Case Small Business With Capital Needs

CASE #10. DATE: June 27, 2021

FACT PATTERN:

Bob started his business- a drill machine shop, with himself and one other worker-10 years ago. Currently, the business has 11 employees and is remarkably busy and receiving orders constantly and the future is bright. Half of the business comes from the state government as they have done work for the agency for many years. Bob has taken out loans for the growth of his business and has refinanced his home. He has an attorney and accountant. The company has a 401k plan and a good health plan. After we went through the Blueprint Issues[1]  , the owner admittedly has concerns that he has neglected his financial planning, putting most of his focus on his business. 

One Page Problem: 

  • At death, his estate is responsible for the debt; over $256,000– his estate is stuck with a business loan since he signed personally- this is now his spouse’s problem.
  • The business does not have a succession plan- this is a problem at death
  • No evaluation of the business:  For Estate and State taxation, and ultimate sale- This can mean a piece meal sell off. Competitors are not motivated to pay higher than discounted rates for assets affecting the ultimate value the asset will receive on liquidation
  • The owner has no will or distribution plan- 2nd marriage, 2 children and 2 stepchildren- Intestate law distribution. Spouse would be sharing assets with children- Client wants spouse to receive property.
  • Other issues- to work on in the future. These were the priority currently

One Page Solution: [2]

Based on the above issues we suggested the following to work on: 

  1. Updated estate plan:  Estate attorney to draft and execute wills, a bypass trust, healthcare directives, durable power along with other important documents.
  2. Apply for life insurance for the following purpose: 
    1. Family income and capital debt payment
    1. Business key person life insurance
    1. Based on the value of the business, the trust may end up being an irrevocable trust in which the trust will own the life insurance
  3. Start the process of getting a business valuation complete since one has never been done- for the purpose of future business succession planning 

If you would like to have a FREE QUICK ASSESSMENT OF WHERE YOU ARE IN YOUR BUSINESS PLANNING, CLICK THIS LINK, TAKE 1 MINUTE TO ANSWER THE QUESTIONS.  I WILL SEND YOU A FREE REPORT ON OUR FINDINGS. CLICK   YOUR   FREE ASSESSMENT


[1] Set up 16 major areas of concern for business owner which we address to see if there are issues to attend to. 

[2] This was the beginning of the planning. There were other issues to work on. These are the issues currently being planned.

Beneficiary Designations Can Become Very Critical Errors in Your Estate Planning!

 

June  2021  

Beneficiary Designations Can Become Very Critical Errors in Your Estate Planning!   

In all of the years that I have serviced my client’s planning their estates, one of the most important areas of the planning is making sure they are aware of the beneficiaries of their property.   

Many times, they have older life insurance and annuity contracts which haven’t been reviewed over the years, consequently, their family dynamics may have changed, and updating is necessary.  

The life insurance beneficiary and estate beneficiary are not exclusive to the planning.  Other property should always align with the overall planning, however, in this article, I want to focus on some of the pitfalls in naming beneficiaries, as this is, in my opinion, the most common mistake made in planning, not updating beneficiaries.i   

  1. Not thinking about the financial ability of the beneficiary to handle the inheritance they will receive. For example, they could be minors, incapacitated, or just uniformed in their thinking about finances, a bad marriage, and a host of other situations.  That being the case, a trust makes sense as they are flexible to design and can be amended over time. 
  1.  They are an adult, but you just don’t have the confidence that leaving a large sum of money to them is the right thing to do. Example:  leaving $500,000 to a 21-year-old son.  This will usually end up being a nightmare.  Again, a trust can be a great vehicle to control the outcome of paying the lump sum directly. 
  1. Leaving a large amount of money to your elderly sibling, or parents.  They are usually next in line to have to deal with the Medicaid system.  There are other ways of leaving the property to help them for future income and lifestyle needs, which will not jeopardize the asset to the Medicaid system.  
  1. Not naming contingent beneficiaries.  Should the primary beneficiary listed not be living at your death, the assets will pass to your estate versus to the next in line.  Naming contingent beneficiaries guarantees that should your primary beneficiary not be living at your death; the contingent beneficiaries will receive the assets.   
  1. Not naming “per stirpes” to your beneficiaries if you want your beneficiaries’ issues to receive the asset, should the beneficiary not be living.  Example, leaving asset to your child, if living, if not living, to their issues (your grandchildren).  

