Steven L White

This is not a real Will. It merely suggests what could happen if a business owner does not have a
properly structured and funded succession plan for his or her company. All names referenced are
fictitious and any similarity to any real party or business is merely coincidental.

I , John Smith, presently residing in the State of New York, and part owner of Acme Widget Company, being of sound mind and memory, do hereby declare the following:
1. I hereby leave my interest in my company to my family to be divided among them as they see fit even though my spouse or children have no experience in operating and running a widget company. I have the utmost confidence that after my death, everyone will get along with each other, and that Jack Jones, my partner who owns a portion of the company, will have no problems working with my spouse or children.
2. I hereby leave the responsibility of operating the company to my surviving partner, Jack, whom I am sure, will not mind working twice as hard and sharing all of the profits of the business with my family.
3. In the event my family wants to sell my company to Jack, I hereby leave it up to them to work it out with Jack as to the price and terms of the sale.
4. In the event such a sale takes place and the sales price is paid out over a period of time, I have the utmost confidence that Jack or his estate shall pay my family the terms of the sales contract even if Jack dies or becomes disabled.
5. In the event my family wants to sell my share of the business to an outside party, I hereby direct that they negotiate any terms they want without consulting Jack, and request, but do not demand, that Jack get along with any other new owner of the company.
6. If I have a buy-out agreement with my company or Jack that has not been recently updated, I direct that my family sell my interest in the company at whatever price the old agreement says, even though it won’t reflect current fair market value.
7. In the event Jack or the company has no life insurance on my life, I really don’t care if Jack or the business becomes insolvent and cannot afford to pay my family the buy-out price.
8. I hereby direct the IRS to ascertain the value of my interest for estate tax purposes. I am sure the IRS, as a division of the government, will consider the needs of my family when determining any estate tax attributed to my business holdings.
9. I direct that all lines of credit that my business has at the time of my death be paid off at my death because I think the interests of my lenders are more important than those of my family and my business partner.
10. If I leave my business interest to my family and federal estate tax is due, I know my family will work twice as hard to pay the taxes due to the IRS and any state taxing authority.
11. If all or part of my business interest passes to my minor children upon my death, I direct my children’s guardian or trustee to sell the business as quickly as possible, regardless of price, because I do not want to burden my children’s guardian or trustee with the fiduciary responsibility of running a widget company.
IN WITNESS WHEREOF, I, John Smith, do hereby affirm this to be my wishes with respect to the business I spent
my lifetime building.   

The foregoing information regarding estate, charitable and/or business planning techniques is not intended to be tax, legal or investment
advice and is provided for general educational purposes only. Neither Guardian, nor its subsidiaries, agents or employees, provide tax
or legal advice. You should consult with your tax and legal advisor regarding your individual situation.

Steven L. White Jr.

Wealth Strategies Group

Many owners of small companies know intricate details about all facets of their business, from sales and marketing to payroll and personnel. Yet, they rarely know one of the most critical facts of all – how much their companies would be worth if they were put on the market in the exit and succession planning phase of their business plan.  Determining the “fair market value” of a business is important not only when the owner is putting up a “for sale” sign; it also can affect long-range planning. For example, succession planning can help a business owner make arrangements for transferring shares to a partner or heir through a buy-sell agreement funded with life insurance. To determine the buy-out price and fund it with adequate insurance, it is necessary to know how much the business is worth. At the death of an owner, the value that passes to heirs often is of great interest to the IRS in calculating capital gains and estate taxes.   To obtain an analysis of business value, small businesses may wish to hire a professional appraiser. This individual or company will use techniques described in this article to establish an objective opinion on value. This determination then can be used in a variety of planning applications and may eventually help the owner achieve a higher sale price or lower tax impact after a sale. 

From Fair Market Value to Book Value-The goal of a methodical business valuation process is to arrive at a clear and supportable estimate of “fair market value.” Under a section of the Internal Revenue Code, this is defined as: “…the price at which the property will change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having a reasonable knowledge or relevant facts.”  In 1959 the IRS issued a revenue ruling that identified specific factors that can influence fair market value. They include the nature of the business, the economic outlook, book value, earnings, dividends, goodwill and recent prices paid for similar businesses.  

