Your Multimillion-Dollar Exit, page 15
• Try to identify buyers who will perpetuate your business’s vision and values, which include excellent treatment of your employees.
• Your purchase agreement should include provisions about continuing your employees as part of the acquiring company’s workforce and providing them with equal or better benefits than they currently enjoy.
• You may want to provide change-in-control bonuses to individuals who have been particularly helpful to you in building the business, preparing the business for sale, and consummating the transaction. These bonuses are paid only if the deal closes and could be based on a dollar amount or a percentage of the net proceeds received in the transaction.
• If you need to incentivize employees to stay with the continuing company, you may want to structure retention bonuses payable over time. These bonuses may be part of the transaction proceeds, paid by the buyer, or split between you and should be paid out as the employees remain employed after closing.
• In your investigation of the buyer, make sure you understand what your employees will be paid, the benefits they will receive, and any other obligations they will have (i.e., noncompetes) after closing to ensure they will remain with the company.
What’s in It for My Family?
We’ve been very fortunate to have been involved in some very high-profile matters, where we spent a significant amount of time in very complex things which would include investigations involving Enron, Bernie Madoff, and Lehman Brothers. In terms of the insurance world, I think if you were to look at probably the 10 largest insolvencies in US history, we’ve been involved doing forensic work in probably half of them. For a relatively small organization, we developed a reputation for being able to figure out particularly complex things and describe them in a way that was understandable.
—Larry Johnson, entrepreneur, Founder and former CEO of Veris Consulting, a forensic accounting firm
Basic Estate Planning for Your Business
Everyone, including the most driven entrepreneur, needs estate planning and an attorney to prepare their basic estate planning documents. “Estate planning” involves more than just preparing a will; it is a process of understanding
what assets and properties you own,
what they are worth,
how they are titled, and
how you want to manage those assets and properties to care for you and your family if you are incapacitated (i.e., disabled) or pass away.
Basic estate planning documents include wills, trusts, advanced medical directives, living wills, and financial powers of attorney. There are plenty of resources available to learn about basic estate planning and plenty of attorneys to help you. I urge you to consult with an estate planning attorney to draft your estate planning documents and update them based upon what you read in this section.
Caution: some estate planners may neglect to properly link ownership and control of your business to your estate planning documents. I touched on this topic in Chapter 2. Here is a detailed road map for you to follow in constructing your basic estate planning documents with your business in mind.
If you own your business in your own name, it will have to go through the process known as probate upon your death.
In most jurisdictions, your executor will have to file an inventory with the court in the jurisdiction where you reside and reveal the estimated value of your business following your death.
Your executor may have to pay probate tax in some states, such as Virginia, which is based upon the fair market value of the business.
In addition, your executor will be required to provide formal accountings to the court at least annually, which typically are reviewed by the court for a fee.
Your executor will have to pay attorneys, accountants, and the court to complete this process, which may last several years.
Deeper Dive
Some states are very rigid in how accountings must be prepared and submitted if probate is required. The accounting reveals all assets owned in the probate estate and provides excruciating detail regarding all inflows and outflows from the estate. The executor must provide significant backup documentation to the court to support the accounting. This may include bank statements, canceled checks, brokerage statements, receipts, appraisals, and the like, and the specific rules vary from state to state. Usually, the executor of the estate must pay an attorney and/or accountant to prepare the accounting and then must pay the court for the time incurred in reviewing the accounting. If any information is unclear or missing, the court will send the executor a list of additional information required to approve the accounting. The executor will have to provide the information to the court on a timely basis until the court is satisfied that it has what it needs to approve the accounting. All these additional reporting requirements will generate additional fees for the estate’s accountants and lawyers and for the court.
To avoid probate and minimize delays and costs to your family, you should transfer your business interest and all your other assets (except retirement plan accounts) into a revocable trust for your own benefit. You can be the sole trustee and sole beneficiary of your trust—during your lifetime you will have complete access and control over the assets in the trust, and you will not have to ask anyone for permission to do anything with the assets and properties in the trust. If you transfer your business interest into the trust, it will avoid the probate process upon your death.
In addition, if you become incapacitated and your business is in your trust, you will avoid “living probate,” also known as conservatorship or guardianship, where a court must appoint someone to handle your business affairs. Also, if you sign a financial power of attorney, your agent can transfer your business interest to your trust if it is already set up and you did not have a chance to do so.
Now, take your basic estate plan one step further. In addition to adding your business ownership interest to your revocable trust, you should sync the provisions of your trust with your management succession plan (MSP), which I advised you to draft in Chapter 2. This will ensure that the trustee whom you appoint to succeed you in the event of your incapacity or death not only immediately has control over the business but is also bound by the terms of your MSP.