Tax ramifications are important also, Example, you want your two children to receive $125,000 each from your $250,000 IRA.  Child A has little income and is in the 12% income tax bracket.  They will pay $15,000 in taxes (Fed). Child B is a professional making over $450,000 a year.  They will pay much more in taxes, example 35% or $157,000.1 

Child A will pay $15,000 taxes on the IRA and net:  $110,000 and $150,000 (life insurance) = $260,000 

Child B will pay $37,500 taxes on the IRA and net $87,500 and $150,000 (life insurance) = $237,000 

In this case, more of the IRA could be left to child a with less tax than child b up to $329,000 before they hit the 24% tax bracket.  The equalizer would be to leave more of the life insurance tax free payment to child b, and less of the taxable IRA.  When you work it out, you would help save taxes on the IRA by 11%.   

There are many more Pitfalls which I can share with you, however, these seem to be the most common ones that I run into.   

For a free report on “Six Biggest Mistakes When Setting up A living Trust;” Requestion Report #9 in the Drop-Down menu>. We will send it to you immediately.   

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You Saw It Coming And I Saw It Coming, We Both Saw It Coming…But we still bought it!…

After fifty years of running a tremendously successful planning firm, WORKING ONLY eighty days a year, I can make this statement with full confidence!  

Every business owner deserves success and financial independence when they give all they must to build a business.  NO issue here.  If done correctly they will enjoy financial independence and an abundance of leisure time which I call “your beach”.   

What gets in the way of preventing a business owner from becoming financially independent and finding their “own beach”, are two things:   

First Reason: The business owner has their hands in everything. Nothing gets by them.    They work eighty hours a week and wonder why they have no time for themself or families.   They believe you must work “hard” (to them that means anything that keeps them busy).   While they are doing insubstantial work, they are neglecting the important work (The Business and Financial Key Elements to Their Business).   

Second Reason Archaic and falsehood beliefs that business owners “bought into”, such as.  

  • Your inventory and your receivables are like money in the bank,  
  • You must work hard in the early years so you can slow down in the later years 
  • Take every dime you have and invest it in your business 
  •  You need to invest in your business in order to grow 
  •  Every business needs time to grow 
  •  You can’t grow fast 
  •  Borrow as much as you can 
  •  It’s a lot of money, but it’s a write off 
  •  When you go into business you initially spend more money than you want to 
  •  You need to invest in your business   
  • Plow all your profits back into the business   
  • You don’t need to give your key people additional benefits 
  • “It’s easier for me to do it, I’ll do it the right way” attitude 
  • If I train someone to do it, they may leave me and start their own business 
  • You don’t need a business valuation just use a simple formula 
  • I have all the systems in my head, we don’t need a document 
  • I’m not worried about leaving the business, they will figure it out 

Falsehoods, and archaic business principals   do more to destroy businesses than a bad economy.   If you don’t fix this situation, no matter how hard you work; YOU WILL NEVER GET TO YOUR FINANCIAL INDEPENDENCE AND “YOUR BEACH”.   It’s that simple!  

But the good news is that you can correct these problems by using a technique that has worked for me and my business clients for over fifty years.    It’s called the “ONE PAGE BLUEPRINT SOLUTION”, and it only takes TWO HOURS MONTH (two lunch breaks) to implement and correct the two major reasons why business owners can’t become financially independent and find their “own beach.”    

To help you learn more on how you can eradicate the two reasons, I am offering a free copy of my eBook called, “Unlocking Your Business DNA”, (Cracking the code to a better business, bigger profits and more time on the beach).   THIS BOOK WILL help you understand the principals discussed.  Limited supply.  To receive your FREE EBOOK, CLICK.

* Book can be purchased on Amazon; Kindle and Paperback. All profits go to Wounded Warrier Project.

**Full Steam Ahead (title; You Saw It Coming)

Compensation of Business Owners! The Good And The Bad!

