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BUSINESS SUCCESSION PLANNING

BUSINESS SUCCESSION PLANNING

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BUSINESS SUCCESSION PLANNING

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  1. BUSINESS SUCCESSION PLANNING FPPA MANAGEMENT WORKSHOP CHICAGO, IL SEPTEMBER 11, 2007

  2. TWO KEY ALTERNATIVES • THE DECISION TO SUCCEED • BUSINESS CONSIDERATIONS • FAMILY CONSIDERATIONS • FINANCIAL CONSIDERATIONS • INCOME TAX CONSIDERATIONS • ESTATE AND GIFT TAX IMPLICATIONS

  3. TWO KEY ALTERNATIVES • THE DECISION TO SELL • FINANCIAL CONSIDERATIONS • INCOME TAX CONSIDERATIONS • ESTATE TAX CONSIDERATIONS • EMOTIONAL AND FAMILY CONSIDERATIONS

  4. THE DECISION TO SUCCEED – BUSINESS CONSIDERATIONS • LEADERSHIP VISION, BUSINESS ACUMEN • LEADERSHIP CANNOT BE AMBIGUOUS • AN EFFECTIVE LEADER MUST HAVE A VISION OF THE FUTURE AND BE ABLE TO GIVE OVERALL DIRECTION • PEOPLE SKILLS ARE CRUCIAL • OVERALL BUSINESS ACUMEN IS THE MOST IMPORTANT ATTRIBUTE OF A CEO

  5. THE DECISION TO SUCCEED – BUSINESS CONSIDERATIONS • CAPITAL RESOURCES • TALENT IS CRUCIAL, BUT ANY PLAN FOR BUSINESS SUCCESSION WILL MOST LIKELY STRAIN CAPITAL RESOURCES • THIS PROBLEM IS EXACERBATED IF ALL OF YOUR EGGS ARE IN ONE BASKET • THE CONCEPT OF FAIRNESS IS SUBJECTIVE – YOU CAN’T PLEASE EVERYONE • WHETHER THE SUCCESSION PLAN IS WITH FAMILY MEMBERS OR KEY EXECUTIVES CAPITAL WILL BE STRAINED

  6. THE DECISION TO SUCCEED – BUSINESS CONSIDERATIONS • BUSINESS AND OPERATION CONSIDERATIONS • WHATEVER STRATEGY IS USED FOR SUCCESSION, THE KEY ISSUE IS TO KEEP THE OPERATION MOVING FORWARD PROFITABLY • IF FAMILY SUCCESSION IS DESIRED, THEN KEY EMPLOYEES MUST BE KEPT IN THE FOLD • IF KEY EMPLOYEE SUCCESSION IS USED, THEN ONE LEADER MUST BE CHOSEN – LEADERSHIP BY COMMITTEE IS A FORMULA FOR DISASTER • GOLDEN HANDCUFF ARRANGEMENTS

  7. THE DECISION TO SUCCEED – FAMILY CONSIDERATIONS • IF YOU HAVE DECIDED ON A FAMILY MEMBER OR FAMILY MEMBERS TO SUCCEED, THEN CONSIDER THIS FIVE STEP PROCESS • EDUCATE YOURSELF AND BEGIN THE PROCESS AS EARLY AS POSSIBLE • TALK INDIVIDUALLY WITH YOUR CHILDREN ABOUT THEIR ASPIRATIONS • HAVE FAMILY MEETINGS • DEVELOP A GAME PLAN • DEVELOP AN OUTSIDE SUPPORT GROUP

  8. THE DECISION TO SUCCEED – FINANCIAL CONSIDERATIONS • CAPITAL RESOURCES (CONT.) • THE GOALS OBVIOUSLY ARE TO MAXIMIZE THE RETURN TO EXISTING OWNERSHIP WHILE MINIMIZING THE COST TO THE SUCCESSORS • HOW CAN YOU EQUALIZE THE VALUE OF THE BUSINESS AMONG NON-PARTICIPATING FAMILY MEMBERS

  9. INCOME TAX BASICS • CHOICE OF ENTITY • C CORPORATION • LOWER TAX RATE ON FIRST 100K • DOUBLE TAXATION • WILL ANYONE EVER BUY YOUR STOCK? • COMPENSATION ISSUES • ACCUMULATED EARNINGS TAX • MANY CLASSES OF STOCK ALLOWED