As an extra precaution, you may want to appoint a business trustee in your revocable trust who has sole authority over your business interest. The business trustee might only have a say in how your business interest is managed; another person or family member can be appointed to manage your remaining assets and make decisions about distributing the assets to your family or other heirs.
You can also have co-trustees serving together. By appointing co-trustees, you create accountability in two persons to watch over your assets and business and do the right thing by your beneficiaries. Usually, the co-trustees must agree upon any actions to be taken, which, unless one of them is not paying attention, protects the beneficiaries from bad behavior by 1 trustee.
Deeper Dive
Many states now permit you to separate the duties of the trustees into administrative, investment, and distribution duties. The administrative trustee, who may be a corporate trustee, would be responsible for handling accountings, filing and paying income taxes, and managing other administrative duties that may be difficult for an individual trustee to control. The investment trustee would manage trust investments, and the distribution trustee could make decisions about when and to whom the trust income and principal is to be distributed according to the terms of the trust agreement.
Advanced Estate Planning before and after the Transaction
If the value of your assets and properties, including the value of your business, is expected to exceed $6–7 million, then you should consider some of the advanced planning ideas outlined in this section.60 Your liquid net worth may not be there yet, but your business may be worth more than you think. If you are like most entrepreneurs, most of your wealth is concentrated in your business, but that can change suddenly when you sell the business.
Upon a sale or another exit, you will realize the value of the business based upon what you receive in the deal, less transaction costs (e.g., investment banking fees, attorneys’ fees, and transaction bonuses) and income taxes.
At your death, the IRS applies rigorous rules to value your business, and the estate tax is determined based upon the business’s fair market value, even though your estate may not have enough cash to pay the tax.
Your executor must obtain an appraisal from a qualified appraiser to substantiate the value of your business on an estate tax return, which is filed on Form 706.
There are tools and techniques available to minimize and defer the taxes that must be paid, normally within 9 months after the date of death.
The goal is to determine what portion of your business you can afford to transfer now, well before a transaction materializes, to a trust for the benefit of your loved ones (or, in some cases, yourself) to minimize estate taxes that would be payable upon your death if you simply kept the business interest and didn’t spend the net proceeds from the transaction. The valuation of the interest being transferred is more likely to be respected if conducted by a qualified appraiser and the transfer is made well in advance of the exit transaction.
Timing Is Critical
Right before transactions are scheduled to close, founders frequently ask whether there is a way to move assets, including stock or ownership interests of the target company, out of the founder’s estate to minimize gift and estate taxes. It’s usually too late to do anything if it’s on the eve of closing. The real question is how far in advance should you be planning these advanced estate planning transactions?
To shelter wealth from estate and gift taxes and preserve it for your family, there is no hard-and-fast rule regarding when it is “safe” to transfer assets. Your goal is to minimize the likelihood of an IRS audit and the IRS’s success if there is a challenge, so you will want to transfer your business interest far enough in advance (using techniques outlined below) to escape the IRS’s radar.
Advisors apply a sliding scale of reasonableness. For example, if you plan the transfer of a business interest at least two years ahead of the sale transaction, your likelihood of being audited will diminish—and the likelihood of success in an IRS audit will increase—substantially. Conversely, if the transfer occurs within 1 or 2 months of closing, the risk of audit and the chance of losing to the IRS increase dramatically.
Some of the factors that influence the IRS in deciding how hard to pursue a taxpayer include the following:
The size of the transaction (larger ones get more attention)
Whether you have entered into an engagement letter with your investment banker or business broker
Even if you’ve entered into an engagement letter with your investment banker or broker, whether they have begun significant work to prepare you for the proposed transaction, including performing an informal valuation of the business (which may be discoverable by the IRS unless you are extremely cautious)
Even if the investment banker or broker has begun the process of preparing you for sale and soliciting bids for your company, whether any firm offers have been received
Whether you have started to receive strong indications of interest (IOIs) with values or value ranges for your business
Whether you have received letters of intent (LOIs) with specific values and terms of purchase for your business
Even assuming all the factors above exist, ranges of values in IOIs or even specific terms in LOIs where there is no binding or definitive agreement to sell are not fatal and still give you an opportunity to do advanced estate planning. All of this is subject to your tolerance for risk and the specific facts of your situation. Simply put, the closer you get to the transaction closing, the harder it will be to convince the IRS to accept an appraiser’s low valuation compared to what the actual transaction yields.
