The_Art_Before_the_Deal

BERNSTEIN WEALTH MANAGEMENT RESEARCH The Art Before the Deal Maximizing Personal Wealth When Selling a Business Selling a privately held business may be the most important financial event in an owner’s life. Identifying personal goals in advance can help maximize the deal’s value. Critical issues include: • The impact of key deal terms on the owner’s wealth; the highest offer may not be the best • How estate planning prior to the sale can enhance the value created • Quantifying spending needs so that plans can be implemented to meet other financial goals • The financial-planning implications of liquidity strategies other than a full sale This research paper is one in a series produced by Bernstein’s Wealth Management Group on issues of particular significance to sophisticated and affluent investors and their professional advisors. Bernstein does not offer tax or legal advice. Investors should consult their tax and legal advisors. BERNSTEIN WAS ESTABLISHED IN 1967 to manage investments for families and individuals. Today, we oversee some $55 billion in private-client assets and offer global portfolios in stocks, bonds, hedge funds, private partnerships, and real estate. Investment planning is at the heart of Bernstein’s assetmanagement principles. Along those lines, we’ve developed proprietary planning tools to help our clients make betterinformed decisions about the issues that concern them most. Among such issues are retirement planning, complex asset-allocation strategies, annual budgeting, single-stock strategies, multi-generational financial planning, and philanthropic gifting. Our goal for each client is to assemble a portfolio that best suits his or her long-term wealth goals and risk-tolerance parameters. Each of our clients’ portfolios is tailored to his or her specific needs, yet all share the goal of maximizing return over full market cycles at a controlled risk level. Each portfolio is managed according to strict buy/sell disciplines, and all are driven by fundamental research. Tax considerations are integrated into our decision-making process, as appropriate for each client. For most clients, we advocate portfolios that are diversified among imperfectly correlated asset classes from the world’s capital markets. Bernstein Wealth Management Research 1 Significant Research Conclusions For many owners of privately held companies, selling their business represents the culmination of years of work and offers the prospect of financial security for life. Our experience has shown, however, that without strategic financial planning prior to the sale, an owner may not realize its full potential. By defining personal objectives and putting a few key strategies in place, an already lucrative transaction can become a golden opportunity—without slowing down the sale process. Bernstein has developed an analytical framework designed to identify the critical alternatives when selling a business. By integrating potential deal terms, key tax- and estate-planning strategies, and the business owner’s financial goals, the owner and his team of advisors can, we believe, most effectively extract maximum value from the deal. While the model is best used on a personalized basis, our research has uncovered some global themes: • The sale of a business often allows the owner’s spending, legacy, and philanthropic goals to be met—but not always, particularly if strategies to meet them are not mapped out at the beginning. The solution is to ensure that sufficient assets will be set aside to address the owner’s top financial priority (often his spending needs), and then work out plans for meeting his other critical needs—all prior to the sale. • Generating the most value from a transaction is not necessarily tied to finding the highest sale price. Often, the maximum benefit can be gained by making a few critical decisions in advance. These decisions include: ■ Weighing the safety of cash against the tax deferral and greater return potential of a stock transaction. A stock deal may seem more lucrative, but its additional risks need to be factored in, including exposure to price fluctuations before the deal is consummated and the imposition of a lockup period. Evaluating key estate-planning strategies, which often yield maximum benefit if implemented before rather than after the transaction. A careful evaluation of the owner’s goals and anticipated sale proceeds can help determine the types of family or charitable trusts to establish— whether to use a GRAT, a CRT, or both, for example—and the amounts to allocate. Considering various exit or liquidity strategies other than a straight 100% sale—such as the sale of a minority stake in one’s business, a leveraged recapitalization, or sale to an employee stock ownership plan. Key financial-planning questions arise with these strategies, including how much of the owner’s stake to sell. ■ ■ Daniel J. Loewy Robert A. Weiss, CFA Key Contributors: Research Director, Wealth Management Group Director, Wealth Management Group Christopher J. Clarkson, Brian D. Wodar 2 The Art Before the Deal: Maximizing Personal Wealth When Selling a Business 1. THE PROBLEM AND THE OPPORTUNITY Many owners of closely held businesses have spent a lifetime building their enterprises, creating a storehouse of value. In some cases, the company was founded by a prior generation, thereby becoming an extension of the family’s reputation. When the prospect of a sale is explored, it’s no surprise that emotions can run high. On the one hand, these sales tend to be seen as the owner’s ticket to financial security—the proverbial pot of gold at the end of the rainbow. At the same time, a business owner may worry about losing control over his income and the size of the legacy he’ll leave behind. This is typically a life-changing event for the owner, requiring profound financial decisions. financial goals up front, he provides his team of advisors with the information needed to tailor the transaction properly. This is not only a business proposition, but a personal one—complicated by the