Sometimes senior owners can be overzealous about transferring wealth to their successors without giving sufficient consideration to their own needs after retirement. In most cases, however, that sacrifice is not required. With proper planning in advance of substantial wealth transfers to their successors, senior owners can remain secure in retirement without undermining the success of the family business.
Investment advisors should be brought into the discussion of business succession planning to help senior owners forecast and quantify what needs they will have in retirement, and quantify the financial resources that the senior owners already have and identify additional resources outside the family business.
Living Expenses and Other Financial Needs.
A critical part of retirement planning and designing an exit strategy is determining the amount of wealth, cash flow and other economic or material resources they will need after they cease to receive compensation and profits from the family business. Some senior owners have more than enough resources for retirement and can proceed to engage in aggressive lifetime wealth transfers to their successors. Many senior owners, however, may fall within a gray area, in which they find they would be vulnerable to financial compromise if they did not secure greater resources to meet their needs in retirement.
Separate Resources.
The solution for retirement planning for senior owners likely will involve not just one resource but diverse sources of wealth, cash flow and risk management resources. Often it is best if the senior owners do not have to rely on receiving cash flow from the family business in retirement. Otherwise, they will be extracting capital that the business may need for operations or growth, and their security will be partially dependent on the performance of the business under successor management.
Separate resources are social security, medicare, and pension and retirement plans from employment outside the family business. Other potential resources are:
- Marketable securities accounts.
- Rental properties.
- Illiquid, or unproductive assets which can be sold.
- High interest debt refinancing or sale
- Insurance with appropriate face amounts and duration.
Family Business Resources.
After senior owners determine the range of resources they need in retirement to maintain their desired standard of living and after they identify and quantify the resources they have outside the family business to meet those needs, they can consider whether the family business or successor owner should contribute to their retirement resources. Owners should consider some of the following ongoing relationships or transactions with the family business:
- Fees for Services. The business can agree to pay a senior owner reasonable fees for services that he or she provides to the business. For example, the business could pay the senior owner fees for consulting services or for service on its board. If the business's lender does not immediately release the senior owner from the personal guaranty of the business's debt the business can pay the senior owner a guaranty fee to compensate for the ongoing risk.
- Rental, leasing, licensing. If the senior owner retains ownership of real estate, equipment or intellectual property used by the business the business can continue to pay the senior owner for its use of these assets. Alternatively, the business could purchase assets from the senior owner and provide cash flow in payment of the purchase price. Leasing the assets may be more tax efficient for the business than purchasing because leasing would be a current expense, as contrasted with purchasing the assets and expensing or depreciating them over time.
- Redemption or cross purchase proceeds. The senior owner's exit from ownership can be structured to provide cash flow to the senior owner in retirement or it can be structured as a virtually gratuitous transaction, or some of both.
Ownership Exit Strategy.
If the senior owner intends to sell ownership to the successor owners, the transaction should be structured in a away that allocates voting rights and equity, respectively, consistent with the succession plan and protects, as well as it can, the senior owner's right to be in full under the terms of the transaction.
1. Purchase Price. If the purchase price is intended to provide fair value to the senior owner the parties should obtain a formal opinion of value from a qualified business valuation professional. One of the advantages of working with a valuation professional is that he or she can help identify market and business risks that might affect the senior owner's ability to be paid over time. Also, if the senior owner intends to sell his or her units in stages or to allocate the voting units separate from nonvoting units the valuation professional can help model those transactions including premiums or discounts that might apply and how the units are likely to appreciate or the risk they will decline in value between each stage of an exit that involves multiple transfers over a period of years. It may be appropriate to incorporate adjustments to the purchase price such as an earn out or claw back provisions to account for superior performance by the business after the unit transfer or to allow the senior owner to benefit if the business is sold shortly after exit from ownership. For example, when the owners sells to the company successor owner, the purchase price could be set at a conservative amount but with the understanding that if the company subsequently performs better than expected or is sold for a higher price in the first few years after the senior owner's exit, then the senior owner will be paid additional sums based on a formula that has been written into the purchase agreement.
2. Redemption or Cross Purchase. The parties' accountants should participate in deciding whether to structure the senior owner's exit from ownership as a redemption or cross purchase, because it can involve important and nuanced tax issues for the senior owner, the company, and the remaining owners. Usually the purchase of a senior owner's units may be best structured as a cross purchase by specific successors rather than a redemption by the company. This is true for several reasons. First, a cross purchase allows the owner to allocate voting and nonvoting units precisely as determined in the succession plan. In contract, a redemption simply absorbs the voting and nonvoting units, accruing the benefit pro rata among the remaining owners, which, among other things, may have unintentional effects on the remaining owners' relative voting rights or economic rights.
Under many circumstances a cross purchase allows the senior owner to transfer his or her units in a series of transfers over time. In contrast, a partial redemption of a family corporation may cause the sales proceeds to be taxed as a dividend which can create additional tax liability.
3. Staged Transfers. In some cases, the senior owner may wish to begin the process of ownership succession by allowing the successor owners to purchase some portion of the senior owner's ownership units before he or she is ready to retire or relinquish voting control. The parties can agree to execute a series of transaction under which the successors acquire a grater percentage of equity in each transaction. It is likely that these transactions would be structured as a series of cross purchases, rather than redemption. For example, a senior owner could sell the successors' equal amount of his nonvoting stock in consecutive transaction with each of the later transactions closing after the successor owners have fully paid the purchase price under the prior transaction. In that example, the senior owner would likely sell his voting units in the final transaction of the series.
By transferring the units in a series of transactions, the senior owner can bring the successor into ownership gradually to test the succession process, incentivize the successor owners, and with respect to successor owners who are active in the business, focus their efforts and energy by giving them an economic stake in the business's performance.
4. Allocation of Voting Rights and Equity. Transfer of the senior owner's units should be structured consistent with the desired result for allocation of voting rights and relative amounts of owner equity under the business succession plan. Often, greater amounts of equity will be allocated to successors who are active in the business. Voting rights can be delegated to fiduciaries or otherwise separated from the allocation of owner equity. It is likely that if individual successors are investing in the equity of the company and are incurring debt to pay the senior owner for such equity, they will want to have influence on the company's governance that corresponds to the relative levels of obligation and risk they are incurring in purchasing ownership.
5. Cash at Closing. To reduce the risk to the senior owner that the successor may default on the installment payments of purchase price, the parties should explore means of maximizing the amount of purchase price paid at closing. The parties should consider a loan from a bank or other third party lender for a down payment to the senior owner. A loan for even a portion of the purchase price will be able to divert some of the risk of default away from the senior owner. Likely, the senior owner will have to agree that any promissory note she may receive from the successor owner for the balance of the purchase price will be subordinate to a third party lender. As a result, the senior owner might not be free to negotiate for the terms, security and covenants he might want for the successors' obligation to pay the balance at least until the obligation to the third party lender is fulfilled.
6. Payment Terms, Security, Covenants. Unless the senior owner has a donative intent, he should try to negotiate payment terms, security, guarantees and other commitments from the buyers that will help reduce the risk of default or will provide adequate and affordable remedies in the event of default.