The following information and opinions are provided courtesy of Wells Fargo Bank, N.A.
Legacy or Liquidity: Planning your Business Transition Strategy in an Uncertain Tax Environment Prepared by Robin Love Managing Director, M&A Advisory, Business Advisory Services Richard Watson, CFP, CHFC, CLU Senior Director of Planning, Business Advisory Services
In this white paper 1 1 2 2 2 3
Evaluating strategic alternatives Status quo Sale to key employees Sale to an Employee Stock Ownership Plan (ESOP) Sale to a financial buyer Sale to a strategic buyer
3 3 3
Is it better to sell now or wait until later? Capital gains tax reduction for 2012 A timing example—the difference a day makes
Legacy or Liquidity: Planning your Business Transition Strategy in an Uncertain Tax Environment Many business owners remain so focused on running their businesses that they engage in relatively little business transition or succession planning. However, waiting to make important planning decisions can be a costly option. The extension of the Bush tax cuts is scheduled to expire in 2013. If these tax cuts expire as planned, the amount business owners are taxed following the sale of their business could potentially be much higher. In this white paper, we explore long-term business transition options and look at the potential financial impact of ignoring important planning decisions. Regardless of future tax changes, whether gifting their ownership to heirs, selling to management or employees, or achieving liquidity through the sale to a third party, planning for the transition can help improve outcomes in accomplishing shareholder objectives. Planning also can help answer the following questions: Q
How will the trapped wealth represented by the enterprise map over to the personal lives of the owner in the event of death, disability, divorce, or, eventually, retirement?
Q
Will the entrepreneur pass the business ownership to the next generation, relying on family members to carry the business forward?
Q
Or do they prefer to receive full liquidity in a sale to a strategic acquirer?
Q
Can a private equity investor provide partial liquidity, while contributing experience to enhance the business years in advance of a second exit in the form of a future strategic sale?
Today, mergers and acquisitions are routine events in corporate life. Many high quality businesses will receive unsolicited offers from strategic acquirers seeking growth, from private equity firms hunting for robust investor returns, and even from management teams itching to unlock hidden value. As credit markets continue to improve and deal activity rebounds, how will shareholders respond to unsolicited offers? How will they maximize shareholder value if they choose to pursue liquidity proactively? When is the right time to sell?
Establishing the vision, strategy, and tactics of the ultimate transition early allows the shareholders to carefully consider the impact of the transition plan on their families, the business, and the management team. Such forward thinking also enables management to implement business enhancements long before the sale process commences.
Evaluating strategic alternatives Most business owners face a predictable set of strategic alternatives for the sale of their business, including the following: Q
Status quo
Q
Sale to key employees (management buyout)
Q
Sale to an Employee Stock Ownership Plan (ESOP)
Q
Sale to a financial buyer
Q
Sale to a strategic buyer
Each alternative has distinct advantages and considerations. The most appropriate type of transition may depend on the shareholders near- and long-term objectives, the company’s current performance, and prevailing market conditions, among other factors. Each of the above business transition alternatives are discussed in greater detail below. The practical issues associated with each transfer path are then summarized using the (Harvey Ball) diagrams that follow.1
Status quo Description. A decision to maintain the status quo represents the default alternative for existing shareholders. Shareholders retain 100% ownership of the company, maintaining full control. Doing nothing introduces no incremental risk and the shareholders continue to benefit as the company grows and prospers. The company finances expansion through internally generated cash flow and additional bank borrowings in the normal course. Shareholders continue to enjoy the benefits (and risks) of the venture. Practical issues. Status quo offers limited shareholder liquidity and wealth diversification, relegating wealth preservation and creation to ongoing business execution risk. Without input from a strategic or
Legacy or Liquidity: Planning your Business Transition Strategy in an Uncertain Tax Environment
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financial partner, the shareholders continue to go-it-alone, risking wealth by betting on favorable future operating results. Importantly, status quo may not address the liquidity needs of distinct shareholders who develop unique interests and objectives over time. Should additional bank borrowings prove necessary to fund growth, personal liability may increase as a result of the personal guarantees required by the lenders. Valuation
Liquidity
Tax Efficiency
Risk
Sale to key employees Description. In order to capitalize on the experience and loyalty of the existing management team, selling to key employees—sometimes referred to as a management buyout (or MBO)—may be a primary objective of many business owners; in other instances, it can be an important back up transition option, particularly if industry and market conditions or the company’s positioning for an external sale prove to be a challenge. Determining whether a sale to key employees is feasible requires careful consideration of a number of factors. The owner must identify potential successors within the management team and assess whether they have the financial ability and commitment to buy out the owner, which can be especially difficult. Practical issues. Unless the buyout group can secure financing for the buyout (usually from a lender or from an equity sponsor, such as a private equity group), many management buyouts involve some level of seller financing, meaning that the departing owner must carry back an installment note to help the buyout group finance the sale transaction. Since these payments are indirectly based on the continued success of the business, the owner’s remaining payments may be at risk should the business or management team experience a reversal during the seller financing period. Valuation
