The spring edition of Decosimo Advisory Review introduced the concept of strategic transition planning, describing the three types of buyers for a privately held business: family members, the management team, and third parties. In that and the summer edition of DAR, we included case studies about a transition to a third party and to a group of key employees. Following is an example where Decosimo assisted an owner/manager in a successful transition to family members.
Recently, one of our clients approached us for advice on how to transition their business to a second generation while retaining key employees. The client is the founder of a successful manufacturing business. His goals were to transfer ownership of the business to his two children while incentivizing several non-family key employees. The two children had the management ability to operate the business and the financial wherewithal to purchase the business, which simplified the process. After discussing these goals with the client, we developed a transition plan to maximize the owner and family’s after-tax value from the transition.
STRATEGIC FAMILY TRANSITION
The first part of the plan addressed how we could tax-efficiently transition ownership to the children. We planned a series of transfers of ownership, which would reduce the client’s ownership to less than 50%. Consequently, his interest, which would ultimately become part of his estate, (as well as his children’s interests) became noncontrolling (minority) interests.
For tax purposes, an interest in a business is valued at fair market value (FMV). FMV is the price at which the interest would change hands between hypothetical willing buyers and willing sellers. If an interest lacks control, a rational buyer would pay less than that interest’s pro rata amount of the total equity value of the company as if he/she owned an amount able to control the business (51%). Because a minority investor is unable to control the operations, cash flows, and distributions of the company, a minority interest in a business is typically worth less than its pro rata share of the value of the business as a whole. This explains the phenomenon we see when publicly traded companies are purchased outright or taken private at per share values in excess of their trading prices (a control premium).
In addition to a discount for lack of control, which adjusts entire company values to minority interest (as if freely tradable on the public markets) values, minority investors in privately held companies also suffer from a lack of marketability of their interests. Investors in minority interest in public companies can liquidate their investment on a “cash in three days” basis. Minority investors in privately held companies, on the other hand, face an uncertain and potentially long holding period until they realize the value of their investment. The impact on value of this uncertain and potentially long holding period is expressed as a Discount for Lack of Marketability (DLOM).
If the elder generation of a family holds on to ownership of the business until death, the entire company is in the estate and the company is valued at the controlling interest level of value for estate tax purposes. However, when smaller interests are gifted over time, the value base on which taxes are calculated is related to the value of the transferred interest only (determined after discounts for lack of control and lack of marketability) rather than as the pro rata value of the entire company. In the case of this client, we completed this through a series of transfers that resulted in the client owning 49% of the company.
MAXIMIZING AND RETAINING VALUE
Through performing the valuation for the first transfer and discussing the business with the client, we were able to identify some areas in which the client could increase the value of his company. The main area was eliminating key employee risk. The client’s business had a few key managers who were a vital part of operations. In addition, because of the proprietary nature of the company’s products, a key manager that left would be able to compete with the business using their knowledge of its processes.
To illustrate this, a few years ago one of the key employees left the company and formed a competing business. Not only did the company lose this manager’s expertise, but it also now had competition with similar knowledge and processes. Fortunately, as part of our transition plan, we had recommended that the company obtain noncompete agreements that prohibit such activities. As such, the company had a legal cause of action from which they could shut down the competing operation.
Since STP is an ongoing process, we reassessed the company’s current method of managing key employee risk. While the company had created disincentives for the key employees to leave, it had not created additional incentives for key employees to stay, nor had it incentivized them for optimal performance.
We suggested that the client institute an employee bonus plan to accomplish this. Because the client needed to allow variation within the plan between employees, we knew that he needed a nonqualified bonus plan. Nonqualified bonus plans do not meet the IRS’s qualifications to be a deferred compensation plan so contributions are not generally deductible. This feature makes the plan more costly.
However, recent regulatory changes have allowed for some new types of nonqualified plans, including the Leveraged Index Bonus Plan (LIBP). The LIBP provides a deferred benefit to the employee that is funded by life insurance. The plan requires an initial bonus by the employer and a second bonus to cover the tax liability generated by that bonus (payable by the employee). However, significant portions of the first and second bonus are covered by a non-recourse loan to the employee that is secured by the life insurance policy. The employer’s portion of the first and second bonus is thus reduced to a significantly smaller payment to cover the interest on the loan. Since the company’s expenses are to cover interest, they become tax deductible. The “Index” part of the plan is the life insurance policy, which provides equity index returns with a cap and floor (a typical Leveraged Bonus Plan (LBP), would not have this aspect).
In sum, the plan provided a benefit (contingent on remaining with the company) that would help the business retain and incentivize its key employees in a cost-effective manner.
The result of the STP process was our client transferred ownership in a tax-efficient manner. Additionally, the company reduced the risk of losing key employees by providing a bonus plan that aligned employee incentives with owner interests.
At Decosimo, our STP service utilizes a team of individuals with experience and specialized knowledge in the various aspects of transitioning family businesses. If you would like to discuss the transition of your business, please call us in confidence at 800.782.8382.