Wealth transfer planning can be completed even after the parties have signed an LOI, provided the LOI is nonbinding on the specific purchase price, terms, and conditions. However, once a definitive agreement for the acquisition has been signed, it’s probably too late to engage in any advanced wealth transfer planning.
Ideas in Action
A group of founders engaged in pretransaction wealth transfer planning. An investment banker had already been hired for the transaction, and the founders had started their discussions with prospective buyers. In fact, they had received two nonbinding offers in the form of LOIs with purchase prices specified and were getting ready to sign one of them. They executed dynasty trusts customized for each of them and their families. They gifted shares of stock of the target company into these trusts three months before the transaction closed but before an LOI was signed. Interestingly, a qualified appraiser valued the founders’ shares at less than 50% of the actual sales price in the transaction, including discounts aggregating 37% for lack of marketability and lack of control. The IRS never challenged the transactions, and the founders arguably saved millions of dollars in transfer taxes. That’s cutting it close.
You are the one who must evaluate the risk of audit and the ramifications of a successful IRS challenge. Your advisors should help you quantify that risk before you proceed with your planning.
Take Advantage of the Valuation Gaps
The appraiser’s valuation should be low enough at the time of the advanced estate planning transaction to justify the cost and effort of transferring an ownership interest prior to the sale of your company (i.e., the valuation gap generates a greater shift in wealth and greater tax savings at a federal gift and estate tax rate of 40% times the valuation gap). The valuation gap may include the following:
Discounts of 20–40%, representing the lack of control and lack of marketability in the ownership interest being transferred in the gift and estate planning transaction
Reductions in the overall enterprise value because the company is privately held or due to the failure of the appraiser to recognize strategic value or unique assets or opportunities for which a buyer may be willing to pay a hefty premium
Ideas in Action
Betty transferred an interest in her closely held business to an irrevocable trust for the benefit of her husband and children. The transfer was made about a year before she started courting potential buyers. The business had a unique way of processing orders for clients, and the technology, although not patented, was proprietary to the business. When she was ready to sell the business, Betty’s investment banker touted the extra value represented by the special technology in the business that was not reflected in the appraisal used for gift tax purposes. This premium yielded an additional multiple of 5x EBITDA in the transaction, which created a huge wealth transfer win for the client. Betty effectively transferred the entire 5x valuation gap out of her estate multiplied by the percentage interest that she transferred to the trust, resulting in transfer tax savings of 40% of the amount transferred, plus any future appreciation on that amount. The wealth transferred to the trust, which had an ultimate value of more than $10 million (generating 40% × $10 million, or $4 million, in transfer tax savings), will be excluded from her estate, her spouse’s estate, and her descendants’ estates forever.
Because she transferred the business interest into a dynasty trust for the benefit of her spouse, children, and future generations, Betty and her family will reap compounded benefits of avoiding gift tax, estate tax, and generation-skipping transfer tax across multiple generations.
The benefits of valuation discounts cannot be overstated, but they have also been in the crosshairs of Congress and the Treasury Department for decades. The IRS has successfully challenged the magnitude and validity of using valuation discounts in many cases involving intrafamily transfers. In 2016, the Treasury Department published proposed regulations that would have effectively denied taxpayers the ability to continue using valuation discounts in intrafamily transfer situations. The regulations were placed on hold and ultimately withdrawn during the Trump administration, and transactions utilizing valuation discounts proliferate today.
The Treasury Department could resurrect these regulations or another set of rules that significantly curtail the ability to use valuation discounting in advanced estate planning situations. It is also possible that Congress may enact legislative changes that accomplish the same result. So keep in touch with your tax advisor to ensure you can still use valuation discounting in your estate planning transaction.
Deeper Dive
The discount for lack of marketability (DLOM) and the discount for lack of control (DLOC) are applied to private companies when valuing them. The DLOM relates to the company not being publicly traded on a securities exchange. Publicly traded companies are perceived to have a “market” since the shares can be bought or sold in a centralized marketplace. Owners of privately held companies lack the ability to sell their shares in a public market, and a discount is usually applied to this lack of marketability. The DLOC considers the benefits of control not available to a company’s minority shareholders, which may include the ability to do the following:
• Change or appoint officers
• Control the board of directors or managers
• Determine management compensation
• Sell, recapitalize, or liquidate the company
• Pay shareholder dividends or distributions
• Lease, liquidate, or acquire business assets
• Negotiate acquisitions and mergers
• Control the company’s business activities
• Award or challenge contracts
• Sell the company’s stock to the public
• Amend the bylaws, operating agreement, or articles of incorporation
