Gritty details make or break viable agreements
Now that the last bushel of corn is in the bin and the last load of manure has been spread, Greg and Jim Moes finally have the time to revise the buy-sell agreements between the two of them.
The Goodwin, S.D., brothers are part of the Farm Journal Legacy Project, which helps farmers transition their business to the succeeding generation. But before they do that, the Moes brothers have to get their own business plans updated.
Their current buy-sell agreements require each brother to buy out the other’s interest within 60 days of his death or exit from the business. That’s an incredibly short period of time, says Josh Sylvester, a Certified Financial Planner and Legacy Project team member.
Simply getting a valid death certificate can sometimes take a month or more, and then it takes even more time to execute a life insurance claim. Sylvester generally recommends a 180-day buyout period.
"When the agreements were drawn up back in the ’90s, they were cookie-cutter agreements that worked for a lot of farm operations and other businesses," Greg says. "But there were not as many dollars involved as today. It’s scary, because the agreements don’t even come close to meeting our needs today."
That’s an understatement. The brothers’ MoDak operating company valuation now likely totals several million dollars, encompassing the 1,400-cow dairy, the feeding operation and a trucking company.
To smooth the transition, Greg and Jim have to first decide whether operational control goes to the other brother or stays with the surviving relatives of the deceased partner.
Jim has no children in the operation and thinks operational control should be transferred to Greg. Greg has two sons currently working on the dairy, but they’ve only been there a short time. So Greg, too, feels operational control should be transferred to his brother. That, of course, could change in the future if Greg’s sons become more involved in the management of the operation.
To pay for a buyout in case of a death, partners usually take out life insurance on each other. Even though the premiums can be expensive, especially when the partners are in their 50s, it’s usually cheaper than taking out a loan when the other partner exits.
A $1 million life insurance policy might cost $20,000 to $40,000 per year in premiums. But principal and interest payments on a 10-year, $1 million loan would be $124,000 per year—at 4% interest. And that’s before taxes. The gross earnings before taxes needed to generate $124,000 is about $171,000 per year.
Even so, generating $40,000 to $80,000 per year in life insurance premiums to cover two $1 million policies can be a burden. "The insurance has to be affordable, integrated into the entire business plan and meet the cash flow needs of the operation," Sylvester says.
Life insurance works well in the case of the death of one of the partners. But it doesn’t work so well if a partner leaves for other reasons, such as a divorce, disability or retirement.
That’s where the valuation of the business becomes critical, along with agreed upon discounts, period of payout and interest rate.
The Moeses are thinking of discounting the valuation by 40%, having a 20-year payout and setting the interest rate at the long-term Applicable Federal Rate, which changes monthly (in November, it was 2.67%). The next step is to have their attorney draft the agreement.
2012 Legacy Workshops Get Down to the Nitty Gritty
The Legacy Project Workshops are designed to introduce farm families to the farm transition planning process and get the conversation started.
Ten workshops are slated to be held in 2012 in locations around the country.
Another key need in planning for transition is a farm transition consultant, says Kevin Spafford, Farm Journal succession planning expert.
The Legacy Project has certified 11 advisers in eight states and plans to have another 10 to 12 certified by early 2012.
These advisers are not only trained in the transition planning process, Spafford explains, but are familiar with how their clients’ plans might be affected by their local state laws.