Business Transition Plans

Are you prepared?

By Alan Gottlob

The typical family or closely held business has a life much like any of us, beginning in infancy and growing and maturing with the passage of time and the occurrence of various "life cycle" events. Especially during the maturation stage, the business owner begins to focus more closely on where the business should be going in the future and whether the owner will be going in the same direction. At this stage, and almost on a daily basis, every business owner is faced with a question by which he or she is torn between two decision points: "Am I going to keep the business and pass it to the next generation, or am I going to sell the business?"

This transition decision is very complicated and must include such considerations as: the owner's desires regarding work/retirement; family dynamics; income security for the working member/shareholders; the current business environment as it relates to the pricing multiple for the specific business; what will and should happen to the loyal ex-ecutive/employee group; the extent of the owner's other assets; and tax consequences.

Many times, the transition decision to keep or sell is made on a spontaneous basis, without appropriate consideration of the issues outlined above. Some business owners will entertain offers for their company just to see what the options are, but they fail to realize the potential ramifications of rejecting the offer. Often, there is a lack of coordination of the shareholders' personal needs and objectives with those of the business, and little coordination between the generations.

Planning and positioning prior to a decision to keep or sell ensures a more efficient and effective outcome. All successful business owners can and should make these important decisions based on a sound and thorough knowledge of the options available to them and the overall consequences of their decisions. While no decision may be perfect in all respects, careful and complete planning can meet most objectives.

There are various aspects to the keep-sell decision. In many respects, the considerations are the same for either choice, and the decision rests on where one comes out in terms of the specific facts of the business and the objectives of the owner. In order to lay the groundwork for a more detailed analysis, the following outline of major issues that arise on the "keep" and the "sell" sides of the decision should be kept in mind. They create an awareness of what needs to be considered and the effect each issue has on the others.

Keeping the Business
The primary areas to consider when deciding whether to keep a business are:

Value — Determining and employing the appropriate value of the business affects every aspect of the keep decision and drives the planning for keeping the business. Whether the business will be transferred during the owner's lifetime, at his/her death or at the death of the surviving spouse, there are a number of parties who are interested in the value of the business, e.g., the taxing authorities, the surviving spouse, the active heirs, the inactive heirs. Each of them may have an interest in the valuation being different.

With Federal Estate Tax beginning at an effective rate of 37% and moving quickly to 55%, the IRS has a special interest in arriving at the highest value for all assets, particularly for those where the fair market value (the IRS and Court-accepted standard for value) is subject to dispute.

The surviving spouse's interest is value which could be based on trying to plan for the eventual payment of estate taxes, on maximizing the amount available for his or her benefit (especially if he/she is from a second marriage and the children from the first marriage are immediately entitled to a share of the estate), or on effecting a sale to other family members either under an existing agreement or in order to convert the business interest to an asset with less risk and more stable income for him/her.

Active and inactive heirs may have competing interests in business valuation, especially if they don't all share in the business asset or if they are to be "equalized" out of other assets. Even if the heirs' interests are the same, value affects their ability to pay taxes from other assets or from the company.

Valuation is both an art and a science and should be approached with care and an understanding of the purposes for which it is to be used.

Transition to Next Generation — As the business owner approaches retirement or the desire to slow down, or as children mature and are ready to pursue a career, he/she is faced with deciding who is going to be involved in the ownership of the business. Is there a place (or should there be a place) for everyone who wants to be involved, whether or not each individual has the aptitude, ability or temperament? Should only those children who are active in the business have current or future ownership of it; and, if so, how and what will inactive heirs receive as their "fair" share. Without having an acceptable answer to these questions, the business owner will not be inclined to begin making ownership transition at a time, during his/her lifetime, when such transition should begin or, at least, be planned.

Decision Makers — The business owner should run a mental fire drill to understand what would happen to the operations of the business if he/she were permanently absent tomorrow. Are the people running the day-to-day operations empowered to make important decisions? Will the decision makers be required to report to a formal or informal board of directors, or a disinterested or institutional executor/ trustee? Will the business be able to meet its capital and borrowing needs? Has the business owner imparted to someone those little secrets that have made the business successful and which are probably stored in his/her head? Even if a good management team is now in place, will they or do they have incentive to stay on when the next generation of the family takes over ownership and control? These are all questions that should be considered and which can be planned for and implemented before the "emergency" need arises.