  10. INCOME TAX BASICS • CHOICE OF ENTITY • S CORPORATION • PASS THROUGH TO SHAREHOLDERS • ONE LEVEL OF TAX • BUILT IN GAINS TAX FOR FORMER C CORP’S • TAX ON PASSIVE INVESTMENT INCOME FOR FORMER C CORPS • SELF EMPLOYMENT TAX ISSUES OF COMPENSATION IS TOO SMALL

  11. INCOME TAX BASICS • CHOICE OF ENTITY • S CORPORATION (cont.) • NO ACCUMULATED EARNINGS TAX • LIMITATION ON SHAREHOLDERS • NUMBER (POSSIBLE USE OF PARTNERSHIPS) • INDIVIDUALS OR QUALIFIED TRUSTS • NO FOREIGN OWNERSHIP • LIMITATION ON CLASSES OF STOCK • FRINGE BENEFIT RULES • ACCRUAL ISSUES

  12. INCOME TAX BASICS • CHOICE OF ENTITY • LIMITED PARTNERSHIP • NO DOUBLE TAX • NO LIMIT ON OWNERS • NO COMPENSATION ISSUES • SELF EMPLOYMENT TAX • SECTION 754V STEP UP IN BASIS

  13. INCOME TAX BASICS • CHOICE OF ENTITY • LIMITED LIABILITY COMPANY • ALL THE “GOOD” ATTRIBUTES OF A LIMITED PARTNERSHIP AND…. • NO ONE HAS TO BE ON THE HOOK FOR THE LIABILITIES • CHECK THE BOX RULES HAVE SIMPLIFIED THIS CHOICE

  14. ESTATE TAX BASICS • GRITS, GRATS, SKINS, FLP’S, IDGTS, PRIVATE ANNUITIES, ETC. ARE ALL WONDERFUL TOOLS, BUT THEY WILL NOT BE AS EFFECTIVE IF YOU DON’T TRANSFER APPRECIATED ASSETS AT OPPORTUNE TIMES

  15. ESTATE TAX BASICS • TECHNIQUES FOR SHIFTING WEALTH AND CONTROL • RECAPITALIZATION • VOTING FOR NON-VOTING • OK IN S CORP’S • PREFERRED STOCK • BUY/SELL AGREEMENTS • FUNDED/UNFUNDED • LEVERAGED ESOP’S • CHARITABLE REMAINDER AND LEAD TRUSTS • PHANTOM STOCK ARRANGEMENTS • INTRA FAMILY SALES WITH SELF CANCELLING NOTES/OR PRIVATE ANNUITIES • FAMILY PARTNERSHIPS (LLC’S) • INTENTIONALLY DEFECTIVE GRANTOR TRUSTS

  16. ESTATE TAX BASICS • OPPORTUNITIES • TRANSFER COMPANY STOCK DURING DOWN YEARS • USE FAMILY LIMITED PARTNERSHIPS FOR EQUIPMENT AND REAL PROPERTY • GET SUCCESSORS IN AT INCEPTION • MAKE CERTAIN YOU USE ANNUAL EXEMPTION • USE YOUR UNIFIED CREDIT NOW VERSUS LATER • USE OF INSURANCE FOR ESTATE PROTECTION • SECOND TO DIE POLICIES • IRREVOCABLE INSURANCE TRUSTS

  17. ESTATE TAX BASICS • FAMILY LIMITED PARTNERSHIP/LLC • GENERAL PARTNER/MANAGING MEMBER CONTROLS • DISTRIBUTIONS NEED NOT BE PRO-RATA AS LONG AS YOU FOLLOW THE RULES OF SEC 704(b) • VALUATION DISCOUNT FOR MINORITY INTEREST • USE PROPERTY THAT WILL APPRECIATE AND • TAXATION OF CHILDREN UNDER AGE 21 • PROBABLY HAVE TO CONSOLIDATE UNDER FIN 46

  18. ESTATE TAX BASICS • PRIVATE ANNUITIES • BETTING TO LIVE A LONG LIFE • CONSTANT PAYMENT OVER THE LIVES OF THE SELLERS BASED UPON ACTUARIAL TABLES • IF UNSECURED THEN GAIN IS PICKED UP RATABLE OVER THE PAYMENTS • IF SECURED THEN GAIN IS RECOGNIZED IN THE YEAR OF SALE

  19. ESTATE TAX BASICS • PRIVATE ANNUITIES • ADVANTAGES • POTENTIAL INCOME TAX SAVINGS • GIFT TAX AVOIDANCE • LIFETIME INCOME • CONTINUED FAMILY CONTROL • ESTATE LIQUIDITY • AVOIDANCE OF PROBATE • DISADVANTAGES • INVESTMENT RISK • NO INTEREST DEDUCTION