fact that it can take many paths. What may be surprising is that such preparation before the transaction doesn’t have to be onerous; the main thing is for the owner to take those first steps. Complexity Is Manageable This study starts with a discussion of setting goals, prioritizing them, and quantifying the likelihood of achieving them. These goals are then considered in an evaluation of deal terms— because some deal structures are better suited than others to meet certain personal objectives, and often can be modified to fit the owner’s needs more closely and with less risk. Further, because business sales offer a great opportunity to shore up one’s family or philanthropic legacy, we highlight the value that different trust strategies can add, particularly when considered prior to, rather than after, the transaction. We conclude by evaluating the financial-planning issues that arise when an owner considers selling less than 100% of his business because he’s unwilling to give up control completely or because he’s gradually preparing for an inter-generational transfer. The foundation of much of our analysis is a proprietary wealth forecasting model that integrates capital-markets behavior (based on history and research-derived projections) with the owner’s individual circumstances. While the size of the transaction is, of course, critical, we focus throughout our study on extracting the maximum benefit for the owner, given his unique situation, regardless of the deal amount. In our view, this approach not only helps create the best deal for the business owner, it also helps make deals happen in the first place. Personal Objectives Shouldn’t Take a Back Seat In the high-stakes environment of a sale— evaluating offers, trying to close, overseeing the interests of the company and the employees— business owners feel pressure to focus their efforts on the critical business issues, asking themselves questions like: What is my business really worth? What is the right deal structure? How do I make sure the deal closes? These are all key questions that must get addressed by the owner and his deal team. Often it’s not until after the sale closes that the owner addresses more personal concerns: Did I get enough to meet my financial objectives? What estate and trust strategies should I consider? How should I invest my financial assets? But it’s crucial to address these questions before the deal—or the owner risks leaving very large sums of money on the table. By bringing his personal Bernstein Wealth Management Research 3 2. SETTING GOALS An investor’s goals for his wealth can comprise a long, complicated list. Yet, when reduced to their essentials, there are really only four things people can do with their money: spend it; give it to the people they care about; give it to charity; or send it to the government in the form of taxes. Some of these goals will be in competition with others, so a business owner must weigh his priorities: Is a more luxurious lifestyle the priority, or starting a new business? Passing on a large legacy to his heirs, or establishing a charitable foundation? Should he stay involved with the business, for example, or get out—or something somewhere in between? Such decisions will naturally be major drivers of the strategies adopted. DISPLAY 1 Even if an owner just wants to maintain spending at his customary rate, his outlays would have to increase with inflation in order to preserve his purchasing power. Long-term, that could have a corrosive effect: At a modest 3% inflation rate, expenditures today would grow by 81% in 20 years. Underestimating the cost of funding their spending needs can cause former business owners to be more aggressive with their other goals than they can actually afford. Proper planning can help ensure that reserves are set aside for all financial needs—spending, family, charity, and so forth. The first step in that planning process is to quantify the amounts needed for each of those buckets. Consider, for example, an owner who believes he can clear $20 million after taxes from the sale of his business; he’s planning based on a 20-year horizon, and he wants to be confident that he’ll be able to meet his spending needs. Our wealthforecasting tool can help him by modeling the returns from a variety of asset allocations in 10,000 market scenarios ranging from very good to disastrous. The result is a probability distribution of outcomes that the owner and his team can use as a framework for decision-making. In Display 2, on the next page, we use the estimates from our model to answer the question, “How much money will the business owner need to reserve from his sale to meet his long-term spending needs (all growing with inflation)?” Because meeting that particular goal is critical to him, he wants to have a 95% level of confidence: He doesn’t want to have to worry about it. In effect, since he expects his after-tax sale price to be $20 million (in cash), we’re asking if that amount is enough to support his future spending level, and if so, how much will be left over to meet other needs? We consider three different spending levels, and assume that the sale proceeds are invested in a diversified 60/40 stock/ bond mix.1 The Four Places Your Money Can Go Personal Lifestyle Family Charity Government Address Spending First For most investors, the primary task is to ensure that their lifetime spending needs will be met. And many business owners assume the size of the deal alone will guarantee there will be more than enough. Often, they’re right; but not always: They may underestimate their spending needs— especially since former business owners generally find themselves with more free time than they’re used to and a stockpile of assets to draw from. 1 Unless otherwise noted, diversified stocks throughout this study are comprised of 70% U.S, 25% developed foreign, and 5% emerging markets, with the U.S. component 50/50 growth/value; bonds are intermediate-term diversified municipals. See Notes on Wealth Forecasting Analysis, pages 20–22, for capital-markets and inflation assumptions. 