Corporate Tax Status — Under current tax law, which type of entity form is appropriate for the business—C Corporation, S Corporation, Limited Liability Corporation or Partnership? Each of these offers different advantages and disadvantages to the business owner, and there are special consequences that must be considered in changing from one form to another, including state tax treatment, acceleration of certain taxes, the company's need to retain earnings or its ability to distribute its earnings.

Owner's Benefits — Many owners of businesses are not fully aware of the value and extent to which they are receiving benefits from the company other than just salary. Medical benefits, perquisites, pension, employment opportunities for family members and other benefits should be recognized by the owner in his/her decision to retain the business. In addition, in many circumstances, being the owner of the business accords the owner with community status and with other business opportunities.

Employee Compensation — The compensation of employees, especially key executives, is extremely complex. There are many ways to compensate employees in addition to directly through their paychecks. Each of such methods can serve a different purpose and fulfill a different objective, both for the business owner and for the employee. This area is further complicated by adding family who are likely to be future owners to the employee group. Should they be compensated the same as other employees with similar responsibilities? If they are paid more, what effect will this have on them and on the other employees?

Estate Plan — Most people are aware of the importance of having a sound estate plan. Just having the correct legal documents does not constitute a plan for business continuity. Nor does a plan remain static. Changing circumstances and changing values require a periodic review of the plan. Changes in tax law and tax savings techniques may offer opportunities or require changes. Children's ages, maturity, marital status and the appearance of grandchildren often change the objectives and perspective of the business owner and his/her spouse, and these need to be reconciled with the existing plan. Health concerns also will affect one's planning.

Intergenerational Plan — Too often, planning efforts seem to focus only on the senior generation. Yet without proper coordination between the generations, many privately held businesses fail to last long beyond the first generation. With proper emphasis on planning for all the generations, the business can survive and prosper, and more wealth can pass from one generation to another without having to "mortgage" the business.

Selling the Business
The primary areas to consider when deciding whether to sell a business are:

Value — In the event of the sale of the business, the buyer will determine value based on a number of factors, e.g., strategic benefit and fit with other businesses, the earnings and cash flow, the management team. For the seller, gross value paid will often be the determining factor in whether or not to sell, but consideration paid can take a number of forms and should be carefully structured and negotiated.

Getting to Net Value — The impact of the taxes involved (be they capital gains tax, income tax or estate tax on the proceeds) for both the buyer and the seller often are not fully understood. The extent, timing and payor of these taxes can be planned for, but not after the deal is made. Total purchase price should not be as important as the net to the seller and his/her family; and the buyer can be convinced to deliver more to the seller if it is more tax efficient to do so.

Pre-Sale Planning — A great deal of planning can take place in advance of any sale transaction. The more time that elapses between implementation of a strategy and the sale transaction, the better the potential to preserve wealth and structure a deal that is beneficial to all parties. Therefore, it is prudent to begin to plan for a sale even if it is only a possibility.

Transaction Strategy — Before the business is put on the market, its financial status should be examined and stated in the best possible light. Balance sheets and income statements may need to be recast. Then, identifying the appropriate buyer (strategic, financial, institutional or management) and communicating and negotiating with the buyer becomes essential.

Implementation & Positioning — Developing the negotiating team is critical. Defining the role of the owner and of others in the negotiations is an essential prerequisite to making the sale process move smoothly and to obtaining the best result for the owner. Expert and experienced advice is required to determine the type of offer process that will be most effective.

Post-Sale Planning — Coordinating the change in the makeup of the assets from stock in a closely held business to liquid assets requires an analysis of income and security needs and a reconsideration of the existing estate plan.

Net to Owner — From the beginning of planning for a sale through completion of the transaction and beyond, one needs to keep in mind the end result to the owner and his/her family. All of the prior considerations help to achieve the best result for all generations of the owner's family.

Be Prepared
Too many business owners simply prepare a will and think that their business succession or exit strategy is completed. In reality, this is the least important portion of your planning—if you plan ahead. Deciding to keep or sell your business is an important decision that requires a well-planned strategy.