On an accounting level, the most basic measure of worth is book value – defined as balance sheet assets less liabilities. However, most businesses are sold at prices well above book value, because the balance sheet shows assets at original cost less accumulated depreciation, not true replacement value. For example, suppose a piece of machinery was purchased for $50,000 five years ago and the accumulated depreciation has been $15,000. The balance sheet carries this machine at a value of $35,000, even though it could cost substantially more to replace it at today’s prices. Generally, only in distressed businesses does book value provide an accurate indication of fair market value. 

Enhanced Valuation Tools-Most business appraisers use more sophisticated valuation methods than book value, let’s take a look at a few of these: Capitalization of earnings – The calculation begins with annual earnings over one or more years. It then divides earnings by a “cap rate” that reflects the cost of capital and the risk of the company. For example, suppose a company has average annual earnings of $200,000 and a cap rate of 10%. Its estimated value under the capitalization of earnings method would be $200,000/10% = $2 million.   Discounted cash flow – This method, often used to value new businesses or companies with volatile earnings, begins by forecasting future earnings over several years. To account for the time value of money, a discount rate is then applied to each year of forecasted earnings. The discount rate reflects a weighted average cost of capital for similar companies. Finally, a discounted residual value is established at the end of the forecast period. The business value is the sum of all discounted cash flows over the forecast period plus the discounted residual value.  Comparables and Discounts – Some appraisers modify their estimates of value based on an analysis of recent sales of comparable companies in the same market or industry. Under any valuation method, results may be discounted to account for a reduction in value due to a minority interest (less than 50% of a company) or lack of marketability – the inability to resell shares quickly or easily in a competitive market. Small private companies often qualify for high marketability discounts.  The cost to conduct a comprehensive business valuation can range from a few thousand dollars up to $50,000 or more. Regardless of the cost or methods, it is important for the process to be conducted objectively by a qualified professional based on facts. Normally, the end result of this process is a document in which the appraiser describes the methodology and provides an estimated fair market value that will satisfy the scrutiny of the IRS and courts. In turn, this estimated value is a useful input for the owner in developing succession, estate or personal retirement planning. 

An appraisal also may help owners pursue steps for increasing business value over time. As economic cycles and market conditions change, so may the value of a business – and it can be useful to update the process and valuation outcome every few years.   In summary, although many business owners have a vague idea of what their companies are worth, most are merely guessing – and over time, wrong guesses can prove costly. In the worst case, not knowing fair market value could cause owners to sell businesses for less than they actually are worth. For these reasons, the cost to hire a professional business valuation process usually is money well spent.  

Steven L White

The equity that small business owners build in their companies represents a valuable personal asset. But in a privately-held company, how can equity be converted to liquid cash when the owner exits the business?  Creating an exit plan (or “succession plan”) is an integral part of strategic business planning. This writing will help business owners understand why a succession plan is important; how to begin the process; and how to put the plan into action. 

There is a tax Impact at an Owner’s Exit. Succession planning aims to achieve an optimum outcome for the business (e.g., passing ownership to an heir or selling the company) while also converting business equity into liquid cash when it is needed. This goal is important for two reasons: First, at retirement, business owners usually want to enjoy their leisure time or pursue other opportunities. Second, after giving up control, they don’t want to worry about the health of a company they have left behind. An owner’s heirs may lack the expertise or interest to manage the business. At the owner’s death, they would like to receive cash to increase their own personal financial security, and perhaps also to meet income and estate tax obligations.   

 The value of a business passed to non-spouse heirs is included in the owner’s estate at death and could be subject to federal estate taxes. These taxes must be paid in cash, and the filing deadline for federal estate taxes is nine months after the date of death, unless an extension is requested. So, even if heirs do not need or expect a business to produce immediate cash after an owner’s death, federal and state governments require cash to settle taxes. In the worst cases, valuable businesses have been put on the market at “fire sale” prices just to meet estate tax pressures. Aside from taxes, heirs may need cash for other needs including business debts and obligations, the cost of business appraisals, audits, and the cost of closing down the business and paying severance to employees. Almost every business needs a pool of liquid cash to work through a period of transition in ownership. Providing this cash is one of the most important steps in the succession planning process.  