4 The Art Before the Deal: Maximizing Personal Wealth When Selling a Business DISPLAY 2 Assets Needed Today to Fund Goals Over 20 Years* $20 Mil. in After-Tax Sale Proceeds $1.1 For Spending $6.3 $13.7 For Other Goals Annual Spending Rate:† $300K $600K $12.6 $18.9 $7.4 $ Million $900K *95% confidence level †Grown with inflation and after taxes Based on Bernstein’s estimates of the range of returns for the applicable capital markets over the next 20 years. Assumes all proceeds are reinvested in a 60/40 stock/bond mix. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting Analysis, pages 20–22, for further details. The results for this owner vary, depending on the extent of his spending: • With a $300,000 annual outlay (grown with inflation) and a 60/40 mix, we estimate that the owner would have to “reserve” a minimum of $6.3 million of his sale proceeds to be highly confident he will meet his spending needs. If the owner gets his $20 million price tag, he’d have a notable $13.7 million remaining to use for other purposes. • Even with a $600,000 annual spending hurdle, in our assessment a 60/40 mix would still leave the owner with over $7 million “extra.” • To assure meeting a $900,000 spending requirement (with a 95% level of confidence), however, he’d have to reserve virtually all of his sale proceeds. Over the 20-year period in question, assuming all his assets came from his business sale, he’d have only $1 million left to fund all his other needs. If he exceeded that, he’d have to look outside his sale proceeds altogether. critical context for what resources remain for other purposes—to establish a trust or family foundation, for example, or to grow his personal assets to a desired amount over time.2 And as we’ll see, if such determinations are made before the negotiations begin, the deal terms themselves— including the amount of risk and return potential they bring with them—can be tailored to meet the owner’s goals. An analysis like this offers dual benefits. It suggests to the seller how much he’ll need to set aside as a “lifestyle fund,” as it were. It also provides The Team Approach A business owner considering a deal offer should have a team of professionals advising him: an investment banker, a corporate attorney, a trustand-estates attorney, and an accountant, to name a few. Their know-how and the sophisticated tools they employ are essential in evaluating any transaction. Bernstein’s role is one of providing expertise in integrating the intricacies of such planning with investment advice, and facilitating that effort with rigorous quantitative modeling to put the alternatives into the context of a personal financial plan. This approach can make the team’s recommendations more robust and the resulting planning more effective. 2 Certain trust strategies allow for the grantor to retain an interest in the assets within the trust. When that’s the case, assets needed for spending may be at least partially funded from the trust—a possibility that should be incorporated into the financial plan. Bernstein Wealth Management Research 5 3. MATCHING DEAL TERMS TO THE OWNER’S PERSONAL NEEDS Many deals are straightforward, with the proceeds all coming in cash on the day the deal closes. Some offers include a significant amount of stock in the acquiring company, and in those cases other issues may arise: Will the proceeds be fixed at the time the deal closes, or vary based on the performance of the acquiring company’s stock? Will the stock be subject to a lengthy lockup period (during which time selling is prohibited)? And whether stock, cash, or both change hands, contingencies may be added to the deal: Some of the proceeds may be payable in installments over time, for example, or include “earn-outs” based on the company’s operating performance. Such deal-term variants can have material consequences for the owner’s future cash flow. So the deal must be evaluated carefully—and from two different perspectives: the value offered for the business, and the impact of the terms on his personal investment plan. Failure to do so may lead to unnecessary risks or missed opportunities. may be of less value. But another owner with substantial outside assets might favor the riskier stock deal for its higher reward potential. Consider two competing offers—one for all stock, one for all cash. The stock deal is worth $35 million but comes with an 18-month lockup (although one-third of the shares are tradable every six months). The cash deal is worth 10% less, $31.5 million. In both cases, the proceeds when available are diversified into a mix of 60% stocks and 40% bonds. Both deals are expected to close in six months. Which offer is superior? Our analysis of the value that can accrue to the owner at the expiration of the lockup period can be seen in Display 3. In the median case (the Level of Confidence DISPLAY 3 5% 10% 50% 90% 95% Portfolio Value After Taxes Following 18-Month Lockup; Net Proceeds Reinvested 60/40 Stocks/Bonds $ Million $48.5 $32.9 $27.6 $23.3 $31.6 $20.0 Cash or Stock? An issue often faced by a seller is how to compare cash versus stock offers, and mixtures of the two.3 Not surprisingly, which is more advantageous for a given owner depends on what he’s trying to achieve. A cash deal may be preferable for one owner because of the ironclad safety of the payment—even though ultimately the transaction Cash Deal Pre-Tax Proceeds: $31.5 Stock Deal Pre-Tax Proceeds: $35.0 Assumes all proceeds from sale are reinvested in a 60/40 stock/bond mix; proceeds subject to a lockup are diversified into the same 60/40 mix once the lockup period ends. Based on Bernstein’s estimates of the range of returns for the applicable capital markets over the next two years. