November 01, 2003

The Art of Crafting Business Succession Arrangements (2003, 17:06)

The Art of Crafting Business Succession Arrangements

Probate and Property, November/December 2003, Volume 17, Number 6

By James D. Spratt Jr.
James D. Spratt Jr. is a partner in the Atlanta office of King & Spalding LLP. He is vice chair of the C-2 Estate Planning and Administration for Business Owners Committee. This article was adapted from his materials presented at the 14th Annual Estate Planning Symposium sponsored by the Real Property, Probate and Trust Law Section in April 2003.

Few projects are as rewarding for a trusts and estates lawyer as helping a client plan for the ownership succession of a family business. And few are as challenging. The low success rate for family business succession is evidence of the difficulty. Business succession arrangements require a mastery of numerous legal and tax complexities, the science of the subject. These are important, but few plans fail because of the technicalities. More are ineffective because they fail to incorporate the human context of the family or the business organization.

Unlike the legal and tax issues, which tend to be the same for each fact pattern, the human issues are unique to every family and business. Understanding and incorporating the human dimension requires different skills in a lawyer, skills that are more artistic than scientific. In short, crafting successful business succession arrangements is one part science and perhaps two parts art.

No matter how technically correct, no business succession plan can accomplish its objectives if the various stakeholders of the business are not treated equitably. The stakeholders include the family, nonfamily owners, and employees. This article will discuss valuation principles and their significance in business succession. It will then consider strategies to achieve fair results in business succession plans. As will be seen, the art of crafting business succession plans requires a great deal of subjective input. Helping a business owner to understand the subjective elements is a valuable service.

Valuation

Business owners tend to have strong opinions on the values of their businesses, and many are surprised at the conclusions of independent valuation experts. 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 to intrinsic characteristics of the business and outside influences. If the plan calls for the purchase or redemption of some owners upon the occurrence of certain events, a realistic appreciation of value is critical to ensure that the selling owners receive fair value for their interests without jeopardizing the future of the enterprise. For plans in which no sale is contemplated, it is often the case that the business will pass to family members active in the business with other assets passing to other family members. Again, understanding value is essential to a fair allocation of family wealth. Finally, value 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 have reasonable knowledge of relevant facts.” Treas. Reg. § 20.2031–1(b) and § 25.2512–1.

The application of the willing buyer–willing seller test is usually straightforward in the context of publicly traded securities. One looks to the mean between the highest and lowest quoted selling prices on the valuation date. With nonpublicly traded stock, the valuation process is much more complex. Code § 2031(b) provides that the value of stock of a nonpublicly 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.” The Regulations attempt to identify some of the “other factors,” such as the company’s net worth, prospective earning power, dividend-paying capacity, good will, industry outlook, competitive position, management, and other factors. Treas. Reg.§§ 20.2031–2(f)(2) & 25.2512–2(f)(2).

Although issued more than 40 years ago, Rev. Rul. 59–60, 1959–1 C.B. 237, remains the most important guidance on the valuation of privately held business interests. It is the road map for any credible valuation analysis. The IRS has modified Rev. Rul. 59–60 on several occasions, but the fundamental valuation principles articulated therein have withstood the test of time. Rev. Rul. 59–60 lists eight nonexclusive factors that are fundamental to each valuation case. They are

• The nature of the business and the history of the enterprise from its inception,

• The economic outlook in general and the condition and outlook of the specific industry in particular,

• The book value of the stock and the financial condition of the business,

• The earnings capacity of the company,

• The dividend-paying capacity,

• Whether or not the enterprise has goodwill or other intangible value,

• Sales of the stock and the size of the block of stock to be valued, and

• The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.

Understanding which valuation methodology is appropriate for the subject company is critical to the success of the business succession plan. There are three principal business valuation methodologies—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.

Net Asset Method

Rev. Rul. 59–60 refers to book value. The terms “book value” and “net book value” are accounting conventions. The net book value of a company is the historical cost of all of the company’s assets less its recorded liabilities. The book value approach to valuation is better understood as the “underlying asset” approach. This method estimates the value of a business by netting the value of the assets by the liabilities to determine the net asset value of the business and requires an analysis of each asset and liability of the business to determine if a restatement is necessary from historical balance sheet treatment.

