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Exit & Succession Planning
(Long Version)
Exit Planning, as I practice it, is a system and a process to help business
owners exit their business with maximum tax efficiency and with maximum legal
security.
Business owners who wish to transfer their businesses to outside buyers, or
to family or employees (insiders), need to accomplish two goals: (i) minimize
the tax consequences for both seller and buyer; and (ii) obtain maximum legal
security, including security for payment of the purchase price.
Exit planning is not a one-off transaction. Rather, it is a process and a
relationship that can extend over a few years (and it may take this amount of
time to lock in the value of certain tax saving techniques). The process
requires a team of committed professionals – legal, accounting and financial –
because no one professional can do it alone.
Most important, business owners need to start the process sooner rather than
later. If you wait until you want to "get out" to begin the process, you likely
will have already left dollars on the table for the IRS.
The Process.
Exit planning is a long term process consisting of 7 specific steps (below).
Keep in mind that (i) the steps are sequential, but there is substantial overlap
among steps (e.g. steps 6 and 7 can be started at step 3; step 4 is always in
progress); and (ii) each step itself contains many sub-steps (e.g. step 5 can be
a complex transaction consisting of a multitude of action items).
Note that the decision whether to sell the business to an outside party or to
transfer it to insiders is often deferred until you have completed steps 1-3. In
fact, a major goal of exit planning is to determine the best buyer for the
business.
- Set Exit Objectives.
The team (together and individually) meets with
the owner to understand the owner’s goals and situation. This step may
require a number of meetings and heart-to-heart discussions.
- Prepare the Exit Plan.
Based on the meetings, the team provides
owner with a written Exit Plan.
- Determine Value.
A professional valuation is advisable if you wish
to sell the business to an outside party. The valuation determines what the
business is worth (hopefully a high number), based in large part on recent
market activity in your industry. For a sale to insiders, the valuation
seeks to reduce the value of the business (primarily for tax reasons; see
below), and can be based on historical information including cash flow.
- Increase Business Value.
Locking down key employees, and otherwise
establishing a solid and increasing cash flow is fundamental to a successful
sale to either an outside party or to insiders. At this step, we also try to
clean up business and personal liabilities.
- Sale to Outside Party, or to Insiders.
This step is the actual
transaction whereby you sell the business.
- Contingency Planning.
This step minimizes the risk that you might
die or become disabled prior to completing the sale of the business. In such
event, you must be sure that the business continues or is disposed of
according to your wishes, and that your heirs receive a fair value for the
business.
- Wealth Preservation Planning.
Your estate plan, and your retirement
funding, must be consistent with your exit plan.
A close-knit team of legal, accounting and financial professionals is
necessary to see exit planning through. This is because no one professional can
do exit planning alone. This, by the way, is one of the primary reasons why you
rarely see real exit planning done: without a real team, it is almost impossible
to bring in and coordinate all the needed expertise, and it is even harder to
keep you and the individual professionals on track for the time period required
by exit planning (sometimes a few years for all 7 steps).
Basic Concepts
Business owners who wish to transfer their businesses to family or employees
(insiders) need to accomplish two things: (i) minimize the tax consequences for
both seller and buyer; and (ii) obtain maximum security for payment of the
purchase price.
The Basic Mechanism: Tax Efficiency for Sales to Insiders.
First,
understand that these concepts only apply where the buyer is an insider
(which is most of the time) and pays the purchase price in installments
(which is nearly all the time).
The basic tax concept is to minimize the price paid for stock, and
maximize the price paid as compensation. This reduces the overall tax on
the payments for both buyer and seller, and also reduces the cash flow
required from the business. Moreover, reducing the amount of cash flow
dedicated to the payment of seller will reduce the time period needed by
the business to pay seller.
Remember this: for insider sales, the buyer usually has no money.
Seller’s purchase price comes out of the business’s cash flow. The
business earns money and pays it to buyer so that buyer can pay the
purchase price. Buyer takes the money as compensation; the business gets
the deduction. Hence the basic mechanism to save taxes is to reduce the
double tax incurred by having the business pay money to the buyer to pay
seller; rather seek to have the business pay money directly to seller.
Mechanisms to have the business pay money directly to seller include
unfunded non-qualified deferred compensation plans for the seller, the
leasing of equipment or real estate from seller to the business, the
licensing of IP from seller to the business (the business pays royalty
fees to seller), S corp dividends, consulting fees, indemnification fees
(e.g. for the use of a license of seller’s), and simply getting excess
cash out of the business to seller prior to the sale.
| Examples for sale to insider.
#1 – Purchase price
all allocated to stock. Assume FMV and purchase price (PP) are both
$1M. All of the $1M is paid for the stock.
Remember that buyer has no money. Hence the business earns money
and pays it to buyer so that buyer can pay PP. Buyer takes the money
as comp; business gets the deduction.
