Succession Planning for the Family Business:

Understanding the Process and the Strategies May 26, 2009

Why Most “Great” Plans Fail:

1.They ignore family dynamics.

2.They ignore basic business issues.

3.They are tax-driven.

4.They don’t involve “the next generation”.

5.Everyone wants to avoid confrontation.

Family Family CohesionCohesion

how the family will function how the family will function during and after a transition of during and after a transition of ownership and managementownership and management

Business Business Opportunities, Risks, Opportunities, Risks,

& Market Value& Market Valuemeans understanding enterprise value, means understanding enterprise value, need for future capital, industry issues need for future capital, industry issues and other factors that influence its futureand other factors that influence its future

Five puzzle pieces that drive the keep or sell decision

OwnershipOwnershipSuccessionSuccession

is about who will own the company is about who will own the company in the future. Those who own the in the future. Those who own the company may not be the same ascompany may not be the same as

those who run the company.those who run the company.

Governance of Family Governance of Family Wealth Wealth

is how the family develops its humanis how the family develops its humanand intellectual capital in addition to its and intellectual capital in addition to its financial assets. Philanthropy can be financial assets. Philanthropy can be

used as a used as a ““learning lab.learning lab.””

LeadershipLeadershipSuccessionSuccession

is about who will run the company is about who will run the company in the future. Should nonin the future. Should non--family be family be brought in, or the company sold? brought in, or the company sold?

Planning solutions (and governance) tend to begeneration specific

Owner-ManagersEntrepreneur or Sibling Partners

All Active

G1

Hybrid ModelFamily Shareholders

Some Not Active

G2

Advisory Board

Family Trustees, Company Officers, and a few outside

members

Governance

Rotating Board Members with staggered terms and outside

members

Owner-Investors

G3

Hand

s On

(les

s go

vern

ance

) Governance (less hands on)

OwnerOwner--Manager ModelManager Model

Typical Solutions

Installment sale to next generation (or redemption agreement) – during lifetime.

Non-qualified retirement plans for senior generation.

For S corporations, distribute AAA to manage value.

Equalization for non-active family members.

Gift and then buy-back of non-voting sharesOther assets (non-operating real estate)Life insurance

Issues

Who decides who can and cannot work in the company?

Will daughters have the same opportunities as sons?

What to do for “non-actives”?

Business valuation issues.

Financial burdens on the business – to support growth and fund senior generation’s retirement needs.

Who will be CEO among siblings?

OwnerOwner--Investor ModelInvestor Model

Typical SolutionsVoting Trusts (for S Corps), Family Partnerships (for C Corps), and Generation-Skipping Trusts with investment committees empowered to vote family business stock

Sale of stock to defective trusts; life insurance purchased for estate liquidity

Family councils and family committees for policy decisions

Compensation agreements for key people – phantom stock and SAR plans

Benchmark company performance –enterprise level business valuations

Experienced outsiders on board of directors

IssuesWhere to draw “the line” between family and business?

How to educate uninvolved owners?

Time involved in managing shareholder relationships

Fair compensation for family (and non-family) executives

Family perceptions regarding risk and strategic growth

Cash flow needed for distributions vs. retained for growth

Hybrid ModelHybrid Model

Typical SolutionsRecapitalizations and creation of new non-voting shares

Voting rights (on major decisions) for non-voting shareholders

Shareholder Agreements with puts and calls

Provisions if the company is sold to a third party

Voting shares gifted, or sold, to family in key positions

IssuesHow to give non-actives some “voice” … but not too much?

Compensation and perks for actives may become a source of contention

What if actives feel it’s “their”business?

Can checks and balances be placed on those running the company?

How to avoid freeze-outs and shareholder conflict?

Will shareholder agreements create forced sale scenarios?

Hurdle: Evolving from an Entrepreneurial to a Professionally-Managed Business

Organizational Culture and Values

Profit Orientation and Accountabilities

Leadership and Management Development

Budgeting

Innovation

Information and Communication

Key Focus Key Focus AreasAreas

Using a Leveraged ESOP

• To business owners the ESOP is … a buyer of stock and/or a means to start succession planning.

• To employees the ESOP is … a company funded retirement plan and an incentive to act like owners.

