Buy-Sell Funding and Key-Person Risk in an S Corporation

Valuation: $2.4 million EBITDA x 4.5 = $10.8 million enterprise value. Marguerite's 45% = $4.86 million.

Insurance in a cross-purchase with three owners: each owner owns policies on the other two. Tom and Raj each own a $1 million policy on Marguerite, so the aggregate death benefit on Marguerite is $2 million, not $3 million and not $4.86 million. Gap: $2.86 million.

Further gaps:

• The policies are term and expire in three years. Marguerite plans to retire in 18 months, but a sale triggered by death after expiry would be unfunded. Term insurance on a 66-year-old may be expensive or unavailable at renewal.
• A cross-purchase requires six policies and coordinated ownership; it is administratively fragile.
• The buy-sell appears to address death but not retirement, which is the more likely trigger.
• Tom and Raj have limited personal liquidity, so even a funded death benefit does not solve the retirement purchase. Conclusion: the arrangement is underfunded by roughly 60% of the purchase price and is not designed for the actual trigger.

Trade-offs:

Entity redemption (stock redemption): the corporation buys Marguerite's shares. Advantages: one policy or one funding arrangement, uses corporate cash, simpler administration, and Tom and Raj do not need personal liquidity. Disadvantages: no basis step-up for Tom and Raj; the corporation's $1.8 million of accumulated earnings can fund part of it but that consumes working capital; and the redemption must be structured as a complete termination of Marguerite's interest to avoid dividend treatment. For an S corporation, check AAA and accumulated adjustments account ordering.

Cross-purchase: Tom and Raj buy directly. Advantages: basis step-up for them, and the corporation's cash is untouched. Disadvantages: personal liquidity needed, six policies, and unequal ownership percentages complicate the split.

Recommendation: a hybrid is usually the practical answer here. Use an entity redemption for the bulk, funded by corporate cash plus permanent insurance owned by the corporation, and a cross-purchase for a defined slice to give Tom and Raj basis. Because Marguerite will sell all shares, the redemption can be a complete termination. Convert the term policies to permanent coverage before age and health make it impossible; fund the retirement purchase with a combination of cash at closing, a short-term note, and insurance. Do not rely on the line of credit as permanent funding; it is a liquidity backstop.

Raj is the firm's key-person risk: he holds the client relationships. If Raj leaves or dies, EBITDA is not $2.4 million. Actions:

• Retention agreement with equity or phantom equity tied to a multi-year vesting schedule.
• Noncompete and nonsolicitation agreements, enforceable to the extent state law allows.
• Key-person life and disability insurance on Raj, owned by the corporation, with a documented beneficiary and buy-sell coordination.
• A succession plan that transfers client relationships to a second tier, which reduces concentration over time.

The project manager: a stay bonus or retention agreement, plus a documented transition of responsibilities. Losing a key technical person during a ownership transition is a valuation event.

Valuation effect: 4.5x EBITDA may be too high if it assumes Raj remains. A buyer will discount for key-person concentration, customer concentration, and the absence of a management depth. Recommend an independent appraisal with a marketability and key-person discount, and a formula that adjusts for EBITDA decline. Do not let the existing 4.5x become a contractual entitlement without a fresh appraisal and a working capital adjustment. Marguerite's basis is documented; Tom and Raj's is not, which is another reason to build basis through a cross-purchase component.