Owners of small private companies normally receive income as a salary, rather than dividends, and capital gain on the sale of their stock. They also receive other compensatory benefits. In many cases, the business owners can receive rental income from property and assets leased to the company and owned personally (either outright or in trust) by the business owner.  

Because of the tax structure of the company, business owners often find it more tax effective to pay the compensation, rent, royalties from their company to the owner, at the high end of the scale, rather than the low side (common in C Corps).  

A Detriment to The Owner When There Is an Exit 

Receiving this higher scaled income and rental, may have some advantages for tax purposes, and the creation of wealth.  

Having the tax advantages for the business owner, may be a detriment to the selling price during exit planning. This is because the rents and compensation paid to the owner on the higher side lowers the net income of the business.  

When rental and salary compensation are paid on the elevated level, they affect the net income/or net operating cash flow, which creates a downward impact on the selling price! 

At the Time of Exit Transition 

The owner must justify the payout of rental income, compensation, royalties, and other compensatory income. They need to justify the overpayment of this compensation. In a way, the owner must back track the justification of paying the enhanced payouts in the stated areas of compensation. This may put the owner in a position of receiving nondeductible “constructive dividends” paid by the company, resulting in a retroactive tax liability.  

Minority shareholders of the company could complain that the enhanced payments to the owner’s transgression of overpayments is a breach of a fiduciary duty owned to them. Since the over self-generous payouts to themself, there is an effect on the stock value. Consequently, minority stockholders are going to be affected by depressed value. This concerns stock bonus to minority stockholders and key persons.  

One of the solutions to this issue is to start to shift part of the enhanced payouts to more of a mid-level range of the fair market value. This will allow you to enhance the net income/net operating income for the company.  

Along with enhancing the net income and net operating income for the company the shifting of revenue to middle-management, will build a stronger management team.  

Diversified Customer Base, and Operational Procedures, and Systems And Their Importance!

Diversified Customer Base:  Related to the customer base, if customers are too concentrated representing more than 10% of sales. Or, if the company has too few customers which are representing most of their sales.  

This is a particularly important value driver! 

Private Equity firms will often discuss the key value drivers of a company, such as Next Level Management (NLM), operational systems, and diversified customer base 

While there are nine major value drivers, Diversified Customer Base (DCB), is one of the most important for maximizing the potential return and value of a company.  

DCB, typically is where no single client accounts for more than 10% of the total sales. By doing this, it insulates the company from a loss of a major company. It also stabilizes the cash flow and makes it predictable for future planning.  

Any buyer would be concerned if the company they were considering purchasing had 45-55% of their sales in 2 or 3 clients. The purchasers would have a legitimate concern if any of the clients left as it would have a significant impact on the cash flow.  

There would also be a concern if the major clients had a loyalty to the key person or owner, and not the business itself. Since there would not be diversification in the customer sales percentage, a future purchaser would see this as a greater risk factor, and one to avoid.  

To increase the client base, the company may have to consider other markets, services, and products. Going back to having a NLM team, makes implementing a diversity program much easier, with the focus on creating a larger client base, and not one that is very concentrated on a few clients.  

Operating System 

Operating systems that improve and sustain cash flows are a key element in the future value of a company.  

It is extremely important that the business has established and standard business procedures which can keep profitability after the business is sold, and without the current owner.  

Having the ability as an owner, to show potential purchases, that there are procedures, and that they are procedures that work, is of tremendous importance.  

A company would benefit from creating and documenting systems and processes in all the aspects of the business. This ensure consistency of execution or delivery and creates sustainable competitive advantage.  

Documenting systems and processes are such a crucial factor in building company value as it creates the ability for the owner to leave their company on great terms and gives them the potential to receive the highest potential value for their company.  

Critical Step Needed To Create An Exit Strategy! Part 1 

Some business owners think that selling their business is a matter of getting an appraisal and putting the business on the market hoping for a good offer.

Many business owners that I have worked with initially assumed they knew the value of their business and what they could sell it for.

Through our education process they realized there is much more to selling their business, then just the establishing a value and then going to market.     One of those factors or variables is whether the business owner needs the business value for their future retirement, most do!

