How To Fund An Employee Buyout Of Your Search Firm

The best recruiter incentive is ownership. It’s also the most dangerous. You’re trading a commitment by an employee for your livelihood — your life.

Speaking of life, let’s talk about life insurance. Not enough owners do.

William Lareau wrote in his classic Conduct Expected: The Unwritten Rules for a Successful Business Career:

All of us tend to think that we have control over what happens to us because we generally pay attention only to what we do and what happens as a result. We tend to assume a direct cause-and-effect relationship without considering all the thousands of other influences that had an impact. It’s not comforting to think that we are objects of chance, adrift on the sea of probability.

Life as we know it reached its current state as the result of thousands of minor evolutionary changes superimposed on countless previous changes. Every form of life on this planet exists today in its present form only because that form could survive long enough to spawn the next generation.

Those words don’t sound like they’re from an MBA text. They’d be appropriate in a freshman biology primer. There’s no difference though — your business is your life.

Lareau concluded, “Very few business decisions are free from the overpowering influence of the emotional needs of those involved.”

Once you face your own mortality, an employee buyout upon your death becomes the best way to:

  • Maintain full control of your business (during your life, of course);
  • Obtain the loyalty that only ownership instills;
  • Confer a real benefit on those who help you succeed;
  • Maximize the tax advantages of life insurance; and
  • Deduct the premiums as a legitimate business expense.

The basis for a life insurance buyout isn’t the life insurance — it’s the buyout. That means a buyout agreement.

Here’s how it’s done.

1. Determine the Purchase Price

This isn’t easy. Valuing a placement business is a complicated process. Here, it’s complicated even more because future value at the unknown time of your death can’t be determined.

Placement-ManagementThe best way is to start with the formula in Chapter 65 of Placement Management entitled “Placing A Value On Your Company.” Unlike an actual sale of the business, it’s easy to reach an agreement with the “buyer.” That’s because you really don’t care (you’ll be gone), and he doesn’t either (the insurance proceeds will pay it).

How much can be justified to the IRS and state tax authorities? None can be justified to the business. Premiums paid for buyout life insurance are not deductible. However, your recruiter should discuss this fully with his or her accountant. Even if he’s wrong on the valuation, the chances of an audit on something so subjective are very remote. If the valuation was to be challenged, there would be almost no tax consequences. If you think about it logically, the only sanctions would be disallowing the amount of the “excess” premium paid by the recruiter (or the business on his behalf).

Since additional insurance (as from $1 million to $2 million) costs only a fraction more, an auditor would never get a promotion for disallowing it.

2. Describe the Assets Being Sold

Most agreements contain recitals of:

  • Employer and candidate files, including contact information.
  • Capital equipment (computers, furniture, furnishings, etc.).
  • Office supplies, computer software, directories, etc.
  • Telephone numbers, service contracts, etc.
  • Office leases, equipment leases, franchise agreements, network contracts, etc.

But many agreements don’t contain anything about assuming the obligations to pay for these assets (including insurance on them). So unless everything is in a corporate name and the corporation stock will be transferred to the recruiter, your estate may be liable for them.

3. Allow For a Projected Value

Since the business will change in value constantly, a provision for revising the original valuation should be included. There are two ways to do this:

1. An annual revision: Every year, an exhibit (addendum) can be attached to the agreement that contains:

  • The new date.
  • The new purchase price.
  • The signatures of all parties to the agreement.

Simply reworking the formula or using a financial statement from the accountant will give you the number.

2. An objective formula for ascertaining the amount: It should be written right into the agreement, and include:

  1. The original purchase price.
  2. An adjustment for the cost of living.
  3. An adjustment for changes in gross income.

We recommend the formula approach (item 2) because the annual revision is difficult to remember, assemble and mutually accept. However some clients prefer it since they know exactly where they stand at any time. But if the owner dies, and the exhibit isn’t current, the beneficiaries sue.