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting Analysis, pages 20–22, for further details. Getting the Most Out of Our Wealth Forecasting Charts Our wealth forecasting tool is designed to quantify a range of outcomes, given a specific set of financial circumstances— 10 or 20 or 30 years after the sale of a business, for example. To help understand the results, we array them graphically (see, for example, Display 3 above). Each box represents 80% of the outcomes, as forecast by our tool. The number in the middle is our estimate of the median result: An investor could reasonably expect to wind up with that amount or more half of the time. The number at the top of the box indicates the investor’s upside potential. We estimate the likelihood of achieving those results or better at 10%. Conversely, an investor would be confident of achieving at least the amount at the bottom of the box 90% of the time—a measure of the downside. The two vertical lines at the top and bottom of the box represent an additional 5% of the possible outcomes, respectively—though better and worse could occur. In our judgment, arraying a very wide range of outcomes for whatever scenario is being modeled provides a valuable perspective on the potential results. 3 Throughout this study, we are assuming that the stock of the acquiring company is publicly traded, and that it is a large-cap company. 6 The Art Before the Deal: Maximizing Personal Wealth When Selling a Business numbers represented by the dot in the middle of the boxes), we’d expect the all-stock deal to best the all-cash deal by $4 million after taxes. But it’s important to look at the range of scenarios. The bottoms of the boxes and below can be regarded as downside cases: outcomes that we’d expect to see only 10% of the time. In this case, we estimate a downside of $23.3 million for the cash deal, compared with $20 million for the stock deal. Despite the higher initial price of the stock offer, cash is more protective. That’s because there’s always a chance that the acquirer’s stock will fall—perhaps meaningfully—before the deal closes or during the lockup period. And so we’re left with a classic trade-off. full advisory team. At first, the situations of the two owners appear to be very similar: Each is the sole owner of his or her business; they are the same age, and have analogous family situations. They both regard 30 years as their investment time horizon, and both plan to sever association with their companies—using $10 million of their proceeds to fund a major new undertaking. But their differences are just as striking and provide the perspective the team needs to make the proper recommendations. One, whom we’ll call “the philanthropist,” is planning to use the $10 million to fund a charitable family foundation. The other, “the entrepreneur,” wants to use the same amount to start a new business venture. The philanthropist spends less than the entrepreneur—but has much more in outside assets. These underlying differences trump the similarities; in fact, our analysis suggests that the best choice of deal terms for one (stock for the philanthropist, cash for the entrepreneur) might be a big mistake for the other. Two Owners, Two Offers But the analysis doesn’t stop here. While there is no single answer as to which deal is better, a clear choice usually emerges when the specific circumstances of an individual seller are closely examined. Consider the case of two owners of separate manufacturing companies, each receiving two offers: one in cash, the other in stock (Display 4). For our purposes, we’ll assume that each owner has received the cash and stock offers described on page 5 ($31.5 million in cash, $35 million in stock), and that each is utilizing the services of a DI S P L A Y 4 The Philanthropist: Building a Long-Term Legacy Over the years, the philanthropist has built up a sizable portfolio for himself and his family from his earnings. With $10 million available to him outside the sale of his business, he already has Case Study: Different Owners, Different Recommendations Deal Options: $35 Million in Stock or $31.5 Million in Cash “The Philanthropist” Age Family Liquid Assets (exclusive of business) Allocation of Liquid Assets Annual Personal Spending Needs* Time Horizon Critical Goals for Sale Proceeds “The Entrepreneur” 52 Spouse, two grown children $1 million 60% stocks/40% bonds $500,000 30 years $10 million for new venture; secure family’s spending 52 Spouse, three grown children $10 million 60% stocks/40% bonds $350,000 30 years $10 million to fund family foundation; supplement legacy Team Recommendation *Growing with inflation Stock Deal Cash Deal Bernstein Wealth Management Research 7 more than enough to meet his spending needs. In fact, over his long 30-year investment horizon, there is a 90% probability that he will still have at least $4 million left after taxes, exclusive of the proceeds from the sale. Therefore, with a high degree of confidence he can use all his sale proceeds to fund a charitable family foundation and build a larger legacy for his children. As we’ll see in the next section, this highlights an opportunity for him and his advisors to help meet these goals through the use of certain trust vehicles. What’s more, because he’s not depending on the deal proceeds for his family’s needs, he’s willing to take on some uncertainty in exchange for a higher return potential.4 And he’s aware that much of the stock can be diversified in a family foundation’s tax-free environment. With all this information in hand, the advising team recommends going with the stock deal. DISPLAY 5 “The Entrepreneur’s” Portfolio Value After Taxes and Spending Reinvested 60/40 Stocks/Bonds Year 30 Cash Deal Initial Value: $31.5 Mil. Median Downside* 36.0 11.7 Stock Deal Initial Value: $35.0 Mil. 53.2 0 Difference $17.2 Mil. Running out of money *Value at the 90th percentile level of confidence Assumes all proceeds from sale are reinvested in a 60/40 stock/bond mix; proceeds subject to a lockup are diversified into the same 60/40 mix once the lockup period ends. Based on Bernstein’s estimates of the range of returns of the applicable capital markets over the next 30 years. