Family Partnerships and LLCs looking to transfer interest among family members are advised to speak with their estate and tax professionals sooner rather than later as anticipated Section 2704 restrictions are expected to come into play by the end of this summer. Read more
[alert title=”Editor’s Note:” “default”]We’re lucky to have trust and estate attorney Matt Glover join us for our Exit Planning month. Matt discusses some of the most pressing issues when it comes to planning for a succession – oftentimes the issues we see in our valuation litigation practice when they haven’t been addressed. -ed.[/alert]
Statistics vary, but it is safe to say that only a small minority of family owned businesses survive to the second generation. Roughly 30% make it. Even fewer make it to the third generation. To beat the odds, business owners need to plan ahead. Business succession issues should play a central role in their overall estate planning.
Coming to Terms with the Human Dynamics
The cash flow needs of a surviving spouse, long-submerged sibling rivalries, and tensions occasioned by blended families or second marriages can all threaten the viability of a closely held business when the original owner passes away. This means that the success of an estate plan will frequently depend on the willingness of a business owner to confront and make emotionally difficult decisions about family dynamics. The good news is that once made, these decisions usually leave everyone better off with fewer surprises on the death of the original owner.
Lack of adequate planning can leave a surviving spouse in dire straits, particularly where husband and wife formerly relied on income from the business to support their lifestyle. A surviving spouse may be in need of cash flow without a career to fall back on. If not planned for, this can put the needs of the surviving spouse in conflict with the interests of the next generation.
Business owners who intend to leave their business to the next generation also have to make some tough calls about control. Owners in this position sometimes consider dividing control over business assets. For example, one child might be given control over business operations, while another controls the real estate in which the business operates. This is a mistake. While giving an appearance of fairness, divided control often lays the groundwork for family conflict that could tear the business apart.
Alternatively, when some members of the next generation work in the business and others do not, it may be tempting to give control to the first group and non-voting, beneficial interests to the other. This too is usually a mistake. The children who are not in control will likely feel themselves and their legacies at the mercy of their siblings, and the children who have control may chafe under the burden of carrying on business operations with an eye to protecting their sibling’s fortunes.
One viable solution to these difficulties would give both the controlling and non-controlling children the right to compel the transfer of non-voting interests on pre-established terms. The purchase price (set by appraisal or formula) could be paid with proceeds from the business over several years. This approach removes an ongoing source of potential conflict, while allowing both groups benefit from value built up in the business.
Balancing Estate and Income Tax Considerations
By now, most people contemplating estate planning are aware of the drastic changes that recently took place in the federal estate tax system. While increasing flexibility, these changes have not necessarily reduced complexity. Under the old system, avoidance of estate tax was frequently the singular planning imperative, but it is now possible to balance estate tax and income tax considerations. While estate tax considerations may still win out, business owners and their planners may now need to consider whether it is desirable to sacrifices some estate tax efficiency to secure certain income tax benefits, such as a step-up in basis on highly appreciated assets.
Providing Asset Protection for Beneficiaries
It usually makes sense to leave assets, including business interests, in trust for beneficiaries. These trusts provide creditor and divorce protection. They can also include incentives and distribution guidelines to encourage socially desirable behavior and ward off affluenza in the second generation. Far from being unwelcome burdens, asset protected trusts should be seen by informed beneficiaries as adding substantial value to their inheritance.
Even beneficiaries who will be charged with control of an ongoing business may receive their interests in trust. The modern approach to trust drafting can give a beneficiary control of trust assets for all practical purposes, while preserving the asset protection features that make trusts so attractive in the first place.
Establishing a Dynasty
With advance planning, a business owner stands a good chance of preserving family wealth for generations. There are two primary impediments to this sort of multi-generational wealth preservation: the Generation Skipping Transfer Tax, which penalizes transfers of wealth to grandchildren and great grandchildren, and state law, which frequently sets the maximum duration of a trust. Both of these impediments are manageable with some forethought. A well-drafted trust can persist from generation to generation, protecting family wealth and establishing a true dynasty.
Even with the best transition plan, a closely held business may still be torn apart on the rocky shores of an illiquid estate. At the death of the original owner, liquidity will be needed to pay taxes, provide cash flow to support a surviving spouse, fund legacies, and pay the outstanding balance on any installment notes created as part of a business succession plan.
Without adequate liquidity, beneficiaries may be forced into a fire sale of business assets, or their competing interests may slowly tear the business apart. Life insurance, pre-established dividend policies, and deferred compensation plans are some of the tools available to sidestep these problems. All require advance planning.
Maintaining Control during the Transition
Some business owners put off succession planning because they perceive it as threatening their control. Good succession planning, however, serves to maintain an owner’s control over business assets while he or she shepherds them to the next generation(s). Failure to plan ahead represents a far greater threat to control and puts hard won family wealth at risk.
We occasionally work on a valuation assignment where the subject company has a history of losing money. We are engaged by a shareholder of the business owner because they are looking to cut their losses and sell. So what is a company with negative earnings worth?
In most cases, the value of a “going concern” company is based on earnings. There are many (many!) ways to ultimately get to a value, but for the most part, profit drives value. Why? Consider yourself as the buyer of some notional widget maker. WidgetCo, Inc. has some really, really nice machinery. Top of the line. State of the art. Great office space too. But buying the company, do you care more about the machinery and office space, or the ability to use both to turn a profit? In most cases the answer is “profit” – those assets may be nice… but they need to produce a profit for you.
The Unprofitable WidgetCo
Ok, so all well and good. WidgetCo turns a profit, we do some magic, and voila! Value. You go and sell WidgetCo. But what if Widget has a history of losses? What if all those fancy machines and office space aren’t humming away making widgets? The situation just got complicated. In these cases we look at a number of factors:
Turns out that in many cases it’s possible to restructure a company in order to turn a profit. It’s hard work for sure, but there is no doubt that this happens all the time. (In fact, there is a cottage industry that focuses on just this type of work). In setting a price, one of the first steps, then, is to rework the financial statements to present a “pro forma” indication of how WidgetCo could turn a profit. Increase pricing? “Fire” unprofitable customers? Drop excess costs and expenses? While there is an art to this process, the ideal outcome is being able to justify that there is a profit to be earned from WidgetCo … which forms the basis of value.
Value to An Acquirer
Let’s assume that you’ve worked the numbers – maybe even put a plan in place to make some changes- but WidgetCo is still unprofitable. For you. The existing company. Another consideration then is to consider what the value might be to an acquirer. Do you have certain certifications that would be valuable to a competitor? Maybe you have excess machine capacity that a buyer could use (thus driving up utilization rates and ROI)? Or maybe, when combined with a buyer’s service offering, the buyer could sell more to your existing customers.
There are plenty of scenarios here, but the most important consideration is understanding what value your WidgetCo has to a specific buyer.
Value of Assets
When you’ve exhausted your other options, it’s time to consider the dreaded “Fire Sale.” In this case, the business is worth the sum of its parts (less the cost to liquidate). From a valuation perspective, this often means writing down intangible assets to zero. Leasehold improvements? Basically not salable. Franchise fees? Likely not transferable. Whereas “book value” is often the “floor” to value in most situations, in a liquidation scenario, certain adjustments must be made to mark down each asset (or liability) to its ultimate value.
Selling an unprofitable company is hard. Heck, valuing an unprofitable company is hard. It often means investing in help from your CPA or turn-around consultant to realize the most value possible. The other option is liquidation – and this is never a pretty option. We always counsel clients to think long and hard about re-investing in a turn-around scenario (which will require extra cash in) before settling on a liquidation (to get a meager amount of cash out).