• To companies the ESOP is … a technique of corporate finance, a tool to increase productivity and provide a qualified retirement plan.

Escrowed shares

Leveraged ESOP

(1) Bank lends money to ESOP with company guarantee. (2) ESOP buys stock from existing shareholders. (3) Company makes annual tax-deductible contributions to ESOP which in turn repays bank. (4) Stock is held in suspense account and released as loan is repaid. (5) Employees collect stock or cash when they retire.

ESOPESOP

Contributions15% of covered payroll

Loan

Tax-free rollover

Sells shares

Cash

Financial Institution 1

2

3

4

Corporation

Bank

Qualifying replacement securities

• Management changes only if shareholder/manager chooses to leave

• If done in stages – less leverage, less interest expense than an MBO or LBO

• Board of Directors retains control of company

• Not an all-or-nothing alternative

Why ESOPS are Popular –Business Succession Strategy

Why ESOPS are Popular – Liquidity

• Owners can sell all or part of their shares

• Can spread sale of shares over years

• No change of control

• No third-party participation

• No uncertainty of outcome

Why ESOPS are Popular –Defer Gains on Stock Sold

• Pay capital gains now (only on shares sold) and reinvest anywhere or spend the money, OR

• C corporation owners – can elect §1042 rollover and defer capital gains tax (restrictions apply)

• S corporation owners – can defer capital gains by receiving seller note instead of cash – pay tax as principal is paid back

• C corporations only

• Privately-held companies only

• ESOP must acquire 30% or more of the stock (cumulative)

• Seller must reinvest the proceeds within 12 months

• Reinvested funds must be Qualified Replacement Property or “QRP”

• Tax-deferred continues as long as seller holds QRP

• Shareholder must have owned shares for at least 3 years

§1042 Tax-Deferred Rollover

• ESOP’s share of S corporation earnings is exempt from unrelated business income tax (UBIT)

• Taxation is delayed until distributions are made to ESOP participants

• Thus, a 100% ESOP-owned S corp would NEVER pay income taxes

Benefits of S Corp ESOPs

• No tax-deferred treatment on owner’s sale of stock to the ESOP

• Interest and forfeitures are included in 25% of the company contribution limit

• Must meet “broadly based” test (§409p) – in general, need more than 10 employees

Limitations of S Corp ESOPs

• On ordinary issues – ESOP Trustee(s)

• On special issues – ESOP Participants

Vote as a group

On merger, consolidation, recapitalization, liquidation or sale of substantially all corporate assets

No voting rights on sale of stock for cash

Employees only vote allocated shares

Voting Rights of ESOP Trust

• ESOP exploratory committee to be formedHire legal counsel and appraiserFairness Opinion - separate from appraisal

• Borrowing rate determined (if ESOP is leveraged)• Trustees

Administrative Committee

• Voting of shares (as trust fiduciary)Voting reserved to committee

• Repurchase liabilities projected

• Contribution limits determinedExample: $7,000,000 covered payroll x 15% = $1,050,000 of eligible contribution deduction

$1,050,000 will amortize a $4,600,000 ESOP loanAssume loan term of 5 years at 7%

ESOPs Require Ongoing Planning

In summary, the right ownership structure should align family and business interests

• Agreement on goals and objectives for the businessGrowth ratesTolerable risk levelsExpected returnsNon-financial benchmarks

• Timely and accurate information

• Leadership consciously cultivated/CEO succession

• Competent, empowered management teamPerformance-based compensation

• Formalize family ownershipLinkage between company and family, roles and responsibilities, role of the BoardManaging tension: leadership, politics, expectationsLiquidity for shareholders and capital for growth

Succession Planning for the Family Business:

Understanding the Process and the Strategies

We are Brown, Edwards & Company, L.L.P., a regional accounting and consulting firm, serving our clients’needs since 1967. Our mission is to provide business management and tax saving solutions as a necessary extension to traditional accounting and tax compliance services.

Notification as required by the Standards of Tax Practice: Tax information contained in this document is a discussion of relevant issues and is not rendered as a covered or reliance opinion. Therefore it is not intended or written to be used (and cannot be used) for the purpose of avoiding penalties that may be imposed by any tax authority.