1. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-1 Objectives of Buy-Sell Structure Keep stock away from undesirable owners Establish fair mechanism for valuing stock of departing owner Assure smooth transitions of control and ownership issues as owners come and go Assure “market” for shares at appropriate exit points Assure expulsion rights of group, if desired Assure funding mechanisms and procedures Establish estate tax valuation

2. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-2 The Buy-Sell Triggers Death Voluntary termination Expulsion Divorce Bankruptcy Employment termination Disability

3. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-3 The Estate Tax Lock The 2703 Requirements: 1. Agreement is bona fide business arrangement 2. Agreement not device to transfer property to family members for less than full and adequate consideration 3. Terms of agreement must be comparable to similar arrangements entered into by persons in arm’ length transaction

4. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-4 The Big 2703 Exception 2703 requirements not apply if: - Over 50% of the value of property subject to the agreement is owned by non-family members - Non-family members subject to the agreement the same extent as decedent If exception applies, then…

5. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-5 2703 Exception Applies Pre-2703 requirements must be met: 1.Price must be fixed or determinable pursuant to formula or procedure in agreement. 2.Estate must be obligated to sell at determined price. 3. Decedent must have been restricted from selling or gifting during life to any person not subject to same restriction. At a minimum, should have right of first refusal.

6. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Exiting Shareholder Corporation Remaining Shareholders Balance of Stock Redemption Strategy Stock Ownership 100%Cash, Note Insurance Company Insurance Proceeds

7. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Exiting Shareholder Corporation Remaining Shareholders Balance of Stock Cross Purchase Strategy Cash, Note Insurance Company Insurance Proceeds

8. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-6 Cross Purchase – Redemption Trade-off Cross-Purchase Pluses: Stepped-up basis to buyers No AMTI life insurance issues No state law redemption restrictions No loan agreement or creditor restrictions Redemption Pluses: Easier – less cumbersome Insurance structuring easier Easier transfer-for-value issues Deductibility of interest on installment payments No need to get funds out of corp to fund buy-out The Option Strategy – Not death trigger answer

9. Buy-Sell Constructive Dividend Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com C Corp Cash or Property Shareholder A Shareholder B Stock Cross Purchase Obligation Constructive Dividend

10. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Parents Old Corp Now S Inside Children 100% of Stock Stock gifts over time Phasing Out Without Selling Out S Election – New Corp Strategy Service/Management Contract Distributions - No double tax New Corp Planned post mortem stock buyout Employment/Stock Equivalency ILIT Ins. on Parents Cash for premiums Death benefit

11. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-8 Valuation Techniques 1.Third Party Handoff – Appraisal or Appraisal/Arbitration 2.Formula – Never book value. - Capitalized earnings approach (set cap rate) - Discounted value of estimated future cash flows - Asset market value - Combo formula 3.Periodic owner agreement procedure – with back-up. 4.Mixed formula – periodic agreement procedure. 5.The need to look to industry and outside

12. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-9 The Big Mistakes 1.Misused Right of First Refusal 2.Misused Showdown Clause 3.Failure to honor unique rights – too much democracy 4.Bad life insurance structuring 5.Dumb payment terms 6.Ignore the downside 7.No anticipation of S Election Requirements

13. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-10 Staged Exit Procedure Stage One: Shareholder gives notice, wants out per price in agreement Stage Two: Extended reaction period – others have time to secure funding to purchase or find replacement partner (3 to 6 months) Stage Three: Negotiation period if Stage Two not produce solution (1 to 2 months) Stage Four: Extended search period for acceptable replacement partner (2 to 4 months) Stage Five: If still nothing, exiting partner has option to force sale of business. Any partner or group can buy. Tax-free structuring will be accommodated.

14. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-11 Fragile Group Exit Protections - Key person disaster protection - Long-term exit notice to escape overhead and other burdens - The “Lights Out” option - The “Locked-In Equity” Option - Early transition financial payment requirement