Wealth Management
“Heads I win,
tails you lose…. “
By Mitchell S. Rock, Wealth Advisor, Global Wealth Management Division,
Morgan Stanley Smith Barney
A
s the owner of a privately held middle market company
who has worked for years, or decades to build business
value, would you stake it all on a “coin-flip” proposition? I’ve yet to meet an owner who would – because
the risks are too high, and the potential loss is too great.
Yet, when it comes to planning for the eventual sale or transfer of their companies, middle market owners may often leave
the outcome to a game of chance.
According to the Small Business Association, in 2006, more
than 80% of all businesses in the U.S. are family-owned, yet
less than 30% have a succession plan in place. Surprisingly, this
corresponds with the portion of businesses that survive into the
next generation, and the numbers get even worse from there.
Approximately 12% of family businesses are viable into the
third generation and only 3% are still operating into the fourth.
With these statistics, it’s no surprise one of the main reasons
owners fail to capitalize on the wealth they have built is the lack
of a formal transition plan. While a public company has a deep
executive management team and board of directors to focus on
the ongoing concern of the business, a family-owned culture is
very different. Disputes in a family business are often complicated by emotions unrelated to real dollar-and-cents business issues. For example, two partners who have shared in the
growth and success of a business over decades, usually thinking
with like mind, ultimately may have different opinions when
they reach the point of planning for the next generation. Or,
successful and seasoned business owners may make the classic mistake of choosing their successors based on entitlement,
rather than aptitude and ability.
Even within one family, there are situations in which only
one child has the desire, training and skill to carry on a business – yet the owners decide business equity must be shared by
multiple parties, perhaps for reasons of “fairness” or to avoid
family quarrels.
These situations are complex to resolve, and there is no
silver bullet that will work to help all middle market companies
transition ownership and management successfully to the next
generation. However, it is invariably better to address options
44 : presidentandceomagazine.com : April, 2012
and create agreements between owners (or family members) in
a formal succession plan, rather than to let the chips fall where
they may, or a coin flip to land heads or tails.
Transitioning Choices
Owners of a privately held business have three basic choices
for transitioning to the next generation, and each choice comes
with its own challenges and advantages.
1. Keep ownership and control in the family –
In this choice, the major challenge is to identify and groom
the most talented family member(s) for the job of successor, and then create a clear plan for transferring equity and
control to them. They are the “active” participants in the
transition plan, and it may take several years of preparation to increase their skills, confidence and acumen. Other
family members (such as an owner’s surviving spouse) are
the “passive” recipients of business value. The challenge
in planning for them is to turn illiquid business equity,
perhaps of uncertain value, into liquid financial assets that
increase their financial security and compensate them for
having business control in other hands. A key benefit of
this choice is the ability to take advantage of tax planning
strategies that are only available for intra-family transfers,
as a practical matter.
2. Sell the company to its current management team –
This choice is viable when an owner has either a capable
non-family member leading the executive team or else a
“deep bench” of several top executives. The challenges
here exist in two phases: 1) retaining and rewarding the
chosen non-family successor until the owner reaches retirement, dies or becomes disabled; and 2) convincing family
members (including a surviving spouse) they aren’t being
disinherited by the elevation of an outsider to company
leadership. The advantage of this choice is the confidence
of knowing the company is in good hands, and the transition will be completed with leadership continuity.
3. Sell out (totally or partially) to a third-party,
such as a competitor in the same industry –
This choice is not always readily available, and
it may require a business broker or mergers and
acquisition relationship to achieve. Also, the price
a third-party may be willing to pay may be based
on future business results – such as discounted cash
flow analysis (DCF) – that can’t be predicted or
projected with great accuracy. Normally, a thirdparty may want majority voting (51%+ control)
but there are some situations in which acquirers are
content to buy a privately held business partially or
incrementally. The advantage: Whether the buyout is
total or partial, it injects cash that helps the owner and/or
surviving family members achieve financial goals. Also, a
third-party acquirer usually has an experienced management
team in place for leadership continuity.
In each of the choices described above, the business will
eventually be sold by the current owner(s) to someone else, and
this transition typically takes place at a “trigger event,” such as
an owner’s retirement, death or disability. By integrating potential sale terms, family financial goals and key estate planning
strategies into the succession planning process, an owner can
potentially maximize the amount of money that is available for
either his/her own retirement or the financial security of surviving family members.
This type of planning is part science and part art. The science
of succession planning includes business valuation, tax analysis,
structuring and funding of business transfer (“buy-sell”) agreements, and anticipation of federal transfer tax issues.
The art lies in being able to evaluate the mindset of the owner, because no two owners approach a sale or transfer with the
exact same expectations and needs. Determining what type of
seller the owner is will help determine the best available options,
and the factors to consider include both financial and mental
readiness. Usually, it takes a team of professionals to engineer
both the science and art parts of this process. The team needs a
coordinator (“quarterback”) who has a close working relationship with the owner based on a thorough understanding of his/
her objectives and dreams, pressures and constraints.