Liquidity
Tax Efficiency
Risk
Sale to an Employee Stock Ownership Plan (ESOP) Description. An Employee Stock Ownership Plan (or ESOP) is a special type of qualified retirement plan established for the benefit of employees. ESOPs are
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permitted to invest in employer stock and may even borrow money to buyout a shareholder, making it an especially attractive transition option in some situations. For example, business owners with C corporations who have held their stock for three years, sell at least 30 percent of their stock to an ESOP, and purchase qualified replacement property within 12-months of their stock sale can defer their capital gain under § 1042 of the Internal Revenue Code (IRC). Owners of S corporations can also use ESOPs as a transition option or for shareholder liquidity, but do not reap the same capital gain deferral benefits.2 Practical issues. While ESOPs offer many special tax benefits, including potential capital gain deferral for C corporations, they also involve increased complexity (i.e., IRS, ERISA, and Department of Labor regulations specific to ESOPs), which can increase the administrative costs of the transaction. In practice, ESOPs also face management succession, financing, and risk issues similar to management buyouts. Unless the ESOP can secure financing for the buyout (usually as a back to back loan from the company, leveraging the company’s credit facility), the sale transaction may require some level of seller financing to the ESOP trust, though the tax benefits can help to accelerate the repayment term. Valuation
Liquidity
Tax Efficiency
Risk
Sale to a financial buyer Description. Financial buyers and private equity funds acquire minority and majority equity positions in companies, build the businesses by contributing strategic and operational experience, and then achieve liquidity in a future second sale, generally two to six years later. This relatively long timeline often fits the needs of shareholders balancing the wish for near-term liquidity with the desire for participation in the future upside of the business. Selling shareholder groups with divergent interests, such as founders, second generation owners and outside executives, can mix and match their transaction liquidity and equity rollover participation based on their personal situation and objectives. Management stays in place with a focus on growing the business, frequently through acquisitions and other new strategic initiatives.
Legacy or Liquidity: Planning your Business Transition Strategy in an Uncertain Tax Environment
Practical issues. Similar to other non-strategic alternatives, financial sponsor-led liquidity events generally rely on the use of leverage to finance a significant portion of the purchase price while offering few strategic synergies. Tight credit markets, required investor returns and the lack of strategic synergies may limit the purchase price financial buyers can pay. Having new institutional partners, such as the private equity investor and senior or mezzanine lenders, can create new financial reporting and operational requirements at the Board level down to day-to-day operating decisions. Additionally, new transactionrelated debt creates default risk for post-closing shareholders and debt service may become a stressful unpleasant experience for management teams not accustomed to operating with leverage. Valuation
Liquidity
Tax Efficiency
Risk
Sale to a strategic buyer Description. Entrepreneurs and business owners focused on achieving maximum value and full liquidity seek strategic sales. A strategic sale can represent the shortest timeline to liquidity and departing the business post-closing. Facing a buy-versus-build decision, many strategic acquirers turn to acquisitions to quickly build market share and gain access to new markets, proprietary products and complementary brands. Opportunities for synergies, in the form of incremental revenue opportunities and/or expense reductions, can enhance the post-closing value realized by the strategic buyers, allowing them to pay a higher purchase price relative to other buyer types who do not reap such benefits. For strategic buyers, the current market may provide opportunities to accumulate strategic assets, especially for those with strong cash-rich balance sheets and available borrowing capacity. Practical issues. While the benefits of full value and immediate liquidity can meet key shareholder objectives, selling shareholders must come to terms with certain trade-offs inherent in a sale to a strategic entity. While the ownership change eliminates risk to current shareholders from unfavorable internal or external developments in the future, selling shareholders relinquish control of the business, face integrationrelated changes and give up participation in the future upside of the business. During the sale process itself,
the business can be exposed to a variety of risks, including competitive exposure, breaches of confidentiality and management distraction. Valuation
Liquidity
Tax Efficiency
Risk
Is it better to sell now or wait until later? As mentioned in the introduction, waiting to plan can be costly—and timing matters—now more than ever. While business owners cannot alter the inevitability of the ultimate transition, they can affect how and when it happens.
