1. Succession Planning for Small Businesses
Today we are going to talk about succession planning for small businesses.
Ask yourself – If I were to die tomorrow, what would happen to my business? Is there someone who could manage the business without missing a heartbeat? Will my family be taken care of? In this presentation I am going to try to help you consider some of the answers to those questions.

2. Notice
This presentation is designed to provide introductory information regarding the subject matter covered. Neither ING nor its representatives offer legal or tax advice. You should always consult your attorney and tax advisor regarding the applicability of this information to your individual circumstances.
As we go through this presentation, please keep in mind that it is designed to provide only introductory information regarding the subject of succession planning. I cannot provide you with tax or legal advice. You should always consult with your own attorney and tax advisors regarding the applicability of this information to your individual circumstances and business.

3. Four Steps to Successful Business Succession Planning
Understanding the Need
Selecting the Plan Type
Valuing the Business
Financing the Arrangement
In general, there are four steps to successful business succession planning. First of all, there must be an analysis of the need – this includes understanding the business itself and the people and finances involved. Secondly, there is the selection of the type of business succession plan. Next, the business must be properly valued. And finally, financing arrangements must be put in place to provide the means to carry out the succession plan.

4. What’s your “Dream” ?
79% of small business owners say that they want to retain their business within the family
70% of second generation family members share the hope of retaining the business within the family *
What’s your dream? When Arthur Anderson took a survey of family businesses in 1997, 79% of the small business owners said that they wanted to retain their business within their family. Likewise, when the second generation family members were polled, 70% of them also indicated that they shared the hope of retaining the family business within the family.
Arthur Anderson, American
Family Business Survey, 1997

5. What’s the “Reality” ? Cessation rates from 1st into 2nd Generation*
But what is the reality? Despite these good intentions, only 30% of family owned businesses survive to the second generation. Even worse . . .
Arthur Anderson, American
Family Business Survey, 1997

6. What’s the “Reality” ? Cessation rates from 2nd into 3rd Generation*
When an analysis was done of the survival rate of family businesses from the second to the third generation, only 15% of the family business were still in existence. This was another 50% cessation rate.
Does this surprise you? What might be causing this high rate of cessation?
Arthur Anderson, American
Family Business Survey, 1997

7. Issues that affect Family Business Transitions
Lack of a clear, well-defined succession plan
May create conflict between family unity and the continued success of the business
Failure to address the issue of who will run the business
Failure to ensure that surviving spouse will have market for their ownership interest and sufficient lifetime income
Studies tell us that one of the most important factors that affect family business transactions is the lack of a clear, well-defined succession plan. The lack of such a plan may create a conflict between the potentially inconsistent goals of family unity and the continued financial success of the business. Another very important factor is the failure to address the issue of who will run the business – the issue of “control”. Another factor is the failure to ensure that the surviving spouse has a market for the business ownership that they have inherited and sufficient income that will reasonably last for their projected lifetime.

8. Avoid conflicts between the remaining owners and the heirs
Proper Planning Can . . .
Ensure the future succession of the business
Avoid conflicts between the remaining owners and the heirs
The reason why we are talking about these issues is that proper business continuation planning can
ensure the future succession of the business, and
avoid conflicts between the remaining owners and the family of the deceased owner.

9. What events do we need to plan for?
There are several occurrences or events that can disrupt a business –
Death of an owner
Disability of an owner
Bankruptcy or divorce of an owner
Retirement of an owner
Withdrawal prior to retirement
What events do we need to plan for? There are many events that can disrupt or put the business at risk, but the most common ones include:
the death of an owner
the disability of an owner
the bankruptcy or divorce of an owner
the retirement of an owner, and
the withdrawal for whatever reason of an owner prior to retirement.

10. What is a succession Plan?
First – The “human” issues
Second – The agreement itself:
Select type of succession plan
Figure out how much the business is worth and how it will be valued in the future
Figure out how to pay for the plan
When we use the term “succession plan” it actually has several components. First of all there is the human component. I’ll talk more about that in a minute. The second major component is the agreement itself. The agreement usually consists of at least three parts:
To put these parts together we will first have to figure out the best type of succession plan design;
We will then have to figure out how to value the business, both in the present time frame, and also how it will be valued in the future; and
Finally, we will have to figure out how to finance the plan so that it actually happens.

