Life Insurance: Funding Vehicle for Buy-Sell or Non-Operating Asset?

Mercer Capital’s newsletter Value Matters recently published an article which points out a dilemma faced by valuation professionals in appraising businesses that have taken out life insurance to fund a buy-sell agreement. While the life insurance proceeds may be intended to satisfy the company’s liability to purchase the deceased shareholder’s stock, they might be viewed alternatively as a non-operating asset.

Mercer suggests two options:

(1) The life insurance proceeds may be offset against the liability of the company to repurchase a deceased shareholder’s stock. Thus viewed, the proceeds do not increase the company’s value.

(2) The life insurance proceeds may be viewed as a new asset which did not exist prior to the death of a shareholder, thereby increasing the value of the company. The life insurance proceeds, like any other corporate assets, would be available to satisfy the repurchase obligation.

The illustrative example that Mercer provides in his article shows that Option 1 may result in an unfavorable deal for the estate of the deceased shareholder, since the surviving shareholder ends up with a greater stake in a company whose value has not decreased, but did not have to pay for the increased equity from his/her pocket.

At the same time, Option 2 is unfavorable to the surviving shareholder, since the life insurance proceeds may be insufficient to repurchase the decedent’s interest (which has been enhanced by the addition of the insurance proceeds to the value of the company).

Perhaps Mercer did not consider a third alternative: that the insurance proceeds are a separate asset to which the shareholders are entitled in proportion to their percentage interests in the company. Thus, the value of the company is not enhanced by the proceeds, but the shareholders are entitled to the excess insurance proceeds (or responsible for the portion of the repurchase liability not satisfied by insurance) in proportion to their shareholder interests.

The point of Mercer’s article, well taken, is that shareholders should address these issues in their buy-sell agreement, rather than waiting for the issue to be raised (too late!) when a shareholder dies.