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting Analysis, pages 20–22, for further details. Stock Deals: Reducing the Uncertainty We’ve been assuming so far that these business owners can choose between stock and cash deals. But that isn’t always the case. What if, for example, the only offer available was for all stock? Would the entrepreneur be required to accept a deal that might not meet her needs? She could reduce her planned investment in the new venture, lower her spending—or wait for higher offers for her business. (Though of course there’s always a danger in waiting for a better deal that might not develop.) But chances are she wouldn’t be forced to take any of those less desirable measures. Deal terms are often flexible, and she and her advisory team might be able to make adjustments that would likely safeguard her from financial jeopardy. For example, the entrepreneur’s deal team might try to negotiate one of five commonly used strategies designed to cut stock risk either before the deal closes, during the lockup period, or both: • “Floor-and-ceiling” on the offer price: Setting a minimum value that the seller will receive regardless of the acquiring company’s stock price prior to closing (say 85% of the $35 million). A maximum value may also be included to The Entrepreneur: Lifestyle Needs Predominate At first glance, it looks as though the entrepreneur should do the same. The additional value from the stock deal (diversified into 60/40 stocks/bonds) compounds over her 30-year time horizon, offering a median result for her entire portfolio of $53 million, versus $36 million if she’d taken cash (Display 5). On the flip side, if the markets go poorly, the stock deal could potentially leave her with nothing—versus almost $12 million from the cash deal. Given the entrepreneur’s circumstances, she must be prepared for a downside event: The new venture she’s interested in carries significant risks, and she has relatively few assets besides what she’ll receive for her business. Therefore, she wants to make sure she extracts enough from the current deal to ensure her lifetime spending needs. At $500,000 annually, growing with inflation, those needs are substantial. If she chooses stock over cash, she may fall short of meeting her financial goals. 4 This assumes that over time the philanthropist diversifies the single-stock position he’s acquired (whether in his personal portfolio or as part of establishing a trust). Our research indicates that the average single stock’s long-term growth rate is likely to lag the market (as represented by the S&P 500); over the 20 years ending in 2003, the shortfall was 2.7 percentage points annualized. For more detail, ask your Bernstein Advisor for our research study, The Enviable Dilemma: Concentrated Stock—Hold, Sell, or Hedge? 8 The Art Before the Deal: Maximizing Personal Wealth When Selling a Business reduce the acquirer’s risk (say 115% of the $35 million). This tactic addresses the risks prior to close, which in this case was assumed to be a six-month period. • Fixed dollar value of stock: Negotiating a fixed price that the owner will receive at the sale. Though the lockup risk remains, the entrepreneur would be assured of receiving $35 million in stock at close. • Receiving a portion in cash: Arranging for the acquirer to pay some of the proceeds in cash. The entrepreneur’s team might, for instance, negotiate a 20% cash payout. Obviously, this lowers risk—during both the pre-close and lockup periods. • Hedging after the sale: Negotiating the ability to hedge a portion of the acquired stock posttransaction, which can be beneficial since certain hedging vehicles can reduce lockup risk and preserve some upside participation. For example, the owner may be able to establish a collar (simultaneously selling a call and buying a put) or enter a prepaid variable forward contract (similar to a collar but with the added benefit of a large up-front payment to the investor for immediate diversification).5 • Softening the lockup provision: Receiving shares with a lockup period shorter in duration than the initial offer calls for, or applicable to fewer shares. (For the purposes of our case study, we analyze the effect of reducing the number of shares subject to lockup by 50%.) A Closer Look | Getting Paid in Installments If a seller is willing and able to wait to receive his payout, his team may be able to boost the ultimate value of the deal. A common strategy is for the buyer to enter into an agreement with the seller to pay part of the price up front in cash and give the seller a note payable for the remainder, with interest, over time. In return for his willingness to accept such a deal, the owner can generally realize a higher sale price (and, in addition, usually postpone paying some of the capital-gains tax on the sale proceeds). Indeed, according to the Federal Reserve, this kind of “financing” plays a role in more than half of all business sales. A second common strategy for deferring payment to the owner is known as an earnout: a contractual arrangement in which a minimum purchase price is set, with the seller entitled to more if the business reaches certain sales or earnings goals within a specified time period. This arrangement may be motivated by disagreement between buyer and seller about how much the company is worth, or it may be a stipulation by the buyer to ensure the seller’s continued interest in the company’s well-being. In that case, an earn-out is generally accompanied by some sort of employment or consulting agreement. Although that may not align with an owner’s initial plan, the financial incentive could cause him to reconsider. There are, of course, no free lunches. Although getting paid over a period of time—or in line with the company’s performance—can add to the deal’s value, these arrangements also add risk: The company could miss its note payments or its financial targets. While the additional risk to the seller versus a complete, immediate sale can never be expunged, we can place it in a planning context: determining whether the seller can withstand the risk by measuring how it might affect his highest-priority goals. If the owner is depending on the “extra” earnings to fund critical needs, he’s adding vulnerability to his longterm financial plan; whether that’s acceptable or not depends on the complete picture of his circumstances and goals. Armed with this type of information, the deal team may look to renegotiate certain contingencies in an effort to provide added protection for the owner. 