Transcript Succession Planning for Small Business

Succession Planning for Small
Business
Ralph T. Mooney, CPA
Mooney & Thomas, PC
[email protected]
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
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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-oninvestment 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 overor 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)
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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
QUESTIONS?
Succession Planning for Small
Business
Ralph T. Mooney, CPA
Mooney & Thomas, PC
[email protected]