11. Some of the “Human” Issues
Who are the “key” players?
Has ownership been promised to anyone other than the current owners?
Which family members are currently active in the business?
What is their commitment to the business?
Has a promise been made about who will succeed to control?
Are there family members not involved in the business that want in?
Let’s look at the human issues. This is often the hardest part of the planning and the reason why many owners never get their planning finished. You need to look at your business and ask yourself:
Who are my key players?
Have I promised ownership to anyone other than my existing partners?
Are there family members already working in the business and how do I judge their commitment to the business for the long haul?
Is there a “heir apparent” for control of the business? Did I promise that person they would have control?
Are there family members or in-laws who are not currently involved in the business but will want to be a part of it in the future? This could be family members who are children or students who plan to enter the business in the future.

12. Other Important Questions
Is there a long term business plan?
Why is the business profitable?
What is its weaknesses?
What is the profitability of the business if you aren’t here to lead it?
How will the business’ creditors react if you die or become disabled?
Would you consider selling the business to key employees?
Are there any key employees who can afford to buy it?
How important is it to you to guarantee that your business will be controlled by the parties that you select?
There are many other important questions that affect the long-term survivability of the business. These include: (read slide)

13. not because something wrong was done – but because nothing was done!
When a business owner dies or becomes permanently disabled, the business itself may die or be permanently disabled on the same day –
not because something wrong was done – but because nothing was done!
Sad but true, when a business owner dies or becomes permanently disabled, the business itself may die or become permanently disabled on the same day --- not because something wrong was done ---- but because nothing was done to ensure that a workable business succession plan was put in place.

14. Select Type of Agreement
There are three basic types:
Cross Purchase
Redemption
Wait & See
Now let’s take a look at the structure of succession plans. There are three basic ways to structure a buy-sell arrangement. Cross purchase, redemption and what we call “wait & see”. I’ll cover each of these briefly.
To determine which type of structure to use, we need to look at who is obligated to buy a departing or deceased owner’s interest. If the other owners are obligated to buy, it is a “cross purchase” type of arrangement. If it is the business itself that is obligated to buy, then it is a redemption type. If both the business and the remaining owners appear to be obligated to buy, it is what we call a “wait & see” type structure.

15. Cross Purchase
An agreement among business owners to collectively purchase the interest of a departing owner at a specified or ascertainable price.
As I said, if the remaining owners are to be the purchasers, the arrangement is called a “cross purchase” plan. Upon the occurrence of a specified event (e.g. death or disability), each remaining owner buys the agreed upon portion of the ownership of the departing owner. The seller receives cash and/or notes and the buyers receive the business ownership interest in exchange. For example, on the death of a shareholder, the other shareholders would be required to purchase the deceased shareholder’s stock and the estate would be required to sell it at the price (or according to the formula) specified in the cross-purchase agreement.
One of the advantages of this type of arrangement is the fact that the purchasers obtain a tax basis in the acquired business interest which means potential tax savings at a later lifetime sale.

16. Entity Redemption
An agreement that the business itself will purchase a departing owner’s business interest at a specified or ascertainable price.
If the business itself is to be the purchaser, the arrangement is called a redemption or entity purchase plan. Upon the occurrence of the specified event, the business itself buys the agreed upon number of shares of the departing shareholder. The seller receives cash and/or a note and the business receives the stock in exchange. For example, on the death of a shareholder, the corporation would be required to purchase the deceased stockholder’s stock and the estate would be required to sell it to the corporation at the price (or according to the formula) provided in the stock redemption agreement.
One advantage of this arrangement is simplicity. Another is that the funding is provided by the business itself rather than by the individual owners.

17. Wait & See Arrangements
An agreement that permits the business owners to wait until the first death or other triggering event occurs to decide whether the business or the owners will purchase the business interest.
Besides the cross purchase and redemption types of arrangement, there is a hybrid type of buy-sell structure called the “wait & see” buy-sell. This type of structure allows the parties to wait until a triggering event occurs to see which buyer – or a combination of buyers – would best serve the objectives of the parties at that time. In this case the business would have an option to buy all or a portion of a departing owner’s interest. The surviving owners would have an option to buy any of the ownership interest not purchased by the business. And then any interest not purchased by the remaining owners would have to be purchased by the business. This structure ensures that the estate has a buyer and permits the greatest planning flexibility for the parties.

