An ‘Heir Transplant’: Offsetting the cost of borrowing to invest

The following is based on one of The Covenant Group’s clients. All of the names and telling details have been changed.

Last December, I met an old friend for breakfast and learned from him that a client of mine, Brian Baines, had just purchased Vendex, a vending machine company for a million dollars. The acquisition, of course, would have been financed with a loan, and I knew my next step was a call to Mr. Baines.

While Baines was a client of mine, he was only a small client, and not one of my favourites. He was a successful entrepreneur who owned 60% of Bridon Enterprises. He certainly required more insurance than I had so far managed to convince him to buy. He was reclusive and abrasive; however, he had purchased two small term policies from me, which gave me a foot in the door. The upside with Baines was that he was shrewd and recognized a good thing when he saw it. And now, I had a good thing.

My first two calls into Baines went unanswered, but my third turned up a half-hour appointment at 7:00 AM on a Monday morning. I met Baines at his spacious office downtown. He shook my hand briefly. I took a seat across from him and noticed his eyes were fixed on his desktop. He was obviously distracted.

“I will be brief,” I assured him. He quickly looked up, and nodded, as though pleased. I continued, “You’ll know in a few minutes if you like my idea or not. If you do, great. If not, I’ll be out of your hair.”

He nodded again.

I quickly reminded him that I was here to talk to him about his financing arrangement for Vendex, then asked him how many times he had signed for the loan, a crucial question and one I use to open up nearly all my business cases.

“What do you mean by that?” he asked abruptly.

“Obviously you signed for the loan corporately as president of your company, but banks rely heavily on personal guarantees and collateral usually equal to double the loan’s value. Did you also sign personally for the loan?”

“Yes,” he answered after a moment’s thought.

I knew he would answer yes, and that’s why I was here. The bank had him cornered; I held the only way out for him.

“Brian,” I began, “your second signature is really a way for the bank to blueprint itself into a fail-safe position. You may own 60% of the company, but now you’re on the hook for 100% of the risk. Not only are 100% of the corporate assets on the line, but so are 100% of your non-corporate assets. The bank, not your family, is now the first beneficiary of your estate. The loan agreement you signed can be a lethal weapon in the hands of the bankers, and it can be very onerous on the heirs to your estate. The question you have to deal with, Brian, is who are we really trying to protect here? The bank or your family? For instance, were you to die with the loan outstanding, the bank would likely call its loan.”

I saw Brian’s brow furrow.

“What you’ve done, Brian, with your personal assets is leave them as ‘hostages to fate.’ I can help you blueprint your heirs, not the bank, into a fail-safe position.”

“How?” Baines asked.

“Since the bank will look to your estate for repayment of the loan, why don’t we have your wife guarantee the loan? And in exchange for her guarantee, you can pay her a ‘guarantor’s fee’ of 2% or 3% of the loan, which she can use to purchase a life insurance policy on your life with her as the owner and beneficiary. On your death, she lends the insurance proceeds to the company for the specific purpose of discharging the bank loan. The bank won’t care who retires the loan, so long as it gets paid.”

Baines leaned back in his chair, and glanced pensively up at the ceiling. A moment later he declared, “I don’t need any insurance. My wife can pay off the loan by selling another asset, or by borrowing against one.”

I was hoping he would say just that. “Brian, there are really only three ways to pay off a debt at death. One, you can borrow against an asset. Two, you can sell an asset. And three is life insurance. And the only one that makes financial sense is the insurance solution.”

Baines glowered at me challengingly.

“Brian,” I said, “let’s say the debt remains at $1 million. If your wife has to borrow against other assets to pay off the bank, she’ll still be stuck with the debt. She’d have to pay back the principal, and she’d have to do that with after-tax dollars, which means raising $2 million. On top of that, she’d have to pay the interest on loan. If the interest rate is 10%, the annual cost of that loan is $100,000. Even if it’s 6%, the cost is still $60,000, which is still no comparison to the 2% or 3% guarantor’s fee we just looked at.”

“Okay,” Brian said, “so she’ll sell something to pay off the loan.”

“The problem with that option, Brian, is a market will exist for your best assets, and your wife will be left with the worst assets. Furthermore, no one’s going to buy an asset from your estate unless they believe it will be worth more the next day, which means your heirs will forfeit the future growth of those assets. And what if you die during a down market and an asset you hoped would be worth a million dollars isn’t worth that? The bank will look at the rest of your estate and see what they can take.”

Baines leaned forward attentively.

“If we pay the loan off with the insurance proceeds, you’ll also substantially reduce the impact of capital gains taxes on your estate.”

“How?”

“Because the loan will still exist. The value of the company won’t change. The equity in the company is still reduced by the debt, only now, the loan is in friendly hands. Your company will be indebted to your wife, not the bank. Your wife will own the company and she can draw down the loan over the years strategically as she sees fit, tax-free.”

Our half-hour appointment was up. Baines dismissed me gruffly. I considered this a positive response. A week later he called and asked me to underwrite his ‘guarantor’s fee.’

Lessons Learned

The concept I sold Mr. Baines is called the ‘Substitute Creditor.’ In the estate planning business, when someone signs personally for a loan, effectively placing the bank ahead of their heirs as the beneficiaries of the estate, we call it an ‘heir transplant’. The ‘Substitute Creditor’ concept remedies this problem by substituting the heirs for the bank, transferring the debt into friendly hands. This concept is a wonderful solution for investors who borrow money to make an investment, whether they are investing, as Baines did, in a business, or in mutual funds, securities, or any other form of investment. The risk for all investors is that they will die before the loan is repaid. Without insurance in force, the investor’s heirs will have to pay off the loan by borrowing or by selling assets. In many cases, this means forfeiting the very asset or investment that the loan originally financed. If the investment was a wise one and still promises to yield a profitable return, the heirs will lose the investment’s future growth, not just its current value. This, of course, defeats the whole purpose of making the investment in the first place. And what happens if the cycle in the market is low and the investment is devalued, or has under-performed altogether? Today, the prospect of a serious correction or even a crash is very real. As advisors, we must ensure that our clients are adequately protected against all contingencies.

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The Covenant Group is referred to by many as where entrepreneurs go to become Business Builders. They are considered to be thought leaders and authors of the best-selling books, The 8 Best Practices of High-Performing Salespeople, The Entrepreneurial Journey, and The Business Builder.