This approach seldom generates an accurate value for an operating company, because it fails to take into account the goodwill associated with the business. With operating companies, book value is typically viewed as a floor for valuation purposes, perhaps appropriate for companies in financial distress when liquidation is likely. The book value method is used frequently in the valuation of holding companies, which have little goodwill at the holding company level.

Market Value Method

With the market value method, the subject company’s value is based upon the value of similar companies that are publicly traded or recently acquired in private transactions for which information is available. To apply this approach, comparable company values are measured based upon stock prices or transactions. This value is then divided by an earning parameter such as sales, net income, or cash flow, or by a balance sheet parameter such as stockholders’ equity. The resulting multiple is applied to the subject company to estimate its value.

This method is ideal when a sufficient number of publicly traded or recently purchased companies that are comparable to the subject company can be identified. This identification can be quite difficult, however. Similarity in size, methods of operation, markets and customers, accounting methods, and sales and earnings growth is important for an accurate result under this method. The more unusual the subject company, the less appropriate this method of valuation.

Earnings Method

The earnings method estimates fair market value based on the earnings and cash flow capacity of a company. This approach evaluates the present worth of the future economic benefits that accrue to the investors in the business. It can be approached by two methods.

If a business has a history of consistent earnings, and it is expected that the earnings will continue into the future, the appraiser may use the capitalization of earnings method. With this method, a normalized level of earnings is multiplied by a capitalization factor. The capitalization factor is typically the inverse of the assumed cost of capital of the business and is similar to the price/earnings ratios of publicly tradedcompanies.

Another commonly used earnings approach is the discounted cash flow method. It projects the future cash flows from the operations of the business and discounts them to present value using an appropriate discount rate, typically the assumed cost of capital. This approach is used when the past earnings stream of a business is not representative of future prospects.

Valuation Adjustments

Valuing an interest in a business is typically a two-step process. First, the entire value of the enterprise is established, and then the value of the interest is determined. The valuation methodologies discussed above are intended to estimate the value of the entire enterprise. When valuing an interest in the enterprise, it is appropriate to consider whether discounts or premiums should be applied to the interest, because seldom is the value of an individual business interest merely a proportionate share of the value of the entire enterprise. The most common adjustments include the minority interest discount and the discount for lack of marketability. The value of a controlling interest is often increased by a control premium. Valuation advisors have a number of methods of computing these discounts and the control premium, and these adjustments are well recognized by the courts. Other discounts may be appropriate as well. These include a key employee discount, a nonvoting stock discount, a blockage discount, and a discount for unrealized capital gains.

One thing that is clear from a review of valuation methodologies is that business valuation is more art than science. Any business valuation requires a significant amount of subjectivity on the part of the valuation expert. It is important for the business owner to understand the subjective assumptions that must be made in valuing the family business and, if possible, to incorporate guidance into the plan on how these judgments should be made in the future. Valuation can affect many aspects of the business succession plan, so an understanding of valuation principles is essential to the planning process.

Strategies to Achieve Fairness

Whether a successful business is a blessing or a curse for a family depends upon the decisions made by the older generation in the succession plan and how well those decisions are communicated to the younger generations. Many times it is easy because retention of the business is not realistic, perhaps because there is no management succession plan. If the business is sold, the proceeds can be divided with other assets of the estate, and the business does not present any difficult issues of fairness among the children. Similarly, when the business is not managed by family members but by professional managers, the business interest can be viewed as “just another asset” and distributed in kind along with other assets of the estate.

Problems arise when children or grandchildren are active in the business. Because of differences in ability or inclination, it is seldom the case that family members make equal contributions to the success of the business. Resentment over these differences surfaces quickly after the death of the patriarch or matriarch. It is sometimes the case that children are blind to the shortcomings of their siblings or willing to overlook them for the sake of family harmony. It is just as often the case that the children’s spouses are very aware and less willing to look the other way.