18. The Importance of Business Valuation
Valuation is the process of arriving at what the IRS calls “fair market value.”
Helps minimize conflicts between shareholders and with the IRS
Can establish value for estate tax purposes
In establishing a succession plan, it is essential to set up a method for valuing the business. When figuring out valuation, we should always keep an eye on what the IRS calls “fair market value.” This concept of “fair market value” is extremely important because if the fair market value of the business interest can be established, that will go a long way toward minimizing conflicts between the remaining owners and the departing owner or his estate and problems with the IRS. If “fair market value” is accurately reflected in the buy-sell agreement, it will likely be accepted for estate tax purposes by the IRS. I’ll talk more about this in a minute.

19. How to Value the Business?
Some possible approaches:
Agreed upon fixed price
Book Value
Earnings based valuation
Appraisal
How do we go about valuing a business? There is no right or wrong answer here. Some of the most common methods include a fixed price, book value, an earnings formula and by appraisal.
The fixed price is the simplest because the parties just choose the price they want. However, this method is rarely used because it generally does not reflect the changing fair market value of the business. In other words, the price selected today isn’t likely to still be a fair price 5 years from now.
The book value method measures assets less liabilities. This method is also rarely used, again, because it doesn’t reflect fair market value.
The earnings based valuation method generally uses past earnings and multiplies by an industry specific factor. This is a commonly used method, particularly with operating businesses.
The appraisal method requires the services of an independent appraiser at the time the valuation is needed. This method is also commonly used and is probably the most accurate method for establishing fair market value.

20. Is the Value Acceptable to the IRS?
It is important that the value be acceptable to the IRS so that
Selling price = Estate Value
Factors to consider:
Obligation to sell
Restriction on lifetime transfers
Determinable & reasonable price
Bona-fide business purpose
Arm’s length transaction
As I already mentioned, it is very important that the valuation of the business is acceptable to the IRS so that the selling price of the business interest is equal to the value that the IRS puts on the business interest for estate tax purposes.
So what can we do to help make the value acceptable to the IRS for federal estate tax purposes? The IRS has told us that there are at least 5 requirements that must be met. First, the estate must be obligated to sell the business interest upon the decedent’s death. Second, the buy-sell agreement must restrict each owner’s right to sell his or her interest without first offering the interest to the remaining owners. Third, the buy-sell agreement must set a method by which the price will be determined and the price must be reasonable under all circumstances. Fourth, the buy-sell agreement must have a bona-fide business purpose, which most will. Finally, the buy-sell agreement must be comparable to similar arrangements entered into by unrelated persons in an arm’s length transaction. If these requirements are met, the value of the business established by the agreement should also work for estate tax purposes.

21. Establishing a sinking fund Installment payments Life Insurance
How is it Financed?
Borrowing
Establishing a sinking fund
Installment payments
Life Insurance
Let’s now move on to the topic of how to finance the succession plan. The financing of a buy-sell arrangement is as important as the design of the plan itself. The best succession plan will fail if there isn’t sufficient capital available to execute the plan when the time comes. Some funding choices that can be considered include:
Borrowing to purchase the ownership interest
Establishing a sinking fund
Paying for the business interest with a note or through the business cash flow over a period of time; or
The purchase of life insurance.

22. Financing the Plan Borrowing Credit and financial strain on business
Can substantially increase costs
Credit and financial strain on business
Not guaranteed
Relying on the ability of the surviving owners or the business to borrow funds to buy the ownership interest under a buy-sell arrangement involves a high degree of risk. The loss of an owner who is often also a key employee typically impairs the credit worthiness and borrowing ability of the other owners or the business itself. This may affect the interest rate charged and will probably substantially increase the cost of funding. This also puts a credit and financial strain on the business, which may need to continue borrowing for business purposes. And finally, there is no guarantee that borrowed funds will be available at any reasonable cost at the time that they are needed.