  20. ESTATE TAX BASICS • SELF CANCELLING INSTALLMENT NOTES (SCIN) – BETTING ON A SHORTER LIFE • INSTALLMENT SALE THAT ENDS UPON THE DEATH OF THE SELLER • UNLIKE A PRIVATE ANNUITY IT IS FOR A SUM CERTAIN OVER A DEFINITE TERM. • MUST HAVE A COMPLETE TERMINATION OF INTEREST OR RISK ORDINARY INCOME TREATMENT • ADDITIONAL CHARGE IF INSTALLMENT NOTE IS GREATER THAN 5 MILLION

  21. ESTATE TAX BASICS • ADVANTAGES OF A SCIN • ESTATE TAX SAVINGS • INTEREST DEDUCTION • INCOME AND SECURITY • DISADVANTAGES OF A SCIN • REMAINING INCOME IS TRIGGERED IN THE YEAR OF DEATH

  22. ESTATE TAX BASICS • GRANTOR RETAINED ANNUITY AND INCOME TRUSTS (GRAT/GRIT) • USEFUL METHOD TO TRANSFER PROPERTY THAT WILL APPRECIATE AT TODAY'S VALUE DISCOUNTED BY THE NUMBER OF YEARS THE TRUST CALLS FOR (GENERALLY LIMITED TO 10) • IF GRANTOR DOESN’T SURVIVE THE REQUIRED NUMBER OF YEARS, THE CORPUS REVERTS TO HIS OR HER ESTATE

  23. ESTATE TAX BASICS • CHARITABLE REMAINDER AND LEAD TRUSTS • REMAINDER TRUST LEAVES CORPUS TO CHARITY UPON DEATH OF GRANTOR • LEAD TRUST GIVES INCOME TO CHARITY NOW WITH CORPUS REVERTING TO GRANTOR IN FUTURE • BOTH OFFER A TAX DEDUCTION FOR CHARITABLE CONTRIBUTIONS • REMAINDER TRUST TAKES CORPUS OUT OF GRANTORS ESTATE

  24. ESTATE TAX BASICS • INTENTIONALLY DEFECTIVE GRANTOR TRUST (IDGT) • TAKES ADVANTAGE OF A DEFINITIONAL ANOMALY BETWEEN INCOME AND ESTATE TAX RULES • TRANSFER IS EFFECTIVE FOR ESTATE TAX RULES, BUT NOT FOR INCO0ME TAX RULES • SHIFTS APPRECIATED PROPERTY TO A TRUST WITHOUT RECOGNIZING CURRENT GAIN – ALL FUTURE APPRECIATION GOES TO BENEFICIARIES • ELEMENTS OF IDGT HAVE BEEN APPROVED BY IRS, BUT THEY HAVE NEVER OPINED ON THE ENTIRE PROCESS, NOR HAVE THEY CHALLENGED IT. • SIMILAR TO A GRAT, BUT NO CURRENT INCOME RECOGNITION (OR GIFT TAXES), BUT ALSO NO SECURITY.

  25. NON-FAMILY SUCCESSION • LEVERAGED ESOP • COMPANY LEVERAGES ASSETS AND PURCHASES STOCK FROM OWNER • OWNER CAN RE-INVEST PROCEEDS IN ALMOST ANY DOMESTIC STOCK AND DEFER TAXES UNTIL REPLACEMENT ASSET IS SOLD • OWNER CAN STILL RETAIN CONTROL • S CORP STATUS CAN STILL BE RETAINED

  26. NON-FAMILY SUCCESSION • BUY/SELL AGREEMENTS • A KEY EMPLOYEE CAN BE A PARTY TO A BUY SELL AGREEMENT WITHOUT ACTUALLY OWNING STOCK CURRENTLY • CAN BE FUNDED WITH INSURANCE OR SIDE FUND, OR CAN BE UNFUNDED • USUALLY VALUES THE BUSINESS BY FORMULA • DIFFICULT TO DO WITH FAMILY MEMBERS DUE TO THE CHAPTER 14 VALUATION RULES – NON-FAMILY MEMBERS ARE PRESUMED TO BE DEALING AT ARMS LENGTH