Does the owner really want to “die with his boots on,” carried
out of the business on the last day of work? Or does he/she
dream of putting all the daily pressures and demands of the
business in the past, while spending retirement puttering in the
garden with grandkids and feeling financially secure? For the
transition plan to be successful, the team’s coordinator needs
to know the answer and communicate it effectively to the other
members.
Delving into the Science
Several key members of a transition planning team are specialists on the “science” side of the process. They include business appraisers, attorneys, CPAs, estate planning technicians,
charitable gifting experts, and others.
To simplify, think of three areas in which they work: management, ownership and tax liability. In each area, they will
create analysis, agreements, documents and transition funding
strategies, all of which help to turn a conceptual process into a
more tangible and detail-oriented plan, with clear obligations
and expectations for all parties involved. These specialists also
will help to clarify the specific events that trigger transitions in
ownership and control and transfers of stock and cash. Typically,
the planning will be triggered, at minimum, upon the death or
long-term disability of an active owner. In many cases, it also
can be triggered by: 1) the owner’s planned retirement; 2) an
owner’s divorce; and 3) an owner’s desire to leave the business
prior to retirement, death or disability.
All planning should begin with the goals and objectives of
the owners and their family in mind, and a few strategic questions must be answered. They include:
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How much business control do you want to maintain?
Do you wish to keep your shares within the family?
Who will run the business once you step down?
Who are your key employees, and how can you assure their
PRESIDENT&CEO Magazine :: 45
Wealth Management
•
•
continued best efforts and dedication to the company?
Are there sufficient liquid assets to provide for a surviving
spouse and/or heirs, while also paying estate taxes?
How much money do you need to reach your lifetime or
retirement financial goals?
Fair Market Value Vs. Market Value
The fair market value of a business is based on the price a
knowledgeable, willing, and unpressured buyer can be expected
to pay in an arm’s-length transaction to a knowledgeable, willing, and unpressured seller. The actual market value, however,
often depends on “real world” knowledge and pressures.
For example, suppose a business owner dies unexpectedly,
leaving all of the company stock to a widow who knows little
about the business and has no ability or interest in running it.
She is under pressure to pay the company’s ongoing salary
and bills and also perhaps some income and estate taxes. Now,
assume that there is only one potential buyer in the market, a
third-party competitor, and the buyer knows the widow’s predicament. If the buyer makes a “market value” bid under these
circumstances, there is a very good chance it will be well below
fair market value.
When an owner is considering an internal transfer to a family
member, from which discounts may be taken, a simple fair market value can be estimated and used. If this value is reasonable,
and especially if it is based on a professional appraisal, the IRS
usually will accept it for tax purposes.
However, if an external sale to a third party is being considered, the valuation used might be closer to the market value described in the example above. Often, the valuation of a privately
owned business is based on a range of possible values, in which
the transfer amount may depend on the strategy being utilized,
..there is no silver bullet that will work
to help all middle market companies
transition ownership and management
successfully to the next generation.
timing of the transfer, and competitive conditions at the time of
transfer.
A typical succession plan has two basic elements which
should be considered separately – the transfer of assets and the
transfer of control. For many owners, the business represents
a significant portion of family net worth. To effect a transfer
of that worth at a trigger event, it may be necessary to create
separation between the entities that have a majority ownership interest in the company and those responsible for actually
running the company. This creates a whole new set of transition planning needs, including: 1) How to protect the business
against the loss of non-owner executives responsible for day-today management; and 2) How to tie non-owner executives to the
46 : presidentandceomagazine.com : April, 2012
company long-term with rewarding incentives and benefits, such
as deferred compensation programs or personal life insurance
coverage.
When an owner elects to transfer ownership to one or more
children, it’s critical to consider any potential tax impacts in
planning process. For example, if an owner plans to transfer
shares upon death, the federal estate taxes can be significant.
Families may have to liquidate all or significant portions of
business shares or assets to pay estate taxes. This outcome often
can be avoided by transferring a portion of the business during
the owner’s lifetime through gifting and estate freezing strategies. The technical nuances of these strategies can be complex,
best left to the “scientists” on the team. However, the art lies in
matching them to the owner’s goals, such as maintaining control, removing future appreciation from the estate, and potentially discounting the value of the gift for federal gift tax purposes.
Lifetime giving strategy –
A business owner plans to transfer all shares in a privately
held company to his daughter, one of four children, at
death – because the daughter is the child who has shown
the greatest aptitude for carrying on leadership and management. To “equalize” the estate for the three other children, the owner creates an Irrevocable Life Insurance Trust
(ILIT). Each year, the owner gifts premiums to fund the life
insurance held in the ILIT, using the annual gift tax exclusion – through the end of 2012 this amount is $13,000 per
child per year($26,000 for married couples), or a total of
$39,000 per year for all three child beneficiaries. To qualify
each premium payment as being of a “present interest” (and
thus eligible for the annual exclusion), the trust includes a
“Crummey Power” that gives each child temporary access
to premiums. At the owner’s death, a buy-sell agreement,
funded by another life insurance policy, transfers shares to
the daughter. The ILIT then collects its life insurance death
benefit proceeds, and its professional trustee distributes them
to the three children, according to terms the owner has specified in the trust document.
