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.
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).
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).
ABOUT THE AUTHOR: Matt Dickstein, Business Attorney
Matt Dickstein, Business Attorney, provides business legal services in Northern and Southern California, including the San Francisco Bay Area, San Jose, Sacramento, Los Angeles and San Diego.
Since 1994, I have been representing businesses of all types, big and small. I handle business transactions, corporations & LLCs, real estate ventures, professional practices, and franchises.
Copyright Matt Dickstein, Business Attorney - Google+
More information about Matt Dickstein, Business Attorney
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.