A business owner must be realistic about this dynamic and deal with the issues presented. Typically, this will mean that the business goes to family members who are interested in running it. Assets other than the business go to other family members. Determining the value of the business for these purposes is critical. To the extent family members are active in the business, careful consideration must be given to the value created by their contribution of time and energy. It is seldom the case that the parent, the child active in the business, and other children have even remotely similar views of the active child’s contribution to the business. Achieving fairness or, perhaps more importantly, a perception of fairness for family members is critical.

The success of the business succession plan is also important for nonrelated owners of the business and employees of the business. A poor plan can affect all of the stakeholders of a business to the extent it fails to recognize adequately the contribution of nonfamily members and their ongoing roles. Moreover, a poor plan can result in an ownership structure in which control is uncertain or so fragmented that no single group has a sufficient economic incentive to care whether the business survives. These issues must be addressed in the interest of fairness to all interested parties of the business. Following are ten strategies to consider to achieve fair results in business succession plans.

Obtain an Expert Valuation

As explained above, the starting point for a successful business succession plan is a valuation analysis prepared by a qualified and objective valuation expert. Few business owners have a realistic understanding of the values of their businesses. The valuation process provides an educational opportunity for the business owner to look at the business from a more objective perspective, perhaps the way it will be viewed by the family or the IRS after his or her death. No fair succession plan can begin without an understanding of the value of the business and the factors that affect its value.

Expand the Professional Team

Although many attorneys, CPAs, and CLUs have expertise and experience in business succession matters, resolution of certain issues may require other disciplines. There are professionals who approach business succession from perspectives other than the legal or tax. 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. The business owner is too close to the action to understand the dynamics at play.

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 it has management depth. Second, the likelihood of a successful succession plan will be enhanced to the extent management authority will pass to managers with a history in the business.

The boards of directors of many private companies fail to include outside directors. This can be a mistake, because the board of directors will have significant responsibilities after the death of the business owner and the experience of outside directors can be invaluable during this time of loss for the family. Outside directors are particularly reassuring to the employees of the business, who many times are concerned about the absence of authority.

Because individuals who serve on boards of directors assume fiduciary duties that can cause concerns about financial liability, some companies invite outsiders to serve on a board of advisors. The board of advisors meets periodically to review the operations of the business. The board of advisors is a part of the succession plan that is visible to the family and the employees. When necessary the board of advisors can assume the role of the board of directors or can serve an advisory role to the family or new management recruited after the death of the business owner.

Enter into Employment Agreements with Key Employees

The retention of key employees is critical to a successful business succession plan. Key employees should have the security of knowing that the death of a business owner will not jeopardize their employment. Likewise, the business needs the assurance that its key employees will not abandon the company shortly after the death of a business owner. Employment agreements containing an employment term after the death of the owner can give key employees the comfort they need.

Employment agreements can provide incentives for key employees to stay on after the death of an owner by providing for additional compensation to employees that complete a transition term. This is like a “retention bonus” that many financially troubled companies offer to key management to keep talent from seeking greener pastures.

The role of key employees should be defined in the succession plan. This is important for several reasons. Key employees of family businesses often feel threatened by family members who may have management ambitions. Many children of business owners are anxious to prove that they are as capable as the older generation of running the business. Often these ambitions are unrealistic, and everyone is aware of it, except the child who does not know what he or she does not know. 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 reason.” Good reason may include change in title, curtailment of responsibilities, or reduction in compensation or benefits.

Define Compensation Arrangements

A fair compensation system is critical to the success of any business. During the life of the patriarch or matriarch it is common for the system to operate as a benevolent dictatorship with employees trusting the judgment of the decision-maker. Any successful business succession 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—the board, management, or the owners? What compensation arrangements are designed to fulfill best the goals of the business—salary, bonus, deferred compensation? Is equity-based compensation, such as options or restricted stock, appropriate or is it critical to keep ownership in the family? If so, would a phantom stock arrangement satisfy management’s expectation of ownership? Is an ESOP appropriate? To the extent one family member or group has voting control of the business, what limits on compensation are necessary to avoid abuse of the compensation system?

Obtain Appropriate Life Insurance

Life insurance is an important component of most business succession plans. In a buy–sell arrangement it 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. Here it is common for the insurance to be owned by a party other than the insured, such as a life insurance trust or partnership owned by younger generations.

