Transitions Digest

Step 5

How do you successfully transfer your business to a child, key employee or co-owner? The most successful method is to follow a recipe that mixes, in equal measure, three key ingredients:

• One part: the ability, experience and dedication of the prospective new owners;
• One part: a company with strong, consistent cash flow and little debt; and
• One part: a transaction designed to prevent income taxes from eroding the cash flow available to you, the seller.

It should be obvious that a business cannot be successfully transferred unless the new ownership is capable. Furthermore, we cannot expect the transfer to be successful if the business itself lacks the ability to provide an ongoing stream of income with which to pay for the business acquisition. What may not be so obvious; however, is the corrosive affect of income taxation upon the transfer of a business to “insiders” — children, key employees or co-owners. Let’s look at two key facts associated with transferring business to an insider.

First, your children or key employees may not have cash to buy you out. Therefore, any sale may take many years to complete — a potentially risky prospect. Further, all of the cash used to purchase your ownership may come from one source: the future cash flow of the business after you have left it.

Second, without planning, the cash flow can be taxed twice. It is this double tax, (sometimes totaling more than 50 percent) that can spell disaster for many internal transfers. Through effective tax planning, however, much of this tax burden can be legally avoided. Witness what Karl Clark did.

Karl Clark agreed to sell his company to a key employee, Sharon Smith, for $1 million. This value was based on the company’s annual $250,000 cash flow, which Karl historically took in the form of salary. While Karl understood that Sharon could not pay $1 million (nor could she secure financing), he did think that she could buy out the company over a five- or six-year period, using the available cash flow of the company.

Karl’s calculations were way off the mark. The time needed for a buy out was at least 10 years. But why were his calculations so off base? In a word, taxes — actually in two words, double taxation. Without proper planning, this is what happens if Sharon buys the company (and what can happen to you when you attempt to sell your business to your children or employees):

1. Sharon receives the cash flow ($250,000 per year) and is taxed on it at an estimated 35 percent federal and 5 percent state income tax rate(These rates may vary depending on total income and your state’s tax rate).
2. Sharon pays $100,000 in taxes (40 percent of $250,000). This is the first tax on the business’s cash flow.
3. Sharon pays the remaining $150,000 (net after tax) to Karl.
4. Karl pays an estimated 15 percent federal and 5 percent capital gains tax on the $150,000 he has received for the sale of his ownership interest, or $30,000 in taxes. This is the second tax on the original stream of income from the business. The result?
5. The company distributed $250,000 of its cash flow, but Karl was only able to put $120,000 in his pocket.

Without proper tax planning, you too, may experience an effective tax rate that could be in excess of 50 percent on the company’s available cash flow used to fund your buyout. This is likely to prevent, as it did for Karl and Sharon, a consummation of the sale of the business.

How might you design your sale to lower taxes and maximize the opportunity for success?

1. Plan. Like Karl, you should have a plan that yields you a greater after-tax amount for the sale of your company. Since the cash flow of the company may increase, the key is to provide Uncle Sam a smaller slice of the available cash flow.
2. Use an experienced advisory team, usually consisting of a business attorney, CPA and insurance or financial professional. They should understand the importance of tax sensitivity to both seller and buyer in order to make more money available to you.
3. In addition, you and your advisors should use a modest, but defensible valuation for the company. Because a lower value is used for the purchase price, the size of the tax bite is correspondingly reduced. The difference between what you will receive from the sale of your business, at a lower price, and what you want to be paid to you after you leave the business is “made good” through a number of different techniques to extract cash from the company after you leave it.

Tax planning for the transfer of your company to an insider takes time, planning and knowledge. But it can possibly save a tremendous amount of money. Take time now to begin the planning process.

• Learn as much as you can about how to best accomplish the transfer of your business.
• Seek the advice of your advisory team. Taking action sooner rather than later may help your business transfer recipe provide a tastier result. Bon appetit!

Subsequent issues of The Exit Planning Digest discuss all aspects of Exit Planning. The provider of this Newsletter (Holly A. Magister, CPA, CFP®) offers you unbiased information about what you may need to know. Subscribe to our free Exit Planning educational newsletter to learn more about how to grow and/or plan for your business exit.