Helping the owner figure out what they need for retirement is critical in establishing what they need to sell their business for, and what action is needed to increase the future value of the business (Value Drivers).  In this article I will cover two of the seven steps that  are the most critical when planning a future exit from the business.

Whether the sale is one year or ten years from now, these are the steps needed to sell  a business.

  1. Must identify the Exit Objectives (why, when, and in some cases who) 
  2. Identify Personal and business financial resources; (this is part of the future financial security of the business owner and their family).  
  3. Maximize and Protect Business Value
  4. Ownership Transfer to Third Parties
  5. Ownership Transfers to Insiders
  6. Business Continuity
  7. Personal Wealth and Estate planning

In this post I will cover steps 1-3, and cover steps 4-7 in the June issue.  

In comprehensive Exit planning, (when you break the process down it looks like this):

Your Exit Objectives

  • Building and preserving business value
  • Selling your company to a third party
  • Transferring your ownership to insiders

Your Business and Personal Financial Resources

  • Business Continuity
  • Personal wealth and estate planning

Owner’s goals and aspirations are

  • Financial Need
  • Overall Goals
  • Value based goals
  • Defining the owner’s goals and aspirations shows the client’s wants and needs and identifies what is  important to the business owner. By spending time collecting this information from the business owner we establish a strong relationship, while differentiating you, and allowing you to be the quarterback of the plan.

Accurate information from the owner is critical to planning.      Calculating what the GAP of resources the owner needs to have in order to supply their future retirement income is critical.  It is here where the measurement of their resources helps to decide what they need to sell their business for, to help fund the gap.    Continue reading “Critical Step Needed To Create An Exit Strategy! Part 1 “

Planning Your Business For An Exit! 

Repeatedly, when the topic of exit planning is discussed in conversation with   my business clients, they tell me they are not ready to sell their business.   In which I reply, “the moment you started your business, your “exit planning” should have started.  I get the raised eyebrows.   

Let me explain why this happens; The generic term “exit planning” has taken on a meaning of, “when I want out of the business and when I am ready to sell.”    Advisors use the term as though it was a noun, such as a piece of property.     

To me “exit planning” means: “Actions taken by an owner to create the highest potential value for their company, so when the need arises in which they wish to sell,   or make a financial transition with the company they are prepared”.   

I liken my reasoning to owning a home, keeping it up to date, and fixing problems as they arise, knowing at some point someone may knock on the door and make a great offer to buy the home.  The great offer is the highest potential value for the home.    

If on the other hand the homeowner let the home deteriorate over time, under the same type of scenario the offer the owner would have received would have been much lower, if any.    

If an owner chose to use my definition of “exit planning,” they would start at once to implement the value drivers needed for a company to create the highest potential value for the future. Creating these transferrable value drivers take time, in many cases years to implement.    

There are 8 Value Drivers:  

  1. Financial Performance:  Your history of producing revenue and profit 
  2. Growth Potential: Your likelihood to grow your company in the future and at what rate.  
  3. Structure:  How dependent is your company on any one employee, customer, or supplier?  
  4. Valuation:  Can your company control cash flow?  
  5. Recurring Revenue:  The quality of automatic revenue you collect  
  6. Exclusive control: How are you differentiated from competitors in your industry?  
  7. Customer Satisfaction: The likelihood customers will re-purchase and refer your company.  
  8. Are you needed:  How would your company perform if you were not able to work for three months?   

As you can see there is a difference in the term “Exit Planning.”  Therefore, I suggest, to everyone who opens a new business that they should start their exit planning at once, so all the value drivers needed to increase their company to its highest potential value will have time to create the value.   

 

Single Appraiser vs. Multiple Appraiser Choices

This month I wrote about multiple and single Appraiser choice.  My friend Ed Pratesi was nice enough to give me some of his thoughts, which I definitely respect due to his experience and training.   Ed, thank you for this contribution.

