Succession Planning for Small Business

1. Succession Planning for Small Business Ralph T. Mooney, CPA Mooney & Thomas, PC rtmooney@mooneythomas.com

2. 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

3. 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

4. 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

5. 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

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

7. Business Valuation Basics • Standard (Premise) of Value • Fair Market Value • Fair Value • Strategic Value • Forced Liquidation Value • Orderly Liquidation Value

8. Valuation Approaches • Asset Approach • Market Approach • Income Approach

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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.

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. QUESTIONS?

28. Succession Planning for Small Business Ralph T. Mooney, CPA Mooney & Thomas, PC rtmooney@mooneythomas.com