4. Consider the Cost Of Insurance

We’re talking about straight term insurance here. If you’re big on whole life with cash values and other gimmicks, fine. They’re investments your business is making. Usually high-security, low-tax ones with yields that generate more paper than profit.

Be sure you’re able to compare the benefits. It usually takes a PhD with a microscope and more patience than a recruiter to do so. The average insurance agent has blinders — policies that set his sights on the “Million Dollar Club.”

So go for straight term insurance. You’ll know exactly how much you’re buying, and how much it costs. You can call around, give agents your age, and obtain quotes. As long as the company has a rating of “C” or better in the latest edition of Best’s Insurance Reports, don’t worry. Best’s ratings are universally available.

Term life is the easiest possible type of insurance to administer because — let’s face it — there’s not much to argue about.

5. Provide For Additional Insurance

Most term policies allow for increasing the coverage, but features you might want to investigate are:

  1. Comparable rates regardless of physical condition.
  2. No limitation on the amount of increases.
  3. Increases whenever you want to make them.

Decreasing coverage is rarely an issue, since inflation and time push up the value of your business. However, it’s worth checking. Agents tend to talk about reduction options when they’re selling, but resist them when the time comes. Be sure the policy protects you here. Otherwise, to decrease coverage you may have to cancel the policy and buy a new one. You’ll be older and rates will be higher. Even worse, you may be uninsurable.

6. Arrange For Payment of the Premiums

One way is to simply increase the compensation to the recruiter in exchange for his agreement to pay the premiums personally. Although the business can deduct his compensation as a business expense, there’s difficulty verifying the payments were made.

So the preferred way is to pay the premiums.

Lawyers Edwin White and Herbert Chasman noted in Business Insurance:

[A]rrangements are often made whereby the purchasing employee authorizes the proprietor to pay the insurance premiums as they become due and to charge them to the employee’s salary account. In these cases, the premiums paid by the proprietor are not deductible by him as premiums, but are deductible by him as salary paid out.

Either way, the recruiter can’t deduct the amount of the premiums.

As with the formula for valuation (Item 3B), we advise automatic payroll deduction and payment.

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7. Disposition If the Recruiter Leaves

It’s not legally required that the employee remain to buy out the business. We see three devices to cover this regularly:

1. Creating “golden handcuffs”: If you create them, your agreement should clearly provide that the policy will only be in force while the recruiter remains. Some agreements contain additional terms for:

  • Transfer of the policy to another employee or third party (subject to the consent of the insurance company).
  • Payment of the “cash value” or other residual amount on non-term “products” to the consultant.

2. Continuing the policy: This is most acceptable in the case of a recruiter who leaves the placement business. However, there are situations where even those who continue working a desk keep their buyout agreement in force. We don’t recommend it in directly competitive placement, since restraint of trade and conflict of interest allegations are likely.

But what about a temporary service consultant who leaves to start a search business from home? I received that call awhile ago, and everyone was delighted to continue the agreement.

3. Giving the option to the owner: Reserving the right contractually is the best way. That keeps the “golden handcuffs” snapped shut unless the owner decides to open them. The recruiter “misdeeds” at his own risk.

Since state insurance laws and policies vary on whether “insurable interest” benefits can be assigned or otherwise transferred, check with your agent and lawyer.

Finally, don’t forget to include a provision prohibiting payment to the recruiter in lieu of the premium. He’s either in the program or he’s not.

8. Allow For Insufficient or Excess Insurance Proceeds

Many buyout agreements omit this critical issue. It’s critical because the probability of the proceeds being too low or too high is almost 100%. A few options are:

If the proceeds are too low:

  • The recruiter will pay the balance within 90 days or risk losing the purchase.
  • The recruiter will sign a promissory note for the balance, at a certain number of points above the prime lending rate.
  • The purchase price will be reduced to equal the proceeds. The recruiter will form a limited partnership with the beneficiaries. The recruiter becomes the general (active) partner, and pays them out of the business income. They are the limited (passive) partners until they are paid in full.