Finally, insurance may be necessary to augment an estate to the extent the business is passing to some family members but not others. If the estate is not large enough to achieve equality, life insurance can make up the difference, providing assets to family members who will not receive an interest in the business. On the other hand, to the extent liquid assets will pass to inactive family members, insurance can provide liquidity for family members receiving the business.

Key person life insurance may be appropriate as well. This is insurance payable to the business to compensate for the loss of the leadershipand management skills of the deceased owner. The proceeds may be necessary to provide financialstability to recruit or retain talented management.

Use Lifetime Strategies to Reduce Estate Taxes

Any business succession plan will benefit from estate planning strategies that have the effect of reducing estate taxes. These strategies preserve wealth, which increases the chances of a successful transition of the business. These techniques include discount entities, gifts, grantor-retained annuity trusts, installment sales to intentionally defective trusts, preferred stock recapitalizations, freeze partnerships, and opportunity transfers, among others.

Consider Alternative CapitalStructures

In many business succession plans one size does not fit all. Different owners need different equity ownership pieces. Some owners may have a need for income and are less concerned about capital appreciation. Preferred stock or a preferred partnership or membership interest can accommodate these divergent goals. A preferred interest can be designed to accomplish various financial goals depending on the circumstances. Although an S corporation can have voting and nonvoting stock, it cannot have preferred stock. Consequently, S corporations provide little flexibility in designing a capital structure that provides different financial rights for owners.

Many business owners choose to segregate certain assets, such as real estate or intellectual property, from the operating assets of the business. Generally, this segregation is done for tax or liability reasons. Gain is triggered by distributing appreciated assets from a corporation, even an S corporation, but generally not from a partnership or limited liability company. A separate entity also can serve to insulate the real estate or intellectual property from the claims of creditors of the operating business. The asset holding company leases the real estate or licenses the intellectual property to the operating company in consideration of rents or royalties. This type of ownership structure allows a business owner to separate the assets for estate planning purposes. Business assets are converted to investment assets that can pass to the family members not active in the business.

Properly Allocate Voting Control

Allocation of control 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. As a general rule owners who are active in the business should have control. A capital structure that includes voting and nonvoting interests will allow those active in the business to control it without regard to the percentage of the overall value they own. A similar result can be achieved with a limited partnership or limited liability company because the general partner or manager controls, regardless of ownership percentage.

Care must be exercised, however, in protecting the noncontrolling owners. Minority or otherwise noncontrolling owners may need rights that give them input into compensation, dividends or distributions, operating and capital expenditure budgets, major transactions, transactions with affiliates, hiring and firing, and other significant business matters. In the alternative, noncontrolling owners can be given an exit alternative to the extent they are dissatisfied with the decisions of the controlling owners. This can include a put right that requires the redemption of their ownership interest. This put right can be tied to some level of performance by management below which the noncontrolling owners have the right to cash out. If this cash out is too harsh a result, the ownership can be structured in such a manner that control shifts if certain performance criteria are not achieved.

Communicate the Plan

After the death of the matriarch or patriarch, a new social order emerges within a family. When families are connected economically through a family business, the dynamics are more complex because the stakes can be high. Family members will have divergent views on the future of the business, each certain that his or her plan is what the parent would have wanted. Business owners must clearly communicate the succession plan with family, nonfamily owners, key employees, and the board of directors or advisors. The key elements of the plan should be documented in writing.

The plan should cover management succession, control, compensation issues, and valuation. To the extent the business is passing to family members active in the business with other assets passing to others, the parent should explain his or her reasons for the division, especially if those active in the business are receiving credit in the valuation for their efforts.

Conclusion

Business owners seek legal advice to understand the technical issues with business succession arrangements.  For certain, attorneys must understand these issues.  A succession plan, however, must operate in the family and business context.  Subjective issues abound, and the business owner must not only make the proper judgments but also communicate the plan in a manner that promotes harmony.  Helping a business owner understand the legal and tax framework for a business succession plan is a valuable and necessary service, but it is only the beginning.  Counseling the client on the human dimension is essential for a successful business transition.