 Complete Series

Posted on May 15th, 2009 under Exit Planning, Exit Planning Digest, Mergers and Acquisitions. Tags: acquisition, Add new tag, buy-sell transfer, buyout, companies change, Exit Planning. Comments: 4

The Exit Planning Review™ Bi-Monthly Newsletter

With this issue of The Exit Planning Review™ we begin a discussion of how owners of mid-sized business are making decisions about their futures in a quickly changing economy.As exit planners, we consistently urge business owners to take the initiative when planning their exits. Today, we apply that perspective to encourage business owners to go beyond panicked headlines and take a clear-eyed look at their options in light of their: (1) exit objectives, (2) companies and (3) current M&A conditions in their marketplaces before they decide if their exits must be moved forward or delayed.

Each owner is different: some are so close to retiring that they can taste it, while others have years to work before they can even think about leaving the limelight. Some owners have a sense that hidden in this recession there just might be opportunities to be grabbed. Others are looking to protect what they’ve built and want nothing more than to survive. Some owners have invested outside of their companies, while for others their companies are, by far, their largest asset.No matter your situation, you and your advisors have some serious work ahead of you. This series of newsletters will examine three components of your decision-making process: your exit objectives (especially your target exit date and how that might need to change), your company (how you can help protect or build its value and its sale-ability) and, should you decide to sell, what you can expect.

Your Exit Objectives

If you suspect that the current economic downturn means that the departure you planned in the next five to ten years will be delayed, you’ve got a lot of company. According to a 2005 PricewaterhouseCoopers’ survey of 364 CEOs of privately held, fast-growing companies, “nearly two-thirds … plan to move on within a decade or less: 42 percent within five years, and 23 percent in five to ten years.” (“Wide Majority of Fast-Growth CEOs Likely to Move On Within Ten Years, PwC Finds.” January 31, 2005.)The question is: What do you do about your target departure date? If you leave it as is, do you spend your energy protecting what you’ve got or actively working to build value?

If you decide to move your departure date forward by selling now, how does that affect your other retirement goals (transferring for the amount of money you want and transferring to the party of your choice)? Is your company attractive to buyers? Are there buyers active in the marketplace? And, how can you get top dollar for your company?

We’ll look at each of these options in upcoming issues of The Exit Planning Review™.

Your Company

As operations become leaner and meaner, is your company more vulnerable than ever before? Specifically, are there things that you can do to protect the value of your most valuable asset, your company? What can you do to help minimize your company’s tax exposure? Is there a way to prevent the departure of your key employees? We will examine how you can help protect value, minimize taxation and protect trade secrets, vendor relationships and referral sources.

After looking at protecting business value, our next issue will look at how owners can build business value during a recession through acquisition. Before you dismiss this strategy as unrealistic for your company, please read about owners who are taking advantage of lower purchase prices (by using seller financing and earn outs) to acquire specific assets (like customer lists and equipment) of smaller, less adaptable, less capitalized or less well-managed competitors.

Current M&A Conditions

In the last issue of this series of newsletters on adapting your exit plan during a recession, we’ll take a look at what is going on in today’s Merger & Acquisition market for mid-sized businesses ($5 million to $250 million of value). We’ll look at which companies are selling, who is buying and what credit is available to finance deals of this size.

As a business owner, you have a number of arrows in your quiver and need not stand impassively on the sidelines during a time of economic volatility. Unlike the “average” investor, you aren’t limited to the single strategy of pulling dwindling assets out of the market. Even if the general economy suffers, your business profitability need not.

Subsequent issues of The Exit Planning Digest discuss all aspects of Exit Planning. The provider of this Newsletter (Holly Magister, CPA, CFP®) offers you unbiased information about what you may need to know. Subscribe to our free Exit Planning educational newsletter to learn more about how to grow and/or plan for your business exit.

Posted on November 24th, 2008 under Economy, Exit Planning, Exit Planning Digest, Mergers and Acquisitions. Tags: business appraisal, business appraiser, business brokers, business changes, business for sale, business planning, buy-sell agreement, buy-sell agreements, buy-sell transfer, buyout, changing economy, companies change, exit objectives, exit planners, Exit Planning, Exit Planning Digest, Exit Planning Review: Valuation in Buy-Sell Agreements, fair market value, m&A conditions, mid-size business, protecting business value, retire, retirement, retirement goals, Strategic Exit Plan, Strategic Exit Planning, target departure date, valuation, valuation methods. Comments: None

The Exit Planning Review™ Bi-Monthly Newsletter

In this series of articles about buy-sell agreements, we’ve talked about what those agreements are, what transfer events they cover, why these agreements should be updated as shareholders and companies grow and change, and why the choices you’ve made about whether buyouts are mandatory or optional may change over time. In this article, we’ll discuss the all-important issue of valuation: the pros and cons of using three common valuation methods.

