Shortly after the turn of the century (!), I started work on my first book on buy-sell agreements. That book, Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions?, was published in 2007.  That same year I gave a major presentation on the topic at the annual conference of the Business Enterprise Institute in Denver.   It was fun and I received several additional invitations to speak afterwards.

During that almost two-hour presentation, I provided two slides on an idea I called “The One Percent Solution.”  I developed the term as a vehicle to talk with clients about the value of valuation and other financial and estate planning activities conducted to manage (pre-liquid) private company wealth.  The gist of the idea is simple:

Consider a budget for managing your pre-liquid wealth (defined as your ownership interest in your private company) similar to the fees you pay to manage your liquid wealth (stocks, bonds, other liquid investments).

When thinking about investing to manage your pre-liquid wealth, consider how you likely manage your liquid wealth:

• Holders of liquid wealth, including stocks of public securities, bonds of many kinds, securitizations of assets and other assets with active or relatively active markets tend to place them “under management” with financial planners, money managers, investment advisers or other professionals who manage their wealth actively.
• Asset managers charge fees for their services. Equity managers might charge 100 basis points, or 1%, of assets under management. Bond management fees tend to be lower, say from 20 to 50 basis points or so.  And private equity, venture capital, and hedge fund fees tend to be higher, perhaps 1.5% or higher.
• If you have a million dollars in managed, liquid funds, even in your company’s profit sharing plan, you are likely paying fees of 75 to 100 basis points for the services of your asset managers.  You and I and almost everyone else with significant liquid wealth does the same thing, so on your million dollar account, you are likely paying fees of perhaps $10 thousand, or say 1% of “assets under management,” or AUM for short.

Pre-liquid assets either become liquid or facilitate the creation of liquid assets when they are sold (entire businesses or partial sales) and when they distribute cash to their owners. Do owners of privately owned companies typically thing about their pre-liquid assets as investments? Not if our experience is representative. This leads us to The One Percent Solution.

The One Percent Solution Defined

So what is The One Percent Solution?  Consider 1% of the wealth tied up in your (or your clients’) private businesses as the starting point for discussion for the budget for managing that wealth.  So if a closely held or family business is worth $20 million, the budget for managing that wealth might be about $200 thousand, or about $100 thousand if you use 50 basis points as your “management fee” percent.

The Booklet

During that speech in 2007, I said no more than what I’ve written above about The One Percent Solution.  However, a few months later, I received a call from a sales manager with National Financial Partners. I thought he was going to ask me for a repeat of my buy-sell agreement presentation.  While he found that talk very helpful, he was most interested in a one-hour presentation on, you guessed it, my two slides regarding The One Percent Solution.

I delivered that presentation and also wrote a booklet on the topic for each financial planner at the conference. That booklet is available today as a complimentary pdf download. Financial planners have purchased the book in bulk to give to their clients and I have given a number of speeches on the topic.

A New Book In New Series Is Coming

Because I am a member of the baby boomer generation and because I am a transitioning business owner, I am keenly interested in succession planning for baby boomer business owners. As such, I have begun a new series of Kindle books. The series is entitled The Baby Boomer Business Owner Transition Guides. My first book in this Kindle series was recently published: Buy-Sell Agreements for Baby Boomer Business Owners. It is my third book on the topic of buy-sell agreements. It is a condensed and generationally focused version of my 2010 print book, Buy-Sell Agreements for Closely Held and Family Business Owners.  

At the request of several financial planners and attorneys, I am in the process of revising and expanding the original The One Percent Solution (available as a complimentary pdf download).  You can follow along because I will be writing installments on the topic for the blog as the new book develops. The new book will be the second book in The Baby Boomer Business Owner Guides series.

Conclusion

If you have ideas or thoughts you would like to share about managing private wealth, please feel free to call or email me.  I’d love to hear from you and consider your ideas as the new The One Percent Solution progresses.

Q:  Isn’t a valuation process agreement just a fixed price buy-sell agreement that is updated every year?

Answer:

The question is a good one.  And the answer is “no” and “yes.”

“No.”  A buy-sell valuation process agreement specifies just that – a valuation process to determine value.  The price is determined by appraisal. It is the appraisal process that establishes value on a regular basis or at trigger events, and not agreement of the parties in the context of setting price. So a valuation process agreement is not just a fixed-price agreement that is updated each year.

“Yes.”  A valuation process agreement does set a price which, for a time, is fixed.  In that context, it is a “fixed-price” agreement.  However, unlike with an actual fixed-price agreement, which calls upon the parties to reset the price each year (and they seldom, if ever, do), the valuation process agreement specifies a process for “fixing” the price that is, once underway, outside the hands of any party.

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For more information on this topic and other topics related to buy-sell agreements, check out Buy-Sell Agreements for Closely Held and Family Business Owners.

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This series, “Ask Chris Mercer,” is derived from the Q&A session of the May 16, 2012 webinar, “Buy-Sell Agreements” sponsored by WealthCounsel and attended by over 600.  