Assume buyer pays 35% tax on the comp. Business would need to
pay $1.54M to enable buyer to pay $1M to seller after-tax. Hence
buyer pays $540k in tax.
Seller pays cap gains on the $1M, say at 25% combined state and
federal, for a tax cost of $250k.
Conclusion: Total tax is $790k. Business needed a total cash
flow of $1.54M.
#2 – PP split among stock and compensation. Assume real FMV is
$1M, but you can get to a defensible valuation of $500k. Buyer pays
$500k for stock, and the remaining $500k is paid by business directly to
seller as comp by one of the means shown above.
Business needs to pay $770k to buyer to enable buyer to pay
$500k to seller for the stock (at buyer’s 35% rate). Buyer takes the
$770k as comp and pays $270k in taxes.
Buyer pays the $500k to seller. Seller pays $125k as cap gains
on the $500k (based on a 25% rate).
The additional $500k is not characterized as PP, but instead the
business pays it directly to seller as comp. Business deducts the
$500k payment to seller. Hence business only needs $500k cash flow
to pay the $500k.
Assume seller’s tax rate is 35%. Seller pays $175k in taxes on
the $500k comp.
Conclusion: Total tax is $570k. Total cash flow needed is
$1.27M. With the reduction in needed cash flow, we also reduce the
number of years over which seller receives the purchase price.
#3. Three-Part Sale to Further Reduce Taxes, Cash Flow and Time
Period. Again assume real FMV is $1M, but you can get to a
defensible valuation of $500k. To further reduce the number of years
over which seller receives the purchase price, consider splitting the
transaction into 3 parts: first, a sale of 40% of the stock ($200k),
second, a compensation piece ($500k), and third, a sale of the remaining
60% of stock ($300k).
Step #1 – Business needs to pay $310k to buyer to enable
buyer to pay $200k to seller for 40% of the stock (at buyer’s
35% rate). Buyer takes the $310k as comp and pays $110k in
taxes. Buyer pays the $200k to seller. Seller pays $50k as cap
gains on the $200k (based on a 25% rate).
Step #2 – $500k is not characterized as PP, but instead the
business pays it directly to seller as comp. Business deducts
the $500k payment to seller. Seller pays $175k in taxes on the
$500k compensation (assuming seller’s tax rate is 35%).
Step #3 – Because a couple of years or more have passed by
the time we get to step 3, it is much more likely that buyer can
arrange for financing to pay for the remaining stock up-front
(using the business as collateral). Hence buyer uses bank
financing (perhaps an SBA loan) to pay seller the remaining
$300k PP in one lump sum. Seller pays $75k as cap gains on the
$300k. Assuming a 25% down payment is required by the bank
($75k), and assuming bank/SBA charges of $5.5k, factor in $80.5k
as the needed cash flow. [SBA charges 2.5% of the guaranteed
portion of the loan.]
Conclusion: Total tax is $410k. Total cash flow needed is
$890.5k. After step 3, the term of buyer’s loan sets the cash
flow needed annually for debt service (e.g. standard SBA loan
for the purchase of a business is 10 years).
Notice that in example #3, we have greatly reduced the cash flow
needed to pay seller. This in turn reduces seller’s risk by reducing the
number of years needed to pay seller. We also have greatly reduced the
tax bite to all parties. The tax bite and cash flow needed in example #3
are almost half that required in example #1. Yet in my
experience, nearly all transactions are structured along the lines of
example #1! |
Keep in mind that you (the seller) need to care about the buyer’s
tax, because reducing his tax (i) might increase your purchase price,
and (ii) will strengthen the buyer’s cash flow after the sale (hence
enable the buyer to pay you off faster, or even just to make all of the
installment payments without default). In sum, a low valuation (with
lower taxes paid by the buyer) maximizes the seller’s access to future
cash flow out of the business.
Maximize Seller’s Security. Remember that the twin goals of exit
planning are to increase tax efficiency (see above), and to maximize
seller’s security. The seller needs to structure the transaction to
maximize his security, because the purchase price will be paid over an
extended period of time. In addition to other measures discussed below,
to secure the seller’s position during the time period before final
payment, we consider the following:
Obtain buyer’s and the business’s guaranties of any seller
carry-back.
Retain for seller a control interest in the business until
final payment is made. Consider selling a minority interest as
installment #1, and the majority interest later when new
management is in a better position to secure financing (see
example #3 above). Or consider retaining a control voting
interest whereby you transfer the voting shares last, or you
have nonvoting shares "switch" to voting upon final payment.
Keep seller involved until he is sure that the buyer can run
the business and produce cash flow.
Require buyer to purchase life insurance on seller’s life,
so that buyer can pay off the remaining purchase price in the
event seller dies before final payment.