Before we talk about three common valuation methods, there’s one critical ground rule that you should know: The valuation method used should be consistent with IRS rulings and guidelines. If the IRS disputes the value used, you or the other co-owner may end up paying more taxes, although that value still governs the price paid for the stock. As you might imagine, that is generally not a result that favors the taxpayer.A second issue is not so much a ground rule as it is a lesson from experience. As difficult as it may be to decide the valuation method your agreement will use in all transfer events, think how difficult it would be to agree after that event has occurred—the buyer will naturally want the lowest value and the seller the highest value. This conflict can all too easily result in anger, legal expense, valuation expense, etc.In the world of buy-sell agreements there are three common valuation methods: an arbitrarily agreed upon value, a formula and a fair market valuation (to be performed at the time of the transfer).

SET VALUE

Some companies (especially in the early years when the prospect of hiring a business appraiser is financially daunting) decide to estimate a value for the company. For example, two shareholders may estimate that the company will be valued at $100,000 should any transfer event occur. This methodology is simple and inexpensive; it works when the estimated amount agreed upon is one the remaining shareholder(s) could raise, if necessary, to buy out a departing owner. Seldom is this method fair to all parties when the business ownership interest is valuable; nor is it one the IRS is likely to embrace! It is typically used when: 1) business value is minimal; and 2) the triggering event is a) funded by life insurance or b) small enough that the ownership interest payout can easily be funded through future business cash flow (for example, a minority owner with only a 10 percent share cashes out). This valuation approach may be “better than nothing” in the early years of a business, but a successful business is likely to soon outgrow it.

FORMULA

The second common valuation method is using a pre-established formula to determine the value of the company should a transfer event occur. Formulas are as varied as the companies that create them, but they generally fall into three categories: book value at the time of transfer, some multiple of cash flow (or EBITDA) or a combination of the two.

The formula approach is relatively straightforward and inexpensive to use — as opposed to one requiring a business appraisal. A primary disadvantage can be that the IRS may not be bound to accept the value — even if pre-stated in the buy-sell agreement. In addition, rapidly changing circumstances, in or outside of the business, which dramatically affect value are not “built in” to the formula. As a result, depending on the circumstance, either the buyer or the seller can be disadvantaged (one paying too much or one receiving too little) if a trigger event occurs requiring a purchase and sale.

FAIR MARKET VALUE

The last common valuation method is to require the use of a certified business appraiser, at the time a transfer occurs, to establish a Fair Value for the company using valuation standards and procedures stated in the buy-sell agreement.

Many business owners prefer this method over the others because it is fair both to the seller and to the buyer of the stock. By capturing the value of the company at the time of the transfer, buyers don’t overpay and sellers get what they deserve.

TERMS

No matter the type of valuation method you choose for your company, you will also have to decide the terms of payment. You and your co-owners will decide how much time the buyer will have to purchase stock and what down payment will be necessary. You may decide that buyers will have to personally guarantee unpaid amounts. Will those unpaid amounts carry a minimal interest rate, the prime rate or the rate the company is charged by its bank? What penalties will be imposed for late or non-payment? All of these terms should be clearly stated on a sample promissory note attached as an exhibit to the buy-sell agreement.

In the beginning of a business’s life, few think of leaving; things are simple and your buy-sell reflects that simplicity. As the business becomes valuable, shareholders broaden their interests beyond the business (working less or even leaving it) and ownership becomes complex, your buy-sell agreement should reflect these new and quickly changing realities. Don’t ignore your buy-sell agreement until the day you need it. If you do, the headaches, the heartache and, very possibly, the legal fees, may be more than you could ever have imagined.

Subsequent issues of The Exit Planning Digest discuss all aspects of Exit Planning. The provider of this Newsletter (Holly Magister, CPA, CFP®) offers you unbiased information about what you may need to know. Subscribe to our free Exit Planning educational newsletter to learn more about how to grow and/or plan for your business exit.

Posted on November 5th, 2008 under Exit Planning, Exit Planning Digest. Tags: business appraisal, business appraiser, business brokers, business for sale, business planning, buy-sell agreement, buy-sell agreements, buy-sell transfer, companies change, Enterprise Transitions, Exit Panning Review, Exit Planning, Exit Planning Review: Valuation in Buy-Sell Agreements, fair market value, industries change, retire, retirement, set value, shareholder, shareholders, Strategic Exit Plan, Strategic Exit Planning, valuation, valuation methods. Comments: None