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Selecting the Right Exit Path — Transferring Ownership to Children, Part 1

T. Ray Phillips — Wed, 28 Jul 2010 19:03:20 +0000

The purpose of Exit Planning is for you to achieve your financial and lifestyle objectives after you leave your business. One of the fundamental objectives that needs to be decided early in the Exit Planning Process is selecting your successor.

Trends have indicated that the majority of owners of smaller-sized businesses prefer to transfer the business to other family members, an employee or a co-owner. Only a small percent of these owners want to sell to an outside third party. Unfortunately for owners, the people they first identify as their successors often do not end up as the ultimate owners. Much effort is wasted focusing on the wrong successor target or, worse yet, wrongly assuming a child or employee wants to own the company typically doesn’t take into account alternative plans.
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This and the next few Exit Planning Review™ articles will aim to save you some effort by setting forth the advantages and disadvantages of transferring the business to each category or potential purchaser: family member(s), co-owners, employees and outside third parties. There are pluses and minuses to each choice. Knowing what they are will help you determine which method is most suitable for you. Take time to compare the relative merits and disadvantages of each departure option before making your decision.

Option One: Transfer of Ownership to your Children
If you are a typical business owner, there is a 50 percent chance that you want to transfer the business to your children. If you are a typical owner; however, there is a substantial possibility that you will end up transferring the business to someone else because of the difficulties associated with this type of transition. Therefore, it is in your best interest to realize the difficulty of this transaction, as well as prepare the business for the possibility that it will be conveyed to another type of buyer.

Advantages
• Fulfills personal goals of keeping the business and family together.
• Provides financial well-being for younger family members unable to earn comparable income from outside employment.
• Allows you to stay active in business with your children.
• Allows you to control your departure date.
• Enables you to fix value by starting with the question, “How much do I need or want?” rather than being told, “This is how much I am willing to give you.” This is especially useful in situations in which the business is worth less than the amount needed to live on – if the business were sold to a third party. When you keep the business in the family, you can sell for what you need to live on even if the business value does not justify that sum of money.
Disadvantages
• Great potential exists to increase family friction, discord and the feeling of unequal treatment among siblings. The normal objective of treating all children equally is difficult to achieve because one child will probably run or own the business at the perceived expense of the others.
• Reaching financial goals is normally diminished not enhanced; although with careful planning and implementation, financial goals can often be achieved while transferring the business to the children.
• Because family is involved, your control may be weakened. You can lose effective control even though you still have voting control – due, of course, to the vagaries of family dynamics.
• The real risk of transferring the business – because of family ties – to someone who can’t or won’t run it properly, threatens your financial goals and the existence of the business.
Many of the disadvantages can be minimized or avoided through proper planning, but it is important to be knowledgeable of both the advantages and disadvantages associated with the transfer of ownership to children when choosing a successor. In the next Exit Planning Review™ issue, we will look at the second exit path option – sale to other owners or employees.
If you have any questions about selecting the right exit path, please contact us to discuss your particular situation.

Article presented by T. Ray Phillips, CFBS, AEP, ChFC with The Family Business Legacy Co., LLC, is a member of Business Enterprise Institute’s Network Of Exit Planning Professionals™. © 2009 Business Enterprise Institute, Inc. To contact T. Ray Re: subject matter in this article, call (317) 208-6312 OR e-mail trphillips@finsvcs.com

DISCLAIMER: The information contained in this article is general in nature and is not legal advice. For information regarding your particular situation, contact an attorney or tax advisor. This newsletter is believed to provide accurate and authoritative information related to the subject matter. The accuracy of the information is not guaranteed and is provided with the understanding that none of the providers of this newsletter, including Business Enterprise Institute, Inc., is rendering legal, accounting or tax advice. In specific cases, clients should consult their legal, accounting or tax advisors.

The example provided is hypothetical and for illustrative purposes only. It includes fictitious names and does not represent any particular person or entity.

