Getting maximum value for your firm

May 2008 » Feature Articles
Qualified business life insurance policies are hidden assets that can be converted to cash.
Rhona Sacks, JD, MBA, CLU

Qualified business life insurance policies are hidden assets that can be converted to cash.

Your successful civil engineering company is more than just your most valuable capital asset—it represents the realization of your dream. During the start-up and growth stages, enhancing your firm’s productivity was your primary goal. Now that you’ve decided to sell your company and retire, your primary goal is to extract maximum value from the business you’ve worked hard to build. Unfortunately, too many exiting entrepreneurs (as well as their legal, financial, and business advisors) leave too much cash behind because they fail to recognize the enormous value hidden within one of their most overlooked and underutilized business assets.

Because baby boomers are aging, we are at the precipice of the largest business transition in history, with millions of entrepreneurs seeking to monetize business equity. Deloitte & Touche recently reported that, "71 percent of small and mid-sized enterprise owners plan to exit their businesses within the next 10 years." Because, according to the U.S. Small Business Administration, only 30 percent of family businesses survive to the second generation and just 15 percent survive to the third, most companies are sold, and if a sale isn’t possible, closed. With so many companies up for sale at the same time, the increasing competition to sell demands innovative asset-leveraging strategies to capture optimum value, as well as create more cash with which to expedite a sale.

Hidden business assets
Throughout the business cycle, companies purchase numerous business life insurance policies for risk management, employee benefit, and investment purposes. Examples include policies funding buy/sell agreements, key-person policies, split-dollar policies, policies securing business loans, policies funding retirement and employee benefit plans, and estate liquidity and equalization policies. Traditionally considered inflexible assets with little liquidity, they have long been viewed as necessary yet unrecoverable expenses.

When a company is up for sale, some of these life contracts may become obsolete because the reasons for their purchase are no longer relevant. And after a company is sold, additional business life policies may outlive their usefulness. Historically, exiting entrepreneurs faced limited disposition options when their changing needs rendered their business life policies unnecessary—allowing the policy to lapse, thereby forfeiting the value of all premiums paid or surrendering the policy to the original insurance carrier for its cash surrender value, an amount which doesn’t reflect its true value.

Today, there is another option. You can use an innovative asset optimization technique—a life settlement—to convert the hidden value in qualified business life insurance contracts to significant immediate cash, providing a much higher return on your investment. A life settlement is the sale of a life insurance policy to an institutional investor for a cash payment that is greater than the policy’s cash surrender value. The platform for the life settlement industry was created in 1911 by virtue of Grigsby v. Russell. In this seminal case, the U.S. Supreme Court declared insurance policies to be personal property and freely assignable, thereby granting a policyholder the right to transfer ownership to others.

With a life settlement, when your no-longer-needed term or cash value business life policies are sold for the highest quality institutional offer, you receive a lump-sum cash payment, which can be used for any purpose, including facilitating the sale of your company for the desired price and on favorable terms.

An entrepreneurial tale
Three business partners, ages 66, 68, and 70, were the principals of a successful company. To fund a cross-purchase buy/sell agreement, each partner owned two, $3 million term policies (no cash surrender value) on the lives of the other partners. Seeking to sell their firm, these entrepreneurs received no offers that they felt were adequate for achieving their retirement and legacy goals. Unfortunately, their legal, financial, and business advisors were unaware of the enormous value hidden within these business term policies, believing that they were worthless because of the zero cash redemption value.

Instead of lapsing the policies and receiving no return on the premiums they had paid for many years, these three wise men sold their policies to institutional investors in the secondary life insurance market and received cash windfalls of approximately $600,000 each.

By coordinating the sale of their company with the sale of their obsolete buy/sell policies, the owners were able to sell their company quickly at a reduced all-cash price because the life settlement proceeds provided the money they needed to fill the gap between their original selling price and the offers from buyers.

Life settlement basics
Although life settlement viability is determined on a case-by-case basis, with all transactions subject to relevant legal requirements and underwriting authorization, the general purchasing parameters are the following:

  • the insured is 65 years old or older;
  • the policy’s death benefit is $250,000 or more; and
  • the policy has been in force at least two years.

Unlike applying for life insurance, no medical exams or extensive interviews are required. The underwriting process involves only paperwork, such as your life insurance policy and in-force ledger, as well as your medical records, which are necessary to verify the specifics of your insurance and health. Furthermore, there are no appraisal, application, or processing fees.

Large portfolios of life policies are purchased by institutional investors seeking predictable, non-market correlated returns based on the future value of policy proceeds. In 2006, according to A.M. Best Company, Inc., corporate money managers invested $10 billion to $15 billion in life settlements—more money than in the previous seven years combined—because they are increasingly interested in purchasing pools of life policies to diversify their portfolios into alternative investments.

End of a monopsony
Imagine a world where you were only permitted to sell your house back to the builder, your automobile back to the dealer, and your stocks back to the issuing corporation. This is what a world without secondary markets would look like, and this is the world that life insurance policyholders have traditionally encountered.

Before the emergence of the secondary life insurance market in the late 1990s, the originating insurer was the only potential purchaser for your expendable business life insurance contracts, thereby restricting your policy disposition options to receiving an artificially low cash redemption value. Because the insurance companies set the re-purchase price, policyholders traditionally received little economic value from their superfluous life contracts, on average just 4 percent of the policy’s face value, according to James D. Warring in a September 2005 article in Journal of Accountancy, "Turn unneeded policies into cash: A life settlement can be a better alternative than surrendering a policy."

Fortunately, the life settlement industry has replaced this monopsony (an anti-competitive market situation in which a seller is only permitted to sell to one buyer) with a free-market alternative wherein companies competitively bid to acquire the rights and obligations in your dispensable business life policies. This vibrant marketplace enables you to retrieve the fair market value from these otherwise illiquid business assets. With the average life settlement payout today being 20 percent to 25 percent of the face value, according to Maple Life Financial and Life Settlement Solutions, a life settlement can be an effective tool for liberating substantial liquidity hidden within a dormant business asset.

Caveats
Although selling your unnecessary business life policies in the secondary life insurance market can be profitable, navigating the labyrinthine life settlement marketplace can be challenging. The nascent life settlement industry, in general, lacks ample due diligence and transparency, as well as knowledge of and services responsive to the unique needs of retiring entrepreneurs in the process of selling their companies.

Analyzing the expendability of your business life policies, coordinating the sale of your obsolete policies with the sale of your company, safeguarding your privacy, and securing the highest quality institutional offer demand specialized advisory skills in exit planning, business life insurance, and life settlements. Working with an independent advisor who has expertise in these disciplines is the key to a successful, efficient transaction.

Every day, retiring business owners frustrated by inadequate purchasing offers for their firms unknowingly discard valuable capital assets by cash surrendering and lapsing their no longer needed business life policies. Selling these hidden business assets can be the answer to getting your deal done easily.

Rhona Sacks, JD, MBA, CLU, is founder and president of Legal Life Settlements, a mergers and acquisitions advisory company specializing in helping retiring business owners extract maximum value from their hidden business assets.


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