Business Trend: Business Valuation and Succession Planning
April 3, 2023
2023 Material Handling Business Trend: Business valuation and succession planning have taken on more importance as owners consider retirement and consolidation continues.
Way(s) To Go! You Grew a Successful Business, Now What?
By Alexandria P. Zeigler Schramm and Roman A. Basi
Picture this: You are on your company jet headed to a convention in Hawaii for the weekend. All of a sudden, lights are flashing and a siren is blaring. Everything is shaking. The jet crash lands on some deserted island. There’s no telling when you will be rescued, and your phone and computer are useless. What happens to your business when you don’t show up on Monday? Okay—maybe you don’t have a company jet, maybe there aren’t any tropical weekend conventions in your near future, but preparation for business succession can address a wide variety of situations for when you decide to step away from your current role, sell or pass the business along to someone else.
When considering succession, preparation is key. The process of succession planning involves strategizing to replace or pass on leadership. Who is going to take over when you step back? Would it be a key employee? Maybe the next generation wants to take over the family business. Interestingly enough, a study by the Cornell University SC Johnson School of Business estimates that only 40% of businesses pass from the first generation to the second. Further, only 13% of businesses are passed from the second generation to the third.1 Maybe you don’t have anyone in mind who is fit and willing to take over the business, so you plan to sell the company at a certain point.
Regardless of the form of transfer, you’ll need to consider the tax ramifications. The first step in this analysis would be to determine the value of your company. When buying, selling or transferring a business, this is often the driving factor of the transaction. How does one determine the value of their company? The IRS tells us that the true value of a business is the fair market value or “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, with both parties having reasonable knowledge of the relevant facts.”2
While this definition is clear in theory, it can be complex in practice. To determine the value, the business should employ a professional both familiar with the material handling and equipment distribution industry and experienced in evaluating companies. This type of professional will utilize several methods of appraising a company and weigh the various outcomes to determine a value. It is critical for the professional to be able to communicate and substantiate their calculation, both for the purposes of negotiation and potential dealings with the Internal Revenue Service.
Once the value is determined, you must decide how you want to structure your succession plan. This begs the question: How do you transfer ownership, securing the value you’ve built in a tax-conscious manner? Tax liabilities could greatly impact the amount of money you walk away with. You will best understand the tax liability of a particular plan through a Tax Minimization AnalysisTM (TMA). The TMA accounts for a multitude of factors and produces an after-tax net cash perspective of selling or transferring the company.
A well-rounded TMA will follow the transaction throughout its development so that a seller can understand the financial breakdown of each decision that they make. Such decisions may include structuring the transaction as an asset purchase versus a stock purchase, involvement of real estate in the transaction, an earn-out consideration and federal, state and local tax impact. Having this analysis equips you and your professionals to form a plan that meets your goals, protects you legally and minimizes your tax burden.
Now that you know the value of your company and you have begun to think about the tax implications of various structures of succession, you’re probably wondering how an actual succession plan plays out. When the time comes to step away from the company, you would first look at your Buy-Sell Agreement. A Buy-Sell Agreement is a contract that outlines what happens to an owner’s shares if the particular owner dies, becomes disabled, retires or chooses to leave the business.
This agreement can be drafted to fit whatever goals the owners agree upon, such as a choice to keep ownership of the shares internal by offering the other owners priority on the purchase of the shares rather than allowing the direct sale to a third party. The agreement should also spell out a methodology for calculating the value of shares. Having these measures in order will help avoid potential disputes or hard feelings when the time comes to step away.
To find the best structure, you must consider myriad factors. What does that particular owner contribute to the company? Are the other owners able to buy them out? Does the company have the cash on hand to purchase back the shares? Could the company obtain financing to pay the departing owner for their shares? How are the parties protected throughout the process? The co-owners of the company have several options to increase their interests. They might acquire the selling owner’s shares over time, increasing their ownership incrementally until the selling owner has no remaining interest in the company. Another option is a stock redemption, where the company purchases the entirety of the selling owner’s interests. The succession plan should consider these various factors and scenarios and also be fine-tuned to fit the unique needs of your company.
If you have additional questions with regard to selling your business and developing your succession plan, please contact us by email at email@example.com or firstname.lastname@example.org. Feel free to also call us at (618)-997-3436.
2. Rev. Rul. 59-60