If you have a question for Chris, feel free to email him directly here.

Promissory notes are used as a funding mechanism in many buy-sell agreements.  The topic is discussed in my book, Buy-Sell Agreements for Closely Held and Family Business Owners.  In a recent blog post, Shareholder (Promissory) Notes in Buy-Sell Agreements, we addressed the topic in even more detail.

Two appraisals (two separate years) prepared by Mercer Capital several years ago were used by clients for gifting purposes. The gifting values were challenged by the Internal Revenue Service.  Annual valuations had been prepared for many years prior to the two years in question pursuant to the company’s buy-sell agreement.

Promissory Note Maturity Challenged

In addition to questioning Mercer Capital’s appraisal conclusions, the IRS also raised challenges under Code Section Section 2703.  The shareholders’ agreement in question called for the issuance of a ten year promissory note in the event that stock was purchased due to the operation of the agreement.  The IRS questioned this aspect of the agreement, indicating that it was too long and was not similar to comparable transactions among arm’s length parties.

Since the great majority of buy-sell agreements are between privately owned companies and their owners, it is particularly difficult to prove what “the market” is for the maturities of promissory notes in shareholders’ agreements.

Research of “the Market”

As an expert, I did not want to be in a position of simply stating that “in my professional experience” a ten year note maturity is typical, or at least fairly common for promissory notes issued in accordance with buy-sell agreements.  It occurred to me that evidence of “the market” existed within the historical files of client engagements at Mercer Capital.

I proceeded to look at “the market” for maturities of promissory notes issued by the operation of buy-sell agreements. Since the interest rate in the agreement was also challenged, I also looked at the interest rate for each promissory note identified and the amortization method.

My search of Mercer Capital’s files was not random, but it was not performed with any preconceived identification method.  Our electronic files of corporate documents are mostly in pdf format, and they are not easily searchable.  The methodology was straightforward:

• Begin with a list of corporate clients (i.e., non-banks, because banks, for some reason, seldom have buy-sell agreements)
• Begin at the top of the list and go to the client folder on the server to locate the buy-sell agreement.  This is actually more difficult than it might seem, because many of our clients obtain annual appraisals.  Each new engagement receives a new client number.  So I had to search back, year-by-year, to find the client number and file where we actually had the buy-sell agreement.
• Once I found a particular company’s buy-sell agreement, I read the agreement, seeking to identify three things, the term of any promissory note that might be issues (if any), the amortization method, and the indicated interest rate.
• When I had found and reviewed 20 buy-sell agreements, I stopped.

Observations

The entities, of course, shall remain anonymous.  However, the information derived from this study of 20 buy-sell agreements is informative.  We can learn something from the collection of information and glean aspects of certain of the negotiations leading to decisions regarding promissory notes.

• On the question of maturity raised by the IRS, seven of the 20 agreements have maturities of ten or more years, which indicates that this maturity selection is quite common.
• The most frequent maturity is five years, with eight agreements having this length for maturity.
• The first note is a single payment note with a maturity of one year.  The interest rate is 15%.  It is clear that these shareholders wanted to insure that their company (and the other shareholders) were under some pressure to pay promptly!
• The 18th note is interesting.  It calls for varying maturities, depending on the dollar size of the block of stock — the larger the dollar amount, the longer the maturity.
• Twelve of the agreements call for note payments in annual installments.  This decision likely reflects minimal involvement of shareholders, or at least minimal thinking about the issue.  Most people, if they think about it, would negotiate monthly or quarterly installments.  Regular payments increases cash flow and minimizes risk.
• The interest rates vary  a good deal.  Ten agreements use the prime rate of a named bank or prime, plus or minus a bit.  Three of the agreements use the AFR.
• Four notes clarified that the applicable prime rate would vary with a selected bank’s prime and be reset on the anniversary date of the transaction each year.  The other notes using the prime rate were sometimes less than clear as to whether the selected rate was fixed at the date of note issuance, or would vary in some way.  If these companies issue notes and rates vary significantly over their durations, there could be some interesting discussions about the language in those agreements!

Conclusion

As with every aspect of buy-sell agreements, it is important that any promissory notes that might be issued be appropriately defined and documented.  In the post on promissory notes linked above, we provided the opportunity to download a Checklist for Shareholder (Promissory) Notes in Buy-Sell Agreements.  If you missed it before, now is a good time to download it.

The Checklist for Shareholder (Promissory) Notes in Buy-Sell Agreements is excerpted from Chapter 13 of my book, Buy-Sell Agreements for Closely Held and Family Business Owners.  You will find a discussion of shareholder, or promissory notes, there as well.  If you like the checklist, you will love the book. Quantity discounts available.

By the way, after being scheduled for U.S. Tax Court and extensive preparations, the valuation issues raised by the IRS that were mentioned above were settled on the eve of trial at the original conclusions rendered by Mercer Capital.  All other issues were also resolved in favor of the taxpayer.