Ed Pratesi wrote:

I read with interest your comments on Single Appraiser vs. Multiple Appraiser choices that owners have for a BSA. I agree in part with your assessment that the single appraiser choice is preferred but I do have a number of caveats and suggest that before the number of appraisers needed is secondary to choices made before this decision. Let me explain my thoughts:

Firstly, the choice of number of appraisers almost always works, whether one, two or the three step approach – except when it doesn’t!

Prior to the determination of the number of appraisers needed is preceded by what I refer to as the education process that a business appraiser must take the owners through in order to develop an agreement and a process that will likely be triggered when an unanticipated or unfortunate event has occurred.

In never ceases to amaze me that owners will spend money on creating a business plan, invest in physical assets and talent and not spend enough time on one of the most important events that will occur in their lives – either their exit or a partners exit. My complaint is not pointed at the owners but at the appraiser called in to initially called in to assist in the valuation.

My point simply is the an appraiser needs to explain the valuation process, the valuation methods used to value a business, the applicability or not of the methods to the company, a discussion of the definition of value – (for example fair market value or fair value, more on this in a later discussion), a complete discussion of adjustments that appraiser consider in the valuation process, and what discounts could apply and the reasons for application of discounts.

This part of the valuation process is more consultative and sets the framework for the conduct of an initial appraisal and of the work product. Finally, once the appraisal is complete a meeting to discuss the results and the process is essential and should be prefeaced with scenario planning should a provision of the BSA be triggered.

The goal is to get buy-in on the process not just the number!

I hope I have addressed part of the discussion of the number of appraisers – more to follow if desired…

Ed Pratesi

Edward E. Pratesi, ASA, CM&AA, ABV, CVA

Managing Director | UHY Advisors N.E., LLC
6 Executive Drive, Farmington, CT  06032
D: 860 519 5648 | C: 860 558 0453 | F: 860 519 1982

epratesi@uhy-us.com |  www.uhyvaluation.com

www.linkedin.com/in/ed-pratesi-140b762

 

Life Insurance Proceeds In Business Valuations

If life insurance proceeds are considered as the funding vehicle, then the proceeds of the policy received following the death of a shareholder would not be considered a corporate asset for valuation purposes.(1)

It would be recognized that it was purchased for a specific purpose of funding the buy-sell agreement (BSA). IF it were considered a corporate asset, it would offset the company’s liability to fund the purchase of shares, added back as a non- recurring expense.

Treatment 1: (used as a funding vehicle, not a company asset)

Example: A company with a $10m value, has two shareholders, owning 50% of the company. The company holds a $6m life insurance policy on each owner (assuming no alternative minimum tax issues).

RESULTS: At Shareholder #1’s death, the company collects $6m of life insurance benefits. The surviving partner will receive $10m company value, and $1m of net tax-free proceeds, a total of $11m value. The deceased stockholder receives the $5m for the business.

Treatment 2: (A corporate asset)

Treating the life insurance as corporate assets for valuation purposes.

The proceeds are treated as a non-operating asset of the company. This asset along with other net assets, would be available to fund the purchase the of shares the of a deceased shareholder. Keep in mind that the expense of the deceased stockholder might be added back into income as a nonrecurring expense.  (2)

The treatment type can have a significant effect on the net position of a company or selling shareholder. There is also an affect in the ability of the company to purchase the shares of the deceased stockholder, and impact of the position of the remaining shareholders.

Company $10m, before $6m of life insurance. When you add the $6m into the value, the company value is $16m. The deceased shareholder entitled to $8m, the company pays $6m in life insurance proceeds and takes out $2m in promissory note.

RESULTS: The surviving owner, owns a company with 8 million and a note of $2 million.

Which treatment is fair? One owner ends us with $11m while the deceased owner, ends up with $5m. In treatment 2, the surviving owner has to carry a $2m debt to purchase the business. Two dramatic differences. A good reason, why the discussion should take place with your advisors.

More importantly, all parties should understand the ramifications of adding the life insurance proceeds in the valuation or using the life insurance as a specific vehicle to fund the BSA.

——————————

1. Mercer: buy and sell agreements for boomers

2. Non-reoccurring expenses: Non-reoccurring expenses can be somewhat more complex. These are expenses which is  specifically  designated on the company’s financial statements as an extra ordinary or one time expense.  The company does not expect to continue the expense overtime, at least not on a regular basis. Non-reoccurring expenses can be somewhat more complex. 