  27. NON-FAMILY SUCCESSION • NON-QUALIFIED DEFERRED COMPENSATION/PHANTOM STOCK • UNSECURED PROMISE TO PAY A PORTION OF PROFITS AND/OR PROCEEDS FROM SALE/AND OR INCREASE IN VALUE AT RETIREMENT DATE OR DEATH • CAN BE FUNDED WITH INSURANCE • ALSO KNOWN AS GOLDEN HANDCUFF ARRANGEMENT AS THERE WILL BE A “POT OF GOLD AT THE END OF THE RAINBOW” ONLY IF THE STAY. • EMPLOYMENT AGREEMENTS AND SALARY CONTINUATION AGREEMENTS (CHAPTER 14 RULES DO NOT APPLY)

  28. VALUATION ISSUES • REPEAL OF SECTION 2036(c) • REMOVED THE APPEAL OF PREFERRED STOCK RECAPITALIZATIONS, AND OTHER TECHNIQUES OF FREEZING WEALTH • ADDED NEW CHAPTER 14 VALUATION RULES • SO CALLED SUBTRACTION METHOD WHICH OFTEN MAKES RETAINED VALUE ZERO IF THERE ARE “APPLICABLE RETAINED INTERESTS”.

  29. VALUATION ISSUES • MUST NOT FOOL AROUND WITH RETAINED RIGHTS AND HAVE EACH CLASS OF STOCK PROPORTIONATELY REDUCED WITHOUT OPTIONS OR ANY OTHER RIGHT TO “EXTRAORDINARY PAYMENTS” TO AVOID CHAPTER 14 RULES • OBTAIN A QUALIFIED APPRAISAL FROM AN EXPERT AND FILE GIFT TAX RETURNS • STATUTE OF LIMITATION NOW CLOSES AFTER 3 YEARS • BEWARE OF PUBLIC COMPANY APPROACH THAT IS CURRENTLY FAVORED IN THE VALUATION COMMUNITY

  30. VALUATION ISSUES • FIND WAYS TO MINIMIZE BUSINESS PROFITS FOR SUCCESSION • MAXIMIZE COMPENSATION DEDUCTIONS AND PERQ’S • USE MULTIPLE ENTITIES • AGGRESSIVELY USE FAMILY PLANNING VEHICLES

  31. THE DECISION TO SELL • POSITIONING COMPANY FOR SALE TAKES TIME • MAXIMIZE PROFITS • CLEAN STATEMENTS • AUDITED STATEMENTS • CONTINUITY OF MANAGEMENT • S STATUS OR OTHER PASS-THROUGH STATUS • WILL ANYONE EVER BUY YOUR STOCK

  32. THE DECISION TO SELL • FINANCIAL CONSIDERATIONS • WHAT’S YOUR BUSINESS WORTH • HOW MUCH MONEY DO YOU NEED OR WANT TO MAINTAIN YOUR LIFESTYLE AND OR PASS WEALTH ON TO FUTURE GENERATIONS • LAST CHANCE TO “CASH IN CHIPS” • CAN AVOID SOME OF THE DOUBLE TAX ISSUES WITH COMPENSATION AND LEASE ARRANGEMENTS • BUYER AND SELLER MUST REPORT ALL CONSIDERATION TO IRS

  33. VALUATION • INDUSTRY RULES OF THUMB • MULTIPLES OF CASH FLOW, EARNINGS, EBITDA • PRESENT VALUE OF FUTURE BENEFITS • ASSET BASED APPROACHES

  34. VALUATION CONCEPTS NORMALIZED EBITDA APPROACH WEIGHTED SIMPLE AVERAGE AVERAGE YEAR 1 YEAR 2 YEAR 3 NET INCOME $179,167 $258,333 $25,000 $250,000 $500,000 NORMALIZATION ADJUSTMENTS SHAREHOLDER COMPENSATION >$150K 366,667 400,000 300,000 400,000 500,000 SHAREHOLDER "PERK'S" 54,167 58,333 50,000 50,000 75,000 EXCESS RELATED RENT PAYMENTS 50,000 50,000 50,000 50,000 50,000 EXCESS RELATED LEASE PAYMENTS 25,000 25,000 25,000 25,000 25,000 NORMALIZED NET INCOME 675,000 791,667 450,000 775,000 1,150,000 ADJUSTMENTS FOR EBITDA INTEREST 61,667 65,000 55,000 65,000 75,000 INCOME TAXES 71,667 103,333 10,000 100,000 200,000 DEPRECIATION 216,667 208,333 250,000 175,000 200,000 AMORTIZATION 15,000 15,000 15,000 15,000 15,000 NORMALIZED EBITDA $1,040,000 $1,183,333 $780,000 $1,130,000 $1,640,000 PURCHASE PRICE @ 5X MULTIPLE $5,200,000 $5,916,667 $3,900,000 $5,650,000 $8,200,000 ANNUAL DEBT SERVICE @ 6% - 5 YEARS $1,206,367 $1,372,629 $904,775 $1,310,764 $1,902,348