Purchase life insurance on buyer’s life: (i) to assist with
repurchasing buyer’s stock if buyer dies early; and (ii) to
replace lost income stream caused by buyer’s early death.
Note also that increasing the business’s cash flow (through
tax efficiency) helps keep seller more secure of future payment.
Valuation. A valuation is important (i) to let the owner know how
much he likely will receive for the business, (ii) for setting a price
to an outside buyer, and (iii) for a sale to insiders, to set the lowest
defensible value for the business.
As seen in the above examples, smart valuation can reduce tax
consequences by 50% or more. A low valuation reduces taxes, reduces the
cash flow needed for the sale, and reduces the time period over which
seller is paid. To reduce valuation, use unfunded non-qualified deferred
comp plans (a book liability), and discounts for minority ownership,
lack of marketability and loss of key owner. Also, move assets
(equipment and real estate) and cash out of the business to the seller,
and maximize seller’s retirement contributions. The assets can later be
leased to the business to create payment to seller that is not
classified as purchase price.
Cash Flow.
For a sale to insiders, projecting future cash flow is
important. The parties need to know how much money the seller can pull
out of the business. As a rule of thumb, a sale of a business using the
business’s own cash flow leads to a valuation of 4X cash flow. This is
all the value that can be supported by the cash flow.
Create Ability to Sell Business. An essential part of the process
is talking with business brokers and friendly competitors in the
industry to determine if there is a market for the business, and if so,
the likely purchase price (within a range).
We build value into the business (e.g. by handcuffing key
employees) to make the business more attractive to outside
buyers. In addition, we perform legal audits to address and
reduce liabilities and risk, which further enhances the value of
the business.
These measures have the added advantage of making the
business more stable and profitable for a transfer to insiders.
Protect Assets.
Over time, we move cash and certain assets (e.g.
real estate, valuable equipment, etc.) out of the business to the owner.
The equipment and real estate can later be leased to the business.
Alternatively, we can create a newco/oldco structure, whereby we form
newco to carry on operations, but leave the best assets protected in
oldco. Seller sells newco but retains oldco until buyer has proven his
ability to run the business.
We also eliminate the use of personal assets as collateral for the
business, and we pay down debts secured by personal guaranties.
Motivate and Keep Key Employees. Use equity or cash plans as
incentive. In all cases, the benefits to employees vest over time
(perhaps also based on performance). The purpose is to handcuff the
employee to the business, thereby preserving value.
Equity plans include stock options and restricted stock. All
stock is subject to buy-back. We can use non-voting stock so
that the seller retains control.
Cash plans include non-qualified deferred compensation
plans, simple bonus plans, phantom stock and stock appreciation
rights. Bonuses must be specific, substantial in the eyes of the
employee, and tied to performance standards (e.g. a management
pool can share 30% of taxable income in excess of $1M).
Consider also a stay bonus plan during the planning process. Here the
key employees receive a bonus for staying on after seller leaves or
until the business is sold (usually 1 to 1½ years). The stay bonus vests
over time. This plan ensures continuity during the planning process
until a complete transition has been made.
Role of the Buy-Sell Agreement. A buy-sell agreement is a
necessary part of planning, but in itself it is insufficient for exit
planning. This is because a buy-sell agreement is essentially a passive
form of planning. A buy-sell sets the baseline or default consequences
of death, disability, dispute etc., so that these events can be overcome
without destroying the business. A buy-sell cannot provide for real exit
planning – there is simply too much to do in exit planning, too many
contingencies, and the time frame is too long.
A final note about buy-sells: don’t forget to review your buy-sell
annually and to make sure the death buyout is adequately insured and the
valuation still works.
Contingency Planning. Because it may take you a couple or a few
years to get through your exit plan, contingency planning is necessary
in case of your early death or disability. Remember, if you were to die
or become disabled, the business might lose the key person who makes it
run, the person who keeps employees and customers in place and the
person who supports all bank financing and bonding (through guaranties –
the bank or bonding company might call the loan or the bond upon your
death).
Where a business has more than one owner, use a buy-sell agreement.
Make sure you review it annually.
Single owners (and multiple owners) should consider the following
solutions:
Write down your wishes right now, and give the statement to
your family and advisors. Designate: (i) key employees who can
take over your responsibilities; (ii) friendly competitors who
perhaps can purchase the business or assist with the transition;
(iii) key advisors. State your intent whether the company should
be sold to an outside party or to insiders.
Develop your successors and/or your management team. This is
a crucial step in lifetime planning as well.
To keep employees in place, use stay bonuses for 1 to 1½
years after you leave the business. This hopefully is long
enough to transition to new ownership. You can fund a stay bonus
with life insurance.
Use life insurance to pay off bank debt or capitalize the
transition. This life insurance would be in addition to your
buy-sell insurance (which only ensures that your estate receives
cash for your stock).
Call
me to schedule a legal consultation:
510-796-9144
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