Succession Planning for Small Business Ralph T. Mooney, CPA Mooney & Thomas, PC

What is Succession Planning? It’s a process, just like all other planning Objective is the graceful exit from business ownership Lack of Planning can lead to undesirable results – Business failure – Last one out, turn off the lights

Why Does SCORE Care? Succession Transactions are business sales, just with a different name Circumstances are unique, but elements are similar to other business transactions – Valuation – Deal Structure – Tax Considerations

Why Does SCORE Care? If you are counseling someone about the purchase of a business, the factors always come into play. If someone is contemplating starting or expanding their business, plant the seeds for a successful transition

What’s Included in the Plan? Buyer Candidate (often relative or employee) Business should be positioned for sale – Operations need to be configured to go forward in absence of the owner – Very difficult thing for an entrepreneur Realistic estimate of value Willingness to negotiate

Three Elements of any Transaction Appropriate valuation Reasonable Deal Structure Tax Consequences

Business Valuation Basics Standard (Premise) of Value – Fair Market Value – Fair Value – Strategic Value – Forced Liquidation Value – Orderly Liquidation Value

Valuation Approaches Asset Approach Market Approach Income Approach

Asset Approach A business is worth the total value of its assets Limited Use – Holding company – May be liquidating – No recent history of profits If assets include operating companies, another method may be used on them

Market Approach Similar to many real estate appraisals Based on sales of comparable companies Most theoretically sound Availability of data is very limited There are databases, but true comparability is elusive

Income Approach Method used most often for small business valuation Value estimate derived from a return-on- investment perspective Requires two pieces of data: – Estimated annual income ($$) – Desired rate of return, considering risk (%) Dividing rate into income yields value indication

Income Approach (continued) Simple example of how it works: $10,000 face value bond with 6% coupon rate Risk of default indicates higher return required Target rate of return = 10% Annual income of $600 divided by 10% return ($600 /.10) Bond Value is $6,000 Oversimplification, but concept is there

Income Approach (continued) Need to establish expected annual income – In small business, look at history (5 years, usually) and modify – Modifications for non-recurring income and expenses – Modification for owner compensation-either over- or under-compensation, based on actual work done – Modify average for trends, up OR down

Income Approach (continued) Estimating appropriate ROI %: – Rate is risk-based – Higher rate yields lower value – Compensates buyer for relative risk of investment Rate should be determined with objectivity Valuation experts often use “Build-up” method Information available from Morningstar, Inc.

Income Approach (continued) Discount Rate Build-up: – Starts with “risk-free” rate--20 year US Treasury bond rate is commonly used – Add Equity Risk Premium—long term excess of equity return rates over risk-free rate – Add Industry risk premium or subtract industry risk discount (negative risk) – Combine 3 components and you have objective portion of build-up

Income Approach (continued) Discount Rate Build-up (continued): – Final step--recognize risks unique to subject company (specific company risk premium) – Most significant factor is size—very small size can add 10% or more to discount rate – Other risks (1% to 5% each) Limited management pool Dependence on a few large customers Low barriers to entry (additional industry risk) Any other identified concern

Income Approach (continued) Discount rate must be converted to capitalization rate: – Capitalization rate is discount rate, reduced by sustainable growth rate – Most small businesses cannot reliably predict sustainable growth rates – Result is: discount rate = capitalization rate

Income Approach (continued) Indication of value is expected annual income divided by the capitalization rate Inverse of capitalization rate is multiple I’ve often told clients to use a 3x to 6x multiple on profits to estimate value (cap rate of 16% to 33%) More realistic rule-of-thumb in current environment is capitalization rate of 30% to 40%, or multiple of 2.5x to 3.5x

Transaction Structure Two types of deal structure: – Stock Sale – Asset Sale Stock sales can only occur if corporation Proprietorship must be asset sale Partnership interests MAY be sold, but rare— usually asset sale

Transaction Structure (continued) What do the parties want? Sellers want a stock sale if possible – Lower tax likely Buyers want asset purchase – Avoid seller’s liabilities – Avoid UNKNOWN liabilities – Better tax benefits

Transaction Structure (continued) Unique structure if an “inside” succession – Stock sale if buyer is relative or employee – Sell small amount of stock to buyer – Corporation buys back balance of stock – Both parties benefit Seller gets capital gain Buyer gets built-in financing ―Seller can be protected with escrow for stock until paid

Tax Considerations Seller wants a stock sale for tax reasons – Sale of stock results in capital gain, subject to a more favorable rate – Sale of assets often results in recapture income where all prior depreciation is reported as income in the year of sale-even if part of price is deferred – If seller is a corporation, sale of assets can result in double tax, once at corporate level and again at shareholder level

Tax Considerations (continued) Tax differences for the buyer: – A stock purchase doesn’t usually generate any deduction until stock is re-sold – Somewhat different for S corporations – An asset sale will result in write-off for depreciation of equipment, etc. (5-7 years) – Section 179 (immediate write-off of assets) is currently limited-may be expanded again

Tax Considerations (continued) Other tax-related issues: – Sometimes deals get re-negotiated (including price adjustments) simply to allocate tax burdens equitably – May allocate some of price to consulting agreement—effective when consulting is actually occurring – Parties have adverse tax interests and they really do pay attention to taxes if they want the deal to happen

Tax Considerations (continued) Special tax issues for “inside” succession – Sometimes, inside deals are discounted for a variety of reasons – If buyer is employee, significant discount could be considered to be compensation by IRS – If buyer is relative, significant discount could create exposure to gift tax – Both issues are possible, but don’t happen often because valuation is so imprecise

Conclusion Business succession is one flavor of selling/buying a business Valuation, transaction structure and tax issues are common to all business transfers Planning is key for the seller to have his/her exit turn out well You can help with that

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Succession Planning for Small Business Ralph T. Mooney, CPA Mooney & Thomas, PC