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Putting All of Your Eggs in One Basket

T. Ray Phillips — Mon, 12 Jul 2010 20:12:33 +0000

Putting All of Your Eggs in One Basket

We have all heard the old proverb that it’s dangerous to put all of your eggs in one basket.” But does the proverb apply in the world of business ownership? Specifically, is it a valid warning or just a worn-out cliché? It seems to make good sense to concentrate all of your business effort and ownership in one entity rather than creating multiple entities to own your business and its operations.
In fact, concentrating all of you business wealth and assets in one entity can instead:
• Make it easier for future creditors to attack and attach all of your business assets;
• Result in unnecessary income taxation and avoidable estate taxation;
• Complicate, not facilitate, key employee incentive planning; and
• Consequently, delay your exit from the business.
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If using multiple entities solves the problems listed above, why, then, aren’t more business owners doing it? That’s what Ryan DeVault asked us not long ago.
Ryan is the owner of a growing document storage business. He was prompted to meet with us because he wanted to create incentive plans for his key employees. Part of the company’s growth strategy was to acquire several locations in a four-state area (for document storage purposes) and to create an incentive plan for each branch location manager.
Of course, Ryan wanted to retain the corporate identity and branding so it had never occurred to him that it might be good tax-planning, good continuity planning and good asset protection planning to create multiple entities. Upon discussion of some of the benefits, however, this is what Ryan decided to do:
• Create a new entity — an LLC (Limited Liability Company) or Subchapter S Corporation — for the business operations at each location;
• Create a new entity, probably an LLC, to acquire the real property at each location; and
• Create an LLC to own the equipment at the various locations (shelving, fork lift trucks, etc.).
Why did Ryan (or why would any owner) create all of these entities when doing so would seem to result in significant additional professional fees?
First, Ryan was concerned about liability exposure as he widened his operations. He predicted that he would not be able to control the operations as closely as he had when he had but a single location. In his mind, lack of control and direct supervision equaled greater risk exposure. Properly designed and implemented, creating multiple entities can limit the risk of that particular operation or that particular asset owned by the Limited Liability entity to the assets of that entity.
Second, Ryan felt that the best way to motivate and to retain key branch managers was to “give them a piece of the pie.” He was unwilling, however, to sell or bonus them an interest in the entire business. Of course, they could never afford to buy much of the business. But they could afford to buy an interest in a new entity; an entity in which the assets were confined to the business managed by that employee. It makes good sense to provide ownership to key employees in only those business operations that they can affect by their performance.
Third, Ryan wished to provide income to his two children who were approaching college age. He wanted income paid to them, in their tax bracket, to pay for college and other expenses. He was also interested in transferring wealth from his estate to their estates while indefinitely controlling both the income and the resulting wealth. To achieve those objectives he created a separate entity to own income-producing assets (such as the equipment LLC, or the real estate LLCs) and assigned to the children a small portion of those LLCs. The children would then receive their distributed share of the income in their income tax brackets rather than in Ryan’s.
It goes without saying (almost), that using a multiple entity approach must be carefully considered; you need input from all of your advisors: legal, tax, accounting and financial.
The next two issues of The Exit Planning Review™ will discuss the use of multiple entities in more detail. As this discussion progresses, you will see how employing a multiple entity strategy will decrease professional fees over time rather than increase them.

The example provided is hypothetical and for illustrative purposes only. It includes fictitious names and does not represent any particular person or entity.

Cash Flow Forecasting:The Ultimate Reality Check

T. Ray Phillips — Wed, 10 Mar 2010 15:49:48 +0000

In past issues of The Exit Planning Review™, we have looked at why cash flow is so important to third party buyers, and by extension, to sellers of closely-held companies. In short, a seller must demonstrate an increasing stream of cash flow from the business. Without a healthy cash flow, a buyer may pass over the opportunity to buy your business in favor of purchasing a “good” company with less risk.

In this issue, we will examine why cash flow is also crucial to those owners who wish to transfer their companies to insiders (employees, co-owners or children) and how to allocate cash flow.

Let me suggest the following definition of cash flow. Business cash flow is the portion of the annual net cash flow from operating activities that remains available for discretionary purposes (after the basic obligations of the business have been met). Because we are discussing cash flow in the context of exiting your business, the “discretionary purpose” referred to above is the purchase of your ownership in your company.

As you prepare to transition out of your business (using any type of ownership transfer other than liquidation or, in some cases, a gift of the company to your children), it may be imperative that you secure an accurate future cash flow model. Why?

In a sale to insiders (employees, co-owners or children) cash flow may be the source of the buyer’s payment to you. The future cash flow of the business after you have left it may be the source—the sole source, at least initially—of payments to you. Insiders may not have enough money of their own with which to pay you. Without significant planning and implementation, insiders may not be able to suddenly acquire that cash or the ability to borrow any.

If you choose instead to sell to a third party, the valuation upon which any offer will be made may be based on a multiple of cash flow.

