When is something worth more than it’s supposed to be worth?  If it’s a vintage sports car, it might be that a restoration shop has modified the original car to make it more visually appealing, faster, and more useful than new.  If it’s a decedent’s interest in an RIA, it’s because life insurance benefits paid upon the death of the shareholder are now included in the value of the business.

In Our Experience

One reason we are commonly called in to value an RIA is for purposes of a buy-sell agreement.  A buy-sell agreement provides a method to direct the purchase of a shareholder’s interest in certain conditions, such as a partner leaving the business, becoming disabled, or passing away.

Ideally, a buy-sell agreement provides a mechanism to determine the value of the subject ownership interest and how the transaction is going to occur.  Many buy-sell agreements fund the redemption of a deceased owner’s interest with life insurance that pays a death benefit to the company, which in turn uses those proceeds to pay for some or all of the redemption.

It has long been a question as to whether or not the insurance proceeds should indeed be included in the value of the business.  The difference is significant.

Value Implications of Life Insurance

Imagine an RIA worth $10 million, owned equally by two partners.  Ostensibly, each interest is worth $5 million.  The business owns life insurance with a death benefit of, say, $4 million, to fund the redemption of either partner in the event of their death.  If one partner passes away, the life insurance pays the business $4 million, and the business uses those proceeds to fund part of the redemption.

Previously, it was up for debate in the valuation community as to whether or not the $4 million death benefit was included in the value of the business.

• One camp believed that the $4 million in proceeds was an asset of the business, so the RIA is now worth $14 million ($10 enterprise value plus $4 million in life insurance proceeds), setting the value of the interest to be redeemed at $7 million (half of the total).
• The other camp, which we were in, noted that the redemption provision in the buy-sell is an offsetting corporate liability, and that the insurance was a funding mechanism for that liability. In that view, the interest to be redeemed would be worth $5 million, most of which would be covered by the $4 million in insurance proceeds.

The Courts Weigh In

Even though we were very comfortable with our position, we recommended that buy-sell agreements specify that insurance proceeds should not (would not) be factored into a valuation of the business.  Our comfort was enhanced by a 2005 decision from the United States Court of Appeals, Eleventh Circuit, in the matter of Estate of Blount v Commissioner.

All of that changed recently with a unanimous decision from the United States Supreme Court, which upheld a very different ruling from the Eighth Circuit of the U.S. Court of Appeals in the matter of Thomas Connelly v United States, rendered in June 2023.

Connelly has gotten a lot of attention within legal and valuation communities because it appears to negate the use of life insurance as an efficient way to fund one aspect of buy-sell agreements, redemption upon death of an owner.  Before Connelly, conventional wisdom was that the financial risk to a firm from an untimely death could be covered with life insurance.  With the new ruling, the concern is that a corporation can never buy enough insurance to cover the contingent liability because the dollar value of the liability increases with the very proceeds meant to pay for it.

Our Chairman, Chris Mercer, has written extensively on buy-sell agreements and has a book on the topic that will be published this fall by the American Bar Association.  You can pre-order a copy of it here.

If you’d like to read much more about Connelly, Chris also wrote up the case and its possible implications for closely-held business owners.  We would advise everyone to seek competent legal advice in reviewing and potentially revising their buy-sell.

What You Can Do (Manage Your Ownership)

In the meantime, take Connelly as a reminder that managing the ownership of your business is as important as managing the operations of the business.  In fact, a great ownership model is one that supports the operations, not just one that benefits from operations.  Life insurance was never a substitute for ownership succession planning, or taking your firm to market if you conclude that you’ve carried it as far as it can go.

We have lots of conversations with RIA owners about managing their ownership, and buy-sell agreements are part of that.  Reach out if you have an issue you’d like to discuss in confidence.