GPSolo Magazine - September 2004
Estate And Financial Planning
The Art Of Crafting Business Succession Arrangements
This article discusses valuation principles and their significance in business succession. It then considers strategies to achieve fair results in business succession plans.
Valuation. The beginning point of any business succession plan must be a clear understanding on the part of the business owner of the value of the business and the sensitivity of the value both to intrinsic characteristics of the business and to outside influences. Understanding value is essential to a fair allocation of family wealth and is critical in determining the transfer tax cost of business succession, the most significant expense in the business succession process.
The most fundamental valuation principle for transfer tax purposes is the willing buyer-willing seller test. The regulations formulate the test as follows: “fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”
The application of that text is usually straightforward in the context of publicly traded securities. However, with nonpublicly traded stock, the valuation process is much more complex. Code § 2031(b) provides that the value of the stock of a non-publicly traded corporation shall be “determined by taking into consideration, in addition to other factors, the value of the stock or securities of corporations engaged in the same or a similar line of business which are listed on an exchange.”
Rev. Rul. 59-60, 1959-1 C.B. 237 is the most important guidance on the valuation of privately held business interests. It lists eight nonexclusive factors that are fundamental to each valuation case: (1) the nature of the business and the history of the enterprise; (2) the economic outlook in general and the condition and outlook of the specific industry in particular; (3) the book value of the stock and the financial conditions of the business; (4) the company’s earning capacity; (5) the company’s dividend-paying capacity; (6) whether the enterprise has goodwill or other intangible value; (7) sales of the stock and the size of the block of stock to be valued; and (8) the market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded.
Understanding which valuation methodology is appropriate for the subject company is critical. The three principal business valuation methodologies are the net asset method, the market value method, and the earnings method. Seldom is a single method used for any particular valuation assignment. Typically, a valuation expert will value a business using each method and then determine which is the best indicator of value. Often the result will consist of a weighted average of the results of the different methods.
Strategies to achieve fairness. Whether a successful business is a blessing or a curse for a family depends on the decisions made by the older generation in the succession plan and how well those decisions are communicated to the younger generations. Following are ten strategies to consider to achieve fair results.
First, obtain an expert. Few business owners have a realistic understanding of the value of their businesses. The valuation process provides an educational opportunity for the business owner to look at the business from a more objective perspective.
Second, expand the professional team to include those professionals who approach business succession from perspectives other than the law or taxation. These individuals are trained in management, psychology, organizational dynamics, or cultural anthropology. They have the skills to unearth the business and family culture that provides the context for the plan.
Third, expand the business team. Many privately held companies have little or no depth in the management ranks. This is a mistake for two reasons. First, from a valuation perspective a business has a greater value to the extent that it has management depth. Second, the likelihood of a successful succession plan will be enhanced to the extent that management authority will pass to managers with a history in the business. Failing to include outside directors on the private company’s board of directors can be a mistake because the board will have significant responsibilities after the owner’s death, and the experience of outside directors can be invaluable during this time of loss for the family.
Fourth, enter into employment agreements with key employees; their retention is critical to a successful business succession plan. The role of these employees should be defined in the plan. Judgments about management succession must be made by the older generation or by the board of directors or board of advisors. To protect them from ambitious family members, managers may need protection from termination “without cause.” Similarly, protection from irrelevance may be appropriate. This is achieved by compensating the executive if he or she resigns for “good cause,” such as a change in title or reduction in compensation.
Fifth, define compensation arrangements. During the owner’s life it is common for the system to operate as a benevolent dictatorship with employees trusting the judgment of the decision maker. Any successful plan must address the fact that after the death of the key owner, a new arrangement must be put into place. The issues are numerous. Who will determine compensation? What type of arrangement will fulfill the goals of the business? Is equity-based compensation appropriate, or is it critical to keep ownership in the family?
Sixth, obtain appropriate life insurance. In a buy-sell arrangement, life insurance provides a means to pre-fund all or a portion of the purchase price paid to the heirs who will not continue in the ownership of the business. This pre-funding allows the heirs to realize a fair value without placing a burden on the continuing owners. When the goal is to perpetuate the business within the family, life insurance is critical to provide the liquidity to pay estate taxes.
Seventh, use lifetime strategies to reduce estate taxes. These include discount entities, gifts, grantor-retained annuity trusts, installment sales to intentionally defective trusts, preferred stock recapitalizations, freeze partnerships, and opportunity transfers.
Eighth, consider alternative capital structures. In many succession plans one size does not fit all. Different owners need different equity ownership pieces. Many business owners choose to segregate certain assets, such as real estate or intellectual property, from the operating assets of the business.
Ninth, properly allocate voting control. This is a common issue for parents in dividing the family business. The challenge is to give those active in the business the authority necessary to fulfill their responsibilities without enough power to abuse their positions. Care must be exercised in protecting the noncontrolling owners who may need rights that give them input into such matters as compensation, dividends or distributions, operating and capital expenditure budgets, and major transactions. In the alternative, noncontrolling owners can be given an exit alternative to the extent they are dissatisfied with the decisions of the controlling owners.
Finally, business owners must clearly communicate the plan with family, nonfamily owners, key employees, and the boards of directors or advisors. The key elements of the plan should be documented in writing. It should cover management succession, control, compensation issues, and valuation.
James D. Spratt Jr. is a partner in the Atlanta office of King & Spalding LLP. He can be reached at email@example.com.
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- This article is an abridged and edited version of one that originally appeared on page 20 of Probate & Property, November/December 2003 (17:6).
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- Books and Other Recent Publications: Probate and Trust: An Estate Planner’s Guide to Buy-Sell Agreements for the Closely Held Business; An Estate Planner’s Guide to Family Business Entities, 2d ed. ; An Estate Planner’s Guide to Qualified Retirement Plan Benefits, 3d ed. ; An Estate Planner’s Guide to Life Insurance; Wills, Trusts, and Technology: An Estate and Trust Lawyer’s Guide to Automation, 2d ed.; The Family Limited Partnership Deskbook; Third Party and Self-Created Trusts, 3d ed. and Client Brochures; Asset Protection Strategies; A Guide to International Estate Planning.Real Property: The Commercial Lease Formbook; Expert Tools for Drafting and Negotiation; The Commercial Office Lease Handbook: New York Model Clauses and Commentary; Land Use Regulation: A Legal Analysis and Practical Application of Land Use Law, 2d ed.; Synthetic Lease Financing; A Practical Guide to Commercial Real Estate Transactions; Anatomy of a Mortgage; The Commercial Property Lease, vol. 3; Accessibility under the Americans with Disabilities Act and Other Laws; Land Surveys, 2d ed.