Estate freezing strategy –
A business owner wishes to transfer his shares in a privately
held company to his son, who will take over ownership and
control at his death. However, the business is growing rapidly, and the owner expects to live (and keep working) at least
another 15-20 years, so a transfer of more valuable shares at
that future date could result in substantial federal estate taxes. One strategy is to freeze the current valuation of shares,
for transfer purposes, using a family trust as a common planning technique. Two shares of stock are created: 1) preferred
shares, held by a holding company, controlled by the current
owner; and 2) common stock (“growth shares”) which are
held in trust. The holding company retains all voting control
as long as the current owner is alive. But any future apprecia-
The technical nuances of these strategies can be complex,
best left to the “scientists” on the team.
tion in the growth shares then will occur outside the owner’s
potential estate. If the growth shares increase in value over 20
years, from $10 million to $30 million, the original $10 million valuation will be frozen, and the $20 million appreciation
will not be included in the owner’s estate.
When a business owner gifts a partial interest in a business to
family members, its value may be reduced due to two common
discounts: 1) lack of marketability; and 2) lack of control. Since
the owner of a minority stake in the business does not have a
controlling interest, it is deemed to be less valuable than simply a
pro rata share.
Business Transfer Structures
For purposes of transferring ownership of a business to family
members, several structures can be considered.
One common structure, the Family Limited Partnership
(FLP), which usually has two forms of ownership interests,
general partnership and limited partnership. General partners
manage and control the FLP, while limited partners have no
power to participate in day-to-day management. This structure
allows senior family members to transfer assets into a new entity
in exchange for an ownership interest. The new interest created then can be broken down and transferred to younger family
members. Advantages of an FPL structure include:
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General partners retain control, including the ability to determine any distributions of income, profits or losses.
Limited partners can be restricted from transferring or selling shares. Or, they can be required to offer other partners a
right of first refusal to buy shares.
The partnership is protected against any claims that others
might make against a limited partner, including creditors and
divorcing spouses.
Family members can take advantage of valuation discounts
(marketability and minority interest) in transferring shares.
For owners who are interested in transferring a business,
and would like to generate retirement income from it, a Grantor
Retained Annuity Trust (GRAT) can be a viable option. With a
GRAT, the business owner receives fixed annuity payments for
a specified term in return for placing an interest in the business
into the trust. At the end of the trust term, the business interest
inside the trust may be transferred to the next generation free of
estate and gift taxes.
Other strategies for transferring ownership of a family business include, but are not limited to: installment sales , buy-sell
agreements, private annuities, self canceling installment notes
and intentionally defective grantor trusts. Each of these methods
has advantages and disadvantages, so it is important for owners
to speak with a personal tax advisor.
When a business owner wishes to sell to a third party, the
transition planning team should be expanded to include profes-
sionals with experience in these types of transaction. In some
cases, businesses owners may find themselves preparing for the
“deal of a lifetime” with virtually no experience. Potential buyers
include industry competitors or private equity firms. Each alternative comes with a unique list of advantages and disadvantages.
According to Oscar Cantu, financial advisor and my partner
in The Rock Group at Morgan Stanley Smith Barney: “The best
time to plan for a business transition is while the company is
growing. In fact, we recommend that our clients plan for the sale
or transition of their company many years in advance. Succession planning is a process, not just an event.” If succession planning lacks a clear process, it often becomes driven by a series of
pressures and crises, with potentially devastating results. Fear
can be paralyzing.
Just as it takes many disciplines to run a successful company,
ranging from accounting to marketing and finance, it takes a
team of professionals to properly plan a business transition
strategy. Usually, it’s advisable to have the whole process, and
whole team of advisors, coordinated by an entity willing to work
with the owner and family both before and AFTER the transaction closes.
Whether an owner is considering a family transfer or an
external sale to a third party, it’s critical that the business succession plan be integrated into the personal estate plan. In the end,
achieving an optimal result will require a merger between business and personal goals, all in one plan and process. &
Mitchell S. Rock is a wealth advisor with the Global Wealth
Management division of Morgan Stanley Smith Barney in New
York City. The information contained in this article is not a
solicitation to purchase or sell investments. Any information
presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend
on an investors individual circumstances and objectives. Investing involves risks and there is always the potential of losing
money when you invest. The views expressed herein are those of
the author and may not necessarily reflect the views of Morgan
Stanley Smith Barney LLC, member SIPC, or its affiliates.
Morgan Stanley Smith Barney LLC , its affiliates and MSSB
financial advisors do not provide tax or legal advice. This
material was not intended or written to be used for the purpose
of avoiding tax penalties that may be imposed on the taxpayer.
Clients should consult their tax advisor for matters involving
taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters. Life insurance is offered through Morgan Stanley Smith Barney’s licensed
insurance agency affiliate.
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