If the proceeds are too high:

  • The recruiter will retain the balance to use as she wishes.
  • The recruiter will invest the balance in the business. (Some owners insist.)
  • The purchase price will be increased to equal the proceeds.
  • The recruiter will give the balance to the owner’s survivors, charity, etc.

Suit yourself about how to adjust the variance, but just be sure to provide for it. The last thing your grieving loved ones need is a complicated, protracted, expensive probate hassle with the recruiter. It’s not only bad for them — it will cause the recruiter to blow placements. Eventually, there may be no business to hassle about.

9. Select a Competent Accountant

No analysis of a buyout upon your death is complete without considering the federal estate and any applicable state taxes.

Unfortunately, I can’t help you here since:

  • The laws are constantly changing.
  • The law that will apply depends upon when you die, and even then
  • The tax will depend on your individual circumstances.

A good accountant can save you, your recruiter, and your heirs a fortune. Get a referral any way you can. It’s not easy — there are thousands of bean-counters for every bean. Few business people know the difference, and people tend to refer based upon familiarity rather than competence.

You need a trained, research oriented tax adviser. Certified for sure.

10. Select a Competent Attorney

If that lawyer in the elevator doesn’t really specialize in estate planning, call your local bar association. Most will provide a referral to several attorneys who do. You can ask your insurance agent, but be careful. He’s over his head, and biased.

Business partnership purchase bookThe first question to ask is whether a trust would be advisable. Attorney Alden Guild noted why in Business-Partnership Purchase Agreements:

In this type of arrangement, the trustee would be designated beneficiary of the funding policy… to withhold the proceeds in much the same manner as does a title company in a land purchase transaction. Sometimes it is known that suspicion, jealousy or ill will might arise among the survivors. Certainly in such situations the need for some impartial administration is clear.

If a lawyer can’t explain trusts to you, don’t trust him. Instead thank him politely, pay him for his time, and leave. Then go on to your next referral. Whether you need a trust or not, you definitely need an attorney who understands them. Trusts are about as common to estate planning as resumes are to recruiting. He’d better know them cold.

The conclusion about funding buyouts with life insurance is aptly expressed by Guild:

While it is certainly true that savings which are regularly deposited and not withdrawn can grow year by year, there is no kind of property aside from life insurance, which can provide complete funding from the very instant the business purchase agreement is executed.

[T]here is indeed much to commend life insurance as the only practical funding vehicle.

Here’s to your long, successful livelihood — and life!

More than thirty-five years ago, Jeffrey G. Allen, J.D., C.P.C. turned a decade of recruiting and human resources management into the legal specialty of placement law. Since 1975, Jeff has collected more placement fees, litigated more trade secrets cases, and assisted more placement practitioners than anyone else. From individuals to multinational corporations in every phase of staffing, his name is synonymous with competent legal representation. Jeff holds four certifications in placement and is the author of 24 popular books in the career field, including bestsellers How to Turn an Interview into a Job, The Complete Q&A Job Interview Book and the revolutionary Instant Interviews. As the world?s leading placement lawyer, Jeff?s experience includes: Thirty-five years of law practice specializing in representation of staffing businesses and practitioners; Author of ?The Allen Law?--the only placement information trade secrets law in the United States; Expert witness on employment and placement matters; Recruiter and staffing service office manager; Human resources manager for major employers; Certified Personnel Consultant, Certified Placement Counselor, Certified Employment Specialist and Certified Search Specialist designations; Cofounder of the national Certified Search Specialist program; Special Advisor to the American Employment Association; General Counsel to the California Association of Personnel Consultants (honorary lifetime membership conferred); Founder and Director of the National Placement Law Center; Recipient of the Staffing Industry Lifetime Achievement Award; Advisor to national, regional and state trade associations on legal, ethics and legislative matters; Author of The Placement Strategy Handbook, Placement Management, The National Placement Law Center Fee Collection Guide and The Best of Jeff Allen, published by Search Research Institute exclusively for the staffing industry; and Producer of the EMPLAW Audio Series on employment law matters. Email him at jeff@placementlaw.com.

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