The Interplay Between the Funding Mechanism And the Valuation? 

What happens when life insurance proceeds are part of the funding vehicle of a buy and sell agreement (BSA).    

 Example 

 When a stockholder owner dies and life insurance payments are made, is the valuation of the stock being redeemed as part of the value of the company?   

The way life insurance benefits are treated in the buy and sell agreement (BSA), could lead to different estate treatment and income tax.    In both areas, the results can be dramatic.     

 Does the agreement tell the appraisers how to treat the life insurance benefits in their valuationDoes the agreement provide for the company to issue a promissory note to a deceased shareholder, and what are the terms? 

 Keep in mind, the agreement is no better than the ability of the parties and/or the company to fund any required purchases at the agreed upon price.    An agreement that is silent on this issue is like not having an agreement.  

 Life insurance  

 Generally, life insurance premiums are not deductible, and the pass through of non-deductibility can create pass-through income for the shareholders of S corporations, and the owners of partnerships and limited liability companies.  Knowing how to treat the life insurance premium for tax purposes would be important information for you.  We suggest you discuss this with your CPA.  

 Although the life insurance premium is not deductible, the death benefits generally are tax- free, notwithstanding the alternate minimum tax treatment for C corps.  

Keep in mind the funding mechanism is not actually necessary to define the engagement for valuation purposes and has nothing to do with appraisal standards or qualifications. It provides the funding for the company to afford the value, and to make sure the selling stockholder receives the value.  In essence, it’s the mechanism to fund the liability of the contract, or at least part of it.   

Wants and Needs of the Buyer and the Seller- The normal push and pull!  

The seller wants the highest price and the buyer wants the lowest price.   Without a doubt the best time to set the price would be prior to a triggering event, when both parties are in parity and neither is the subject of the trigger.  It is the best time when both parties will be the most reasonable in setting the rules of the agreements as they are both fair minded in the negotiations.   

 Funding Methods 

  1. Life InsuranceIn most cases life insurance will be the most inexpensive method for funding the death benefit part of the agreement, when comparing, self funding, and loans (including corporate promissory notes) to fund the liability, notwithstanding the ability to get a funding loan from a loaning institution.    In most of the comparisons I have done over the years, life insurance is the least expensive, most guaranteed, and the easiest method of funding for death benefit purposes. 
  1. Corporate Assets: They would have to be accumulated for this purpose, and would likely be included in the valuation, and also would be subjected to taxes during the accumulation stageWhat if the death of the stockholder occurred early after the agreement?  Would there be funds available to fund the liability of the agreement, as there would be a lack of time to accumulate the necessary net profits for the funding?   
  1. External borrowing: Depending on the company’s financial position, it may be possible to fund the purchase price by borrowing.  However, this should be negotiated in advance and before its needed.  Remember, the time to requests funds from an institution is when you don’t need them.  Also, on the other side of this funding element, is the possibility the loan covenant requesting the outstanding note balanced to be called in when there is a dramatic change in ownership and management.    The lending institution may be questioning the ability of the company’s future financial position and the ability to stay profitable.   
  1. Promissory Notes:  If this is going to be used, the terms of the notes should be in the agreement.  Although cash payments are preferable to the seller.   
  1. Combination of cash and promissory notes: Important to note:  Anytime capital is being used by the corporation, it is important not to unreasonably impair the capital of the business. Many state laws prohibit transactions that could impair capital and raise the question of insolvency.  

Without the mention of what funding mechanism is being used in the agreement to repurchase shares, lessens the value of the agreement.  Also, with stated funding, the economic or present value of the redemption price set by the agreement can significantly be reduced, because of inadequate interest or excessive risk leveled on the selling shareholder.   

  

Weak terms in the agreement of the funding mechanism diminishes the value of the agreement from the sellers prospective. However, terms that are too strong can taint the future transactions. What is clear is that it is essential for the parties to discuss the funding mechanism for the triggers of a BSA, keeping in mind both the sellers value position and the purchaser’s ability to fund the costs.