5 In the case of the entrepreneur, we assume a collar might be established on a $100 stock with a put strike price at $90 and a call strike price at $115. This is an illustration; actual terms will vary depending on a host of factors, including the stock’s volatility, dividend yield, the prevailing interest rates, and the length of the transaction. Bernstein Wealth Management Research 9 Display 6 presents our analysis of the downside associated with the all-stock deal for the entrepreneur after 30 years. We show those values for the “pure-stock” alternative and each of the five riskreducing strategies above. Note that each strategy improves the downside result of the all-stock deal. Just by negotiating the “floor-and-ceiling” approach, the team would increase the owner’s wealth in a downside scenario to almost $3 million (from zero). Easing the lockup requirements yields the greatest improvement in this example, since it most materially limits the stock-price risk. Further, though not shown in the chart, we wouldn’t expect these tactics to substantially reduce growth potential. In fact, with a couple of these strategies— the 20% cash and 50% lockup alternatives—our forecasts are higher than for the all-stock deal in the median case.6 On the other hand, none of these strategies will necessarily be easy to negotiate, because they may come with costs that the buyer is unwilling to pay. But with the advisory team working together to assess the financial implications of various bargaining chips and to craft an innovative solution, the chances of improving the deal’s risk/reward profile are measurably greater.7 DISPLAY 6 “The Entrepreneur’s” Wealth After Spending and Taxes Downside Case: Year 30* $9.3 $7.0 $ Million $5.0 $2.9 $0 Pure Stock Floor and Ceiling Fixed Collar Dollar After Sale Amount 20% Cash 50% Lockup $7.6 *Downside case defined as the value at the 90th percentile level of confidence Assumes all proceeds from sale are reinvested in a 60/40 stock/bond mix; proceeds subject to a lockup are diversified into the same 60/40 mix once the lockup period ends. Values include the investor’s entire portfolio, not only the proceeds of her business sale, based on Bernstein’s estimates of the range of returns of the applicable capital markets over the next 30 years. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting Analysis, pages 20–22, for further details. 6 We estimate the median results for the 20% cash and 50% lockup strategies at $53.7 million and $54.2 million, respectively, versus $53.2 million for pure stock (see Display 5). 7 Structuring the sale of a business is highly complex and usually requires investment-banking, legal, and tax expertise. Bernstein does not offer those services, but can play a role in addressing the implications of the sale for the business owner’s financial goals and investment portfolio. 10 The Art Before the Deal: Maximizing Personal Wealth When Selling a Business 4. ORCHESTRATE TRUST STRATEGIES—AT THE MOST OPPORTUNE TIME Matching the terms of a deal to the owner’s goals is just one area where pre-transaction planning can be beneficial. Beyond that, a major liquidity event like the sale of a business creates planning opportunities to build a larger, more tax-efficient legacy and increase philanthropic giving. A variety of trusts can create significant additional value if established prior to—rather than following—a sale. For the sake of illustration, we’ll focus on the two most common beneficiaries of trusts: family and charity. tax. As in all grantor trusts, the grantor remains responsible for any income and capital-gains taxes incurred inside the trust.8 Timing Is Everything If the GRAT is funded with shares from a closely held business, there is the possibility that substantial additional wealth can be passed to the children. When a minority interest in closely held shares is placed in a GRAT, the shares may be assigned a value that is less than their potential future worth because of their inherent lack of marketability at the time. If the owner later decides to sell the business and receives a price higher than that previously assigned value, the beneficiaries (typically the children) reap the benefits of the sale premium free of transfer tax. The right amount contributed to a GRAT can go a long way toward meeting a grantor’s legacy goals. And even if the owner decides not to sell the business, or the sale price is lower than anticipated and the GRAT fails to pass any assets to the children, the only costs incurred are the legal fees it took to set it up. To illustrate the value of establishing a GRAT before a sale, consider an owner who anticipates selling her business at some point in the future. Her goals call for transferring substantial assets to her children, so her legal team recommends placing a 25% interest in her closely held shares into a GRAT, which we’ll assume has a term of three years. Because the shares lack liquidity and marketability, her advisors value this contribution TRUSTS FOR THE BENEFIT OF FAMILY A host of vehicles is available for passing assets from one generation to another. Many of them can make sense at any point, but some hold special appeal if they’re part of a business owner’s pretransaction planning. A grantor-retained annuity trust, or GRAT, is a prime example (Display 7). In a GRAT, an investor (the grantor) contributes assets to a trust and retains a fixed payment each year for the term of the trust, which can be as short as two years. If the grantor survives the term and the investments inside the GRAT perform well enough (success depends on beating an interestrate hurdle tied to Treasury bonds, as defined by the Internal Revenue Code), there will be money left in the trust when the term ends and all the annuities have been paid out. This value can be passed