One starting point for business succession planning is to ask and answer three questions:  What is the business worth now on a “fair market value” basis? Fair market value is the amount that a willing buyer would pay a willing seller in an arm’s-length negotiated transaction. A business appraisal conducted by a qualified professional can help to answer this question. What will the business be worth when the owner exits? Any future growth in revenues or profits should increase business value. Owners also can increase value by making provisions to groom one or more successors.  How will heirs obtain a fair value for the business when the owner exits?

A solution called a buy-sell agreement pre-determines the terms of a sale (including transaction price) and also provides the cash necessary to complete the sale and pay expenses and taxes.  A buy-sell agreement may be formed between two co-owners or partners, who each agree to buy out the other’s interest. Alternatively, it may involve the current owner and a designated successor owner, perhaps a family member or top manager. Most buy-sell participants lack the resources to pay “cash on the barrel” to buy a valuable business. Without planning, they may be capable of completing the transaction only by: 1) borrowing heavily; or 2) paying in installments over time. Since most business owners and their heirs prefer to receive cash at the closing, it is necessary to define the source of the cash well in advance. Often, the primary source is permanent life insurance. After a successor is determined, the next step is to determine the buy-out value. While small business owners have some flexibility in setting the price of a buy-out transaction, the IRS and courts may insist on a valuation that represents fair market reality, as determined by an accepted method.

The methods include: Comparable recent transactions– Business value is based on the terms of sales or mergers involving companies of comparable size in the same industry or market area.  Multiple of revenue or book value – Business value may be pegged to a multiple of gross revenues in the year or two just before the owner exits. For example, many service-oriented businesses sell for about one to two times annual gross revenues. Or, the value may be pegged to an audited balance sheet as a multiple of “book value.” Discounted cash flow—the value is based on total cash flow that the business is projected to generate for a period of years (typically three to five) after the owner’s exit, discounted by a cost of capital.

The next step is to formalize the buy/sell arrangement through a written agreement with the help of an attorney experienced in succession planning. Ideally, this attorney also has some proficiency in estate tax planning and business valuation. An important section of the agreement defines the “trigger events” that will require ownership to change hands. Common trigger events include an owner’s death, disability, retirement, divorce, or separation from employment. When a buyout is triggered by an event other than death, the legal agreement also may include provisions that prevent the departing owner from competing against the company or disclosing its trade secrets.  

Next is to Provide Funding to assure that the Agreement is Carried Out: Permanent life insurance typically is used to fund buy/sell arrangements because coverage can continue, and premiums remain affordable, at any age. Funding buy/sell arrangements with permanent life insurance also has other benefits: Quick and convenient cash for heirs – Life insurance solves the problem of turning an illiquid asset (the business) into liquid cash for heirs or estate settlement. Tax advantages – Life insurance pays a death benefit that is free of federal income taxes. In buy/sell arrangements, the benefit is usually paid to either a surviving party or else the company itself, so the death benefit does not create estate tax consequence for the estate of the deceased. Affordable, level premiums – Permanent life insurance can be purchased at affordable level premiums, especially when the insured person is fairly young and in good health. Cash value—the cash value of a permanent policy can provide buyout funds if an owner exits at a trigger event such as a divorce or normal retirement. Most agreements include provisions for terminating the buy/sell by mutual consent or if specified events occur. In this case, policy’s owner can recoup part of the premium cost from cash value.  

In addition to an owner’s death, another trigger event that can be pre-funded with insurance is an owner’s long-term disability. In this case, disability income insurance can be purchased to fund an obligation written into the buy-sell agreement. This insurance pays to the beneficiary a stated amount of lump-sum or periodic income (after a waiting period) that can be used to fund part or all of a buyout. In summary, business owners rarely stop working long enough to ask why they are working so hard. But there will come a day when this question will become paramount. Ultimately, a small business may not maximize long-term success for the owner and heirs unless the owner plans ahead to reap the rewards. Tip-the best time to begin forming your exit and succession strategy is upon the formation of your business. If you are beyond that period it is my experience and the experience of fellow collegues that 5 years before the event may give you enough time to form and implement a succesion strategy that provides maximum results.

Steven L White