  35. VALUATION CONCEPTS ASSET BASED APPROACH ACQUISITION ACQUISITION ADJ HISTORICAL CASH ($100,000) $100,000 ACCOUNTS RECEIVABLE $2,400,000 (100,000) 2,500,000 INVENTORY 200,000 (50,000) 250,000 OTHER 50,000 (50,000) 100,000 PROPERTY PLANT AND EQUIPMENT 4,500,000 4,000,000 500,000 OTHER ASSETS 25,000 (25,000) 50,000 CURRENT LIABILITIES (2,000,000) (2,000,000) BANK AND OTHER DEBT (2,000,000) (2,000,000) NET ASSETS $3,175,000 $3,675,000 ($500,000) EBITDA VALUATION $2,500,000

  36. VALUATION • WHEN CAN YOU EXPECT TO RECEIVE MORE? • WHEN THE ACQUISITION IS A MISSING “PUZZLE PIECE” IN THEIR STRATEGIC PLAN! • WHEN THERE ARE SIGNIFICANT ECONOMIES OF SCALE CREATED BY THE ACQUISITION

  37. PAYMENT TERMS • A SELLER ALMOST ALWAYS WANTS A SUM CERTAIN PAID AT CLOSING. • A BUYER ALMOST ALWAYS PREFERS TO PAY BASED UPON THE RESULTS (“EARN-OUT”) • IS THERE A MIDDLE OF THE ROAD

  38. PAYMENT TERMS • CONTINGENT SALES PRICE • SUM CERTAIN WITH PERFORMANCE BASED INCENTIVES FOR KEY EMPLOYEES • IF A STOCK PURCHASE MAKE SURE THAT THERE IS A SUFFICIENT ESCROW • SELLER FINANCING IS OFTEN CRUCIAL AS A FINANCIAL INSTITUTION WILL PROBABLY NOT GIVE YOU 100% FINANCING

  39. TAX CONSIDERATIONS • BUYER IS LOOKING FOR CAPITAL GAIN TREATMENT • SELLER WANTS TAX DEDUCTIBILITY? • BEWARE OF THE DOUBLE TAX!

  40. PURCHASE PRICE ALLOCATION • MUST BE AGREED UPON – BUYER AND SELLER MUST FILE STATEMENT WITH TAX RETURN • GENERAL CONCEPTS • FIRST TO VALUE OF HARD ASSETS IN ORDER OR LIQUIDITY • ACCOUNTS RECEIVABLE, INVENTORY, ETC • NEXT TO APPRECIATED ASSETS • LAND, BUILDING, EQUIPMENT • BALANCE TO SECTION 197 INTANGIBLE

  41. GOING PUBLIC • VERY EXPENSIVE AND TIME CONSUMING TO DO AN IPO • ALMOST IMPOSSIBLE DURING BEAR MARKETS • A BETTER APPROACH IS TO FIND A PUBLIC COMPANY “SHELL” AND HAVE IT ACQUIRE THE BUSINESS • PROVIDES LIQUIDITY AND AVOIDS VALUATION ISSUES • CAN BE VERY CUMBERSOME AND LIMITING TO SOMEONE WHO IS USED TO OPERATING A CLOSELY HELD BUSINESS • SARBANES OXLEY HAS MADE THIS WORSE, BUT SMALL PUBLIC COMPANIES HAVE BEEN EXEMPTED

  42. SUMMARY • DECIDE AS EARLY AS YOU CAN WHETHER YOU WILL BE POSITIONING YOUR FOR SUCCESSION OR FOR SALE • MAKE SURE THAT YOU KEEP KEY EMPLOYEES AND SALESPEOPLE “IN THE FOLD” • IF YOU OPT FOR SUCCESSION PICK A LEADER EARLY AND GROOM HIM OR HER TO BE THE CEO

  43. SUMMARY • IF YOU OPT FOR SUCCESSION START THE ESTATE PLANNING AND WEALTH TRANSFER PROCESS EARLY AND TAKE ADVANTAGE OF OPPORTUNITIES TO SHIFT WEALTH • IF YOU DECIDE TO POSITION FOR SALE YOU WILL PROBABLY NEED AT LEAST THREE YEARS TO CLEAN UP YOUR STATEMENTS