Capital gains tax reduction for 2012 Many sale transactions are structured as stock sales (i.e., as opposed to asset sales), which generally result in capital gains treatment for income tax purposes. The maximum rate on long-term capital gains is scheduled to increase from 15% to 20% at the end of 2012,3 meaning that a limited window of opportunity may exist where selling a business may result in a reduced income tax burden, as the example below illustrates.
A timing example—the difference a day makes The chart below illustrates the income tax impact of selling a $10 million business on December 31, 2012, when the maximum capital gains rate is 15 percent, versus January 1, 2013, when the capital gains rate is scheduled to increase to 20 percent. In this simple example, selling while the capital gains rate is still 15% would save approximately $500,000 in capital gains taxes.4
Long-Term Capital Gains Rate Estimated Capital Gains Taxes
December ,
January ,
15%
20%
$. million
$. million
This example clearly demonstrates the benefits of thinking about making planning decisions now. If you are a business owner approaching retirement and have concerns about how to begin the planning and decisionmaking process, please contact your relationship manager. Your relationship manager can help facilitate a meeting with Business Advisory Services (BAS), a strategic team inside Wells Fargo dedicated to working with the shareholders of private businesses and closely-held assets.
Legacy or Liquidity: Planning your Business Transition Strategy in an Uncertain Tax Environment
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End notes
Harvey Ball diagrams are often used to covey or simplify qualitative information. In the context of this white paper, they are intended to show, in a simplified but straightforward fashion, the degree to which a business transition alternative meets the criteria identified in the diagram’s header (i.e., valuation, liquidity, tax efficiency, and risk). The color white, for example, represents a lower probable valuation, less liquidity, higher taxes, and lower risk, while the color tan represents the opposite (i.e., higher valuation, more liquidity, reduced taxes, and higher risk).
S corporations do not qualify for capital gains deferral under IRC § . In planning for sale transactions, some business owners contemplate revoking their S election, so that they can qualify for IRC § capital gains deferral as a C corporation. In those situations, owners can determine if they should reelect S corporation status -years later. IRC § (g).
The maximum long-term capital gains rate is % through the end of , and % for taxpayers in the % bracket.
For simplicity, this example assumes the business interest was held long-term, is worth $ million, the owner’s adjusted basis in his or her stock is zero, and that the transaction was structured as a stock sale.
Disclosures
Wells Fargo Wealth Management provides products and services through Wells Fargo Bank, N.A. and its various affiliates and subsidiaries. The information and opinions in this report were prepared by the investment management division within Wells Fargo Wealth Management. Information and opinions have been obtained or derived from sources we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wells Fargo Wealth Management’s opinion as of the date of this report and are for general information purposes only. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Past performance does not indicate future results. The value or income associated with a security may fluctuate. There is always the potential for loss as well as gain. Investments discussed in this presentation are not insured by the Federal Deposit Insurance Corporation and may be unsuitable for some investors depending on their specific investment objectives and financial position. This report is not an offer to buy or sell, or a solicitation of an offer to buy or sell the securities or strategies mentioned. The investments discussed or recommended in the presentation may be unsuitable for some investors depending on their specific investment objectives and financial position. Indexes represent securities widely held by investors. You cannot invest directly in an index. S&P 500 Index is a capitalization-weighted index calculated on a total-return basis with dividends reinvested. The index includes 500 widely held U.S. market industrial, utility, transportation and financial companies. Wells Fargo and Company and its affiliates do not provide legal advice. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Wells Fargo Bank, N.A. (the “Bank”) offers various advisory and fiduciary products and services. Wells Fargo affiliates, including Financial Advisors of Wells Fargo Advisors, LLC, a separate non-Bank affiliate, may be paid an ongoing or one-time referral fee in relation to clients referred to the Bank. The role of the Financial Advisor with respect to Bank products and services is limited to referral and relationship management services. The Bank if responsible for the day-to-day management of the account and for providing investment advice, investment management services and wealth management services to clients. The views, opinions and portfolios may differ from our broker dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliate of Wells Fargo & Company. Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company. ©2012 Wells Fargo Bank, N.A. All rights reserved. Member FDIC. NMLSR ID 399801 WM ( /)