23. Financing the Plan Sinking Fund Set-aside capital each year
Simple
Set-aside capital each year
Uses after-tax dollars
Potential Accumulated Earnings Tax
Subject to corporate creditors
Not guaranteed
Another way to fund a buy-sell arrangement is to establish a sinking fund. With a sinking fund, the business or the individual owners put aside capital each year to finance the buy-out. A sinking fund is simple to establish. The main disadvantages to using a sinking fund are the fact that it uses after-tax dollars and there will not be sufficient accumulations if there is a pre-mature triggering event. For example, if an owner dies pre-maturely, there may not be sufficient cash set aside to fund the buy-out. Another potential disadvantage can occur when a C corporation establishes a sinking fund. The C corporation may be subject to the accumulated earnings tax if the accumulated earnings and profits are in excess of the corporation’s reasonable business needs. Fortunately, funding for a buy-sell is generally deemed a reasonable business need. Finally, the sinking fund would be subject to the claims of creditors of the business because it would be a business asset. Like borrowing, because there is no control over the timing of triggering events, there is no guarantee that sufficient funding will have been accumulated at the time of a death or disability.

24. Financing the Plan Installments From Business Cash Flow
Depends on uncertain future profits
Financial strain on business
Limited liquidity for decedent’s estate
Not guaranteed
A buy-sell arrangement can also be funded with the use of an installment note. Again, this method is simple to establish. Instead of needing all of the cash upfront, when an owner dies prematurely, the remaining owners just sign an installment note to effectuate the buy-out.
One disadvantage of using an installment note is limited liquidity for the decedent’s estate. For example, an estate may owe estate taxes but only receive a small installment payment in the first year. This can create a serious cash flow problem for the decedent’s estate. In addition, the business needs to have sufficient cash flow to help the remaining owners pay the installment payments while still continuing to grow the business. If there is not enough cash to go around, the remaining owners may have to use their own personal assets to come up with the payments.

25. Financing the Plan Life Insurance
Provides the potential for policy cash values when needed*
Death proceeds are typically received free of federal income taxes
No financial strain on the buyer at the time of the purchase
Cash value accumulations can be used as a substantial down payment in the event of other triggering events (disability or retirement)
Wide variety of life insurance products available
A common method used to fund a buy-sell arrangement is to buy life insurance. Life insurance is a unique funding strategy that has the potential to provide the necessary cash exactly when needed. The death benefit provides the necessary cash upon the owner’s death, while any available policy cash values can often be used for a lifetime buy-out. Life insurance is typically received free of federal income taxes and allows the purchaser to use leveraged dollars to fund the buy-out. Why pay more to fund the buy-out then necessary? Life insurance often provides an efficient method to fund the buy-out and there are a wide variety of life insurance products to suit your particular needs.
Income tax free cash distributions are achieved by withdrawing to cost basis (premiums paid) then using policy loans. Withdrawals will reduce the policy’s cash value and may reduce the policy’s death benefit.

26. Benefits of Succession Planning
Creates a guaranteed “market” for the business interest
Allows those who are interested in continuing the business to do so without interference from the deceased owner’s heirs
Assures that the decedent’s heirs receive a reasonable price for the business interest
Provides liquidity for the estate of the deceased owner by turning the business interest into cash
Establishes the value of the business for death tax purposes
By now I hope you have seen many of the benefits of succession planning. It can
create a guaranteed “market” for the business interest of a departing owner
It can allow those who are interested in continuing the business to do so without interference from the deceased owner’s heirs.
It assures that the decedent’s heirs receive a reasonable price for the business interest.
It provides liquidity for the estate of the deceased owner by turning the business interest into cash; and
It can establish the value of the business for death tax purposes.

27. Do you have a succession plan for your business?
So, do you have a succession plan for your business? If not or if it does not have all of the elements that I talked about today, please give me a call and I will help you get your planning on track toward a successful hand-off of your business to the next generation.

28. Thank you. ReliaStar Life Insurance Company Security Life of Denver
Of New York *
1100 Woodbury Road, Suite 102
Woodbury, NY
Security Life of Denver
Insurance Company
1290 Broadway
Denver, CO
ReliaStar Life Insurance Company
20 Washington Avenue South
Minneapolis, MN
Only ReliaStar Life Insurance Company of New York is admitted and its products issued within the state of New York