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The Last Great Derivatives Trade of the 21st Century

Joel Redmond, CFPBy Joel Redmond, CFP, United States

The derivatives markets have gotten a bad rap in the recent past. In one sense, this is rightly so. The term credit default swap will never have the same connotation it had prior to 2008. Collateralized debt obligations have made investors warier than they used to be. Bernie Madoff’s widely-touted split-strike conversion strategy gave the traditional put and call option a darker hue than ever. Nor are these concerns entirely invalid, if for no other reason than the sheer mass of the market. The Bank of International Settlements estimated worldwide derivatives notional principal at $100 trillion at the turn of the 21st century – well over the market capitalization of world equity markets.

Faced with all this, there’s still one derivatives trade that makes an enormous amount of sense for owners of closely held businesses: the simple creation of a put option on their business. A put option is simply a contract that allows its owner to sell a specific asset at a set price for a specified time period. In the world of publicly traded companies, a put option might look like this:

1 MSFT Apr 35p @ 5

This means that the owner of this put has the right to sell 100 shares (most equity option contracts have a multiplier of 100) of Microsoft at the price of $35/share, at any time between the purchase of the option and a set date in April. The option costs $500 – the premium of $5 multiplied by the number of shares the option covers.

You can see the value of this option to someone concerned that markets will fall: if a bear market comes, and MSFT’s price drops to $20, the owner of the option can exercise the option and put the stock to a guaranteed buyer for $35. (The Options Clearing Corporation is the third party guaranteeing the price of $35 if the party who sold the put defaults.) If someone holds 100 shares of stock and this event happens, the owner of the put stands to gain $35 a share, minus the $5 per share premium, minus the $20 value of the stock he must deliver. So the net gain to him is

($35 – $5 – $20) (100) = $1,000

The owner cleared $1,000 on this trade. Without the option, the stock he holds is only worth $20/share, even if he thinks it should be worth $30, or $50, or $100.

This last point is worth examining. Owners very often spend so much time creating value in their business that they often neglect to set mechanisms in place that will sustain that value should they die, become disabled, or just decide to retire. In other words, they buy MSFT without hedging it. Because most owners of closely held businesses have disproportionate amounts of their net worth tied up in their businesses, they have significant risk exposures. One way to begin to solve these problems is to draft a buy-sell agreement.

Buy-sell Agreements

Buy-sell agreements have varying types, but the overarching model is the same: they employ the purchase of life insurance policies (put options on owner’s lives, essentially) to provide a set price for the disposition of an interest. The simplest type of buy-sell is that which triggers on the death of a key owner. Consider the following situation: Owner A and Owner B each have a 50% stake in their business, valued at $2MM. If there is no agreement in place, and either owner dies, the surviving owner may not wish to pay the full $1MM for the decedent owner’s stake: he might claim that the business’ value has dropped 25% as a result of it. This not only devalues the business, it also robs the decedent owner’s family of $250,000. It also sends a signal to any prospective buyer that the value of the business is in question: it may not be worth $2MM, or even $1.75MM. Finally, if there is no kind of agreement on the business’ value prior to the owner’s death, the executor of that owner’s estate may face a challenge from the IRS as to the actual value of the business.

A simple solution to this dilemma is a simple cross-purchase buy-sell agreement. Owner A buys a $1MM policy on Owner B; Owner B does the same on Owner A. The buy-sell agreement stipulates a number of things. Among them:

  • The decedent owner’s estate’s commitment to selling his stock to the surviving owner
  • The surviving owner’s commitment to buy the stock from the estate
  • The number of shares, percentage interest, and their dollar value
  • Language averring that the assessed value of these interests arise from qualified independent appraisers
  • Agreements to apply for life insurance equal to the valuation amount of each owner’s interest
  • A promise that, if the death benefit is equal to or more than the purchase price of the interests, that the purchase price will be paid (the surviving owner typically gets to keep any additional death benefit)
  • An agreement to pay the difference between the purchase price and the death benefit if the latter is less than the former, either in a lump sum or over time using a promissory note with a specified rate and maturity
  • A clause forbidding an owner to sell his shares during his lifetime to anyone else without first offering them to the other owner at the buy-sell agreement price
  • Additional clauses, particularly if disability is included in the agreement

Doing this accomplishes several things. First, it locks in a sell price for the business: you know once you’ve executed the buy-sell (and funded it!) that your heirs will get $35 for your MSFT stock, no matter what the market is doing. Second, it enhances the value of the business as a going concern, because prospective buyers now know that you’ve created enduring value that lasts beyond your own ability. Finally, a properly executed buy-sell provides security for your family that they’ll be taken care of for the labor you’ve invested. An ancillary benefit is that the value of the business is now fixed for estate tax purposes: the larger the business, the more important this becomes.

Premiums

A final note: any buy-sell agreement comes with its own “premium,” just as in the case of the MSFT option. This premium comes in the form of:

  • Fees for a formal valuation of the business by an independent and qualified appraiser.
  • Attorney’s fees for the drafting of the agreement.
  • The ongoing expense of the life insurance to be purchased on each owner’s life.

If the derivatives markets still seem like a Byzantine nexus of peril and misfortune in the 21st century, take heart from the fact that more people use them to hedge than to speculate: companies hedging their interest rate exposure, fund managers managing their equity exposure, fixed income managers guarding their currency exposure. As a business owner, the primary exposures to consider are precisely the ones that everyday life doesn’t always accord time to dwell on: dying, becoming disabled, retiring. The buy-sell agreement is to the world of closely-held business what the humble put option is to world financial markets: truly one of the last remaining great derivatives trades of the 21st century.

Note: Information not intended as individual legal or investment advice.

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