor.

Nevertheless, you can use this method in valuing stock by projecting future cash flow; from the sales and costs, and discount back to current value with Weighted Average Cost of Capital (WACC).

Dividend Discount Model (DD)

This model suits best for income investors. The idea is to project future dividend distribution based on the average historical dividend payout ratio and discount it back to present value. Although this is the simplest among all, it works best for high dividend yield stocks.

Nonetheless, the stocks must have very strong business performances that can guarantee the dividend payments 10 years down the road. And normally, penny stocks cannot be evaluated this way.

Earnings Growth Model (EG)

This is my favourite method as it is very practical and easy to do. Initially, I project its future earnings using constant or variable growth rate. Either constant or variable growth rate is depends on the expectation of its business performance within that period. Often than not, I normally use the historical business performance as a baseline provided its fundamental value remain intact. Then, I discount the future earnings with the expected return on investment (ROI).

I found this model as highly valuable since the stock price is easily reflected by its earnings. For example, the stock price will reflect its earnings and earnings growth. Assuming the P/E is the same throughout the year, you can expect the stock price to increase the same rate as the company’s growth rate.

So, before buying anymore shares in the future, put some efforts to value the stock. You can reduce the risk of losing money significantly if you buy the stock at much cheaper price than its intrinsic value.