Should you plan to sell part or all of your business beginning in 2010, you, or better yet, your CPA, will need to make cash flow projections for 2010, 2011, 2012, 2013 and 2014. If you are preparing your own cash flow projection, you must resist the temptation to create an overly-optimistic forecast. Your projection must be grounded in the reality of past actual performance rather than in your rosy hopes for the future. For this reason, owners usually ask their CPAs to create these forecasts.

Once a realistic cash flow projection is prepared, you will use it to plan the most tax-effective way possible to achieve that future cash flow. It bears repeating here that the future cash flow of the business may be your buyer’s only source (at least in the early years) of funds to pay you. If the company, under new ownership, cannot achieve the cash flow numbers that you projected, you may not receive the payoff that you expected.

How to Use the Cash Flow Forecast

Forecasting cash flow is the first step. The second is to calculate how that cash flow will be allocated during the ownership transition. Determining the net after-tax distribution to you is the goal of this exercise. To do so, you must calculate, for each year of your exit plan period the expected available cash flow (excluding payments to the business owner) less the cash the company must retain (for growth, working capital, etc.). The remaining cash flow is paid to you as compensation (salary, bonuses, and/or deferred compensation) or it is distributed to the shareholders (you, and to the extent you have sold part of your company, the new ownership). The distributions received by the new ownership, less taxes of 35 percent to 40 percent, is then paid to you.

The cash flow you receive is the sum of:

1. compensation, bonuses and deferred compensation;
2. payments for stock sold to new ownership; and
3. distributions of cash flow based on your remaining ownership.

The net after-tax annual cash you expect to receive combined with your non-business income sources (such as retirement plans, personal investments, etc.) must be sufficient to support you after you leave the business. If the combined amount (business and personal) falls short of meeting your lifetime income/financial needs, your departure date must be delayed or your financial expectations must be adjusted.

Your Exit Plan must integrate your exit desires (when you want to leave, how much money you want and need, and who should own the business after you) with the reality of the likely future cash flow from the business. Forecasting cash flow and the uses of that cash flow is, indeed, the ultimate reality check for your business exit.

The example provided is hypothetical and for illustrative purposes only. It includes fictitious names and does not represent any particular person or entity.

Using A Valuation Specialist

T. Ray Phillips — Thu, 04 Feb 2010 14:00:45 +0000

In order to leave your business successfully, you must not only know what you want (when you want to leave, how much money you will need and who you want to sell to) you must know how much your business is worth. For example, if you told your advisors all about your objectives but you couldn’t tell them with any certainty what your company was worth, how could they help you reach your destination? It would be similar requesting a map but not knowing if you planned to take a plane, a boat, a car or walk to the destination.

Knowing the value of your business is critical no matter who you plan to sell or transfer to. The primary three exit paths are:
1. Transfer your company to a family member
2. Sell the business to one or more key employees or co-owner(s)
3. Sell to an outside third party

Third Party Sale

Let’s look first at sales to third parties. If you plan to sell to an outside third party, you will need an accurate valuation to determine if, after the business is sold and taxes are paid, you will have enough money to achieve your financial goals. A valuation performed in advance will help you decide whether to begin the time-intensive and expensive sale process.

You will also need a business valuation based in reality; rather than on rules of thumb, or what your neighbor sold his business for or any of the other many sources of misinformation. Without a realistic, objective business valuation, how can you make a sound decision?
Retaining a certified valuation specialist to perform this valuation gives you an unbiased valuation. These specialists do not try to sell you a “bill of goods” only to encourage you to list the business for sale.
If you learn that the business is not valuable enough to achieve your definition of financial independence, the valuation specialist should be able to point out areas where the business performance could be improved. Following his or her advice, you can then work to increase the value of the company.

Insider Sale

If you plan to sell the business to an “insider” (a child, employee or co-owner), a valuation provides all parties with a sense of the true fair market value of the business. Based on the valuation, your advisors can create a plan to provide you with the full value while describing the most tax-advantaged method of how the insider and business can use the cash flow to pay for the business.

Often, to facilitate these sales, minority discounts or marketability discounts are used to place the largest possible amount of total after-tax cash in the departing owner’s hands. If discounts are used, they must be substantiated by a certified valuation specialist.

Transfer to Child

If you plan to give even part of the business to children, be aware that the IRS wants to know what valuation method was used. It is concerned that the gift may be undervalued. Therefore, a valuation specialist should substantiate these gifts in anticipation of an IRS inquiry.

In short, in all but the very simplest and low value scenarios, successful Exit Planning requires a valuation that can be relied upon by you, your advisors, and often, the buyers.

The example provided is hypothetical and for illustrative purposes only. It includes fictitious names and does not represent any particular person or entity.