to the grantor’s heirs free of any gift DISPLAY 7 A Typical GRAT Grantor Grant of private or public company shares Grantor-Retained Annuity Trust Remainder of assets after fixed term of years Children or Children’s Trust Tax Liabilities Annual Payments to Grantor In-Kind or Cash (Not Taxable) 8 Bernstein is not a tax or legal advisor. Consult with professionals in these fields before establishing a trust or making any plans affecting your legacy goals or tax status. Bernstein Wealth Management Research 11 at $17.5 million, based on a proportional interest of the contributed assets appropriately discounted. How much can the grantor expect to pass to her heirs? If she goes ahead with the sale and receives, say, $100 million for the business, the shares in the GRAT are now worth $25 million, so there’s an additional $7.5 million available over the original valuation of $17.5 million. Assuming the proceeds from the deal are reinvested in a diversified portfolio of stocks, the pre-established GRAT would provide the entrepreneur’s heirs with $8.6 million in the median outcome versus $2.1 million if set up after the deal (Display 8). Pretransaction planning for just this one trust would add an estimated $6.5 million in value over waiting till after the sale to implement the GRAT strategy. And significantly, should investment results prove to be poor following the sale of the business, our model suggests a 90% chance that the children would receive at least $3.7 million—versus a downside of leaving no legacy through the GRAT had the owner waited until after the transaction to set up the trust.9 Level of Confidence DISPLAY 8 GRAT Remainder to Beneficiaries Contribution of 25% of Business, Valued at $17.5 Mil. Before Sale, $25 Mil. After Sale* Year 3 $15.4 $ Million $12.4 $8.6 $3.7 $2.1 $0 GRAT Established Before Sale GRAT Established After Sale 5% 10% 50% 90% 95% *Invested in diversified equities Based on Bernstein’s estimates of the range of returns of the applicable capital markets over the next three years. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting Analysis, pages 20–22, for further details. be bad news? Because if too much of the grantor’s assets were used to fund the GRAT, the owner would then be transferring more money than anticipated to the kids while potentially being stuck with the entire tax bill from the sale. In some cases, the children may wind up with a larger percentage of the after-tax value of the business than the owner. But we don’t mean to underestimate a GRAT’s gifting advantages. In the illustration above, had the donor chosen to wait till her death, a wealth transfer would have cost her estate nearly 50% in taxes (assuming she’d already used up her Unified Credit).10 By using a GRAT, we’d expect her to effect a large transfer tax-free. The GRAT would materially increase the value of the transaction to her family. In quantifying solutions like these, we can help ensure that the business owner has the right vehicle or vehicles in place—whether a GRAT or any other transfer mechanism—with the right amounts in each, so that legacy goals can be met. Some Caveats A GRAT grantor needs to be very careful in determining how much of his business interest should be placed in the trust. For one thing, the analysis above assumes the owner received $100 million for her business at the time of sale. But market conditions are unpredictable: The sale proceeds might have been disappointing. As potentially disruptive as that situation would have been, an unexpectedly high future value of the business could also mean bad news. The value of the transaction could have soared in an IPO, or a bidding war could have driven up the sale price to levels the owner hadn’t expected. How could this 9 Although a 100% equity allocation for the sale proceeds is used in this case for the purposes of illustration, a grantor may choose a more conservative asset allocation if he has already received a large premium over the contributed value of the shares. By becoming more conservative, he can “lock in” this value for the children without giving up too much of the GRAT’s benefit. For example, a 20/80 stock/bond mix would reduce the median value passed on by the GRAT in our example by $1 million over the all-equity allocation, but would raise the downside by $2 million. 10 The top marginal estate tax bracket at this writing (Summer 2004) is 48%. 12 The Art Before the Deal: Maximizing Personal Wealth When Selling a Business DISPLAY 9 A Typical CRT Donor Contribution Charitable Remainder Trust (Tax-Deferred) Remainder Charity Tax Deduction Annual Payments (Taxable) CHARITABLE TRUSTS Some business owners wish to use a portion of their proceeds to achieve philanthropic objectives in addition to or instead of making gifts to family. This is especially likely if a family legacy is otherwise assured through an already established trust or gifting plan. For these investors, the vehicle of choice may be a charitable remainder trust, or CRT (Display 9).11 In a typical CRT, a donor makes a contribution of low-basis assets (though he can contribute other assets if he wishes) into a tax-deferred trust. In the case of a business owner, the most likely asset would be stock received from the sale of the business, which can be diversified without an immediate tax bill. In return, he receives a charitable tax deduction and annual payouts, which are taxable. The payouts can be either a fixed dollar amount or a fixed percentage of the trust’s market value; either way, they’re subject to certain limits. At the end of the trust term, the remaining assets pass to a charity of the donor’s choice.12 Hence, CRTs offer a means of diversifying a concentrated low-basis stock position while deferring capitalgains taxes, generating a regular income stream, and pre-funding a charitable legacy. In addition, the up-front charitable tax deduction can be particularly valuable for investors receiving a large income distribution from the sale of a business (from salary payments due the owner, a large cash earn-out, etc.).13 “Flip NIMCRUTs”: Delayed Payout Allows Asset Buildup Although most traditional CRTs are used after a business sale is completed, there is a variant that is particularly useful for certain business owners planning before a sale: the so-called “Flip NIMCRUT.” (“Flip” refers to a change in the CRT payouts when a predetermined event occurs, such as the sale of a business or reaching a certain age; NIM means net income with makeup; CRUT is a charitable remainder unitrust.) By establishing a Flip NIMCRUT, the owner delays the full annual payout until the flip occurs. It’s recommended for investors who don’t mind postponing much of the income they receive from the trust. To understand why that’s important, consider that if a CRT fails to create the income needed to meet its annual payout requirement, the donor will have to liquidate some of the trust assets. If a CRT owns publicly traded stock, that shouldn’t pose a problem. But if it owns stock in a privately held business (because it was funded pre-transaction), problems may arise in selling the shares, since they are not freely traded. Prior to the “flip,” however, a Flip NIMCRUT is required to pay out the lesser of the unitrust percentage or the annual net income generated by its assets, making it a vehicle well suited for illiquid shares (such as equity in a closely held business). Once the triggering event “flips” the trust into full-paying mode, an annual payment based on a percentage of the assets 11 For more detail on CRTs, ask your Bernstein Advisor for our research study, Unlocking the Investment Potential of Charitable Remainder Trusts. 12 All CRTs modeled in this study are based on a 55-year-old donor contributing $10 million in zero-basis assets to a lifetime charitable remainder unitrust (CRUT) with annual payouts, with 12 months preceding the first payout. All calculations are permissible payouts and associated with tax deductions according to Sections 7520 and 664 of the Internal Revenue Code of 1986, as amended, and the rules and regulations promulgated thereunder. 13 For more on earn-outs, see “A Closer Look: Getting Paid in Installments” on page 8. Bernstein Wealth Management Research 13 will be made. The hope is that the assets in the trust will have benefited from tax-deferred growth and will begin to pay a large distribution. The farther off the trigger is, the more time the trust assets will have to grow. For business sellers with charitable intent who do not need large current trust distributions, this can be an extremely beneficial vehicle. Use a CRT—or Sell Company Shares? The downside of a CRT strategy implemented before a sale is that by contributing privately held shares, the donor may get only a very small tax deduction, since the value of the deduction is determined by the cost basis of the shares (as opposed to a CRT funded with publicly traded securities, where the deduction is typically determined by the market value of the shares). Display 10 quantifies the personal wealth that would accrue to a business owner under three different scenarios: 1. Selling $10 million in company shares outright; 2. Setting up a traditional CRT with $10 million in transaction proceeds; 3. Establishing a Flip NIMCRUT with $10 million in closely held shares before the sale. DISPLAY 10 In the straight sale, we’re assuming that the owner diversifies his proceeds into a 60/40 stock/bond mix. The traditional CRT, we’re assuming, is funded with zero-basis unrestricted publicly traded stock that the business owner has received from the sale of his business. The CRT then takes advantage of the trust’s tax-deferred environment, sells the publicly traded stock, and invests the proceeds in a more heavily stock-weighted 80/20 balance. In the Flip NIMCRUT, the assumption is that $10 million of his company shares are contributed before the business sale. Once the business is sold, the proceeds are reinvested in the same way as the traditional CRT.14 We further assume that the owner is 55 and establishes the triggering event as his 65th birthday. For the moment, we’re ignoring the value of the assets remaining in the trust for the charity’s benefit. In this case, over a 10-year period personal wealth would be greater without setting up a CRT (on the left of Display 10). The reinvested payouts from the traditional CRT—the only funds that accrue to the investor—don’t have time to grow enough to match the reinvested proceeds from a straight business sale. And since the Flip NIMCRUT has not yet had its triggering event, it has been paying out only income; it performs worst of all for the After-Tax Median Personal Wealth $10 Mil. Portfolio Year 10 Year 20 Year 30 $50.7 $ Million $42.1 $24.5 $14.4 $10.4 $4.2 No CRT Flip CRT NIMCRUT PostPreTransaction (10% Payout) Transaction (10% Payout) $25.6 $23.4 $53.9 Based on Bernstein’s estimates of the range of returns of the applicable capital markets over the next 30 years. Data do not represent any past performance and are not a promise of actual future results. CRT assets invested 80/20 stocks/bonds. Donor retains an annual payout from the CRTs (fixed at 10% in the traditional trust), which is reinvested in a 60/40 stock/bond mix. See Notes on Wealth Forecasting Analysis, pages 20–22, for further details. 14 We assume that no valuation discount has been applied to these shares. Regardless of the asset allocation within the CRT, all distributions from it are invested 60/40 stocks/bonds in a personal, taxable portfolio. 14 The Art Before the Deal: Maximizing Personal Wealth When Selling a Business owner. Over time, however, the benefits of the trusts build. We’d expect the post-transaction traditional CRT to accumulate more wealth than a straight sale by year 20 (with the Flip NIMCRUT lagging the sale proceeds by only $1 million). Over the full 30-year period, both the Flip NIMCRUT and the post-transaction CRT have created more personal wealth: The owner has accumulated $54 million by then with the Flip NIMCRUT— some $3 million more than from a traditional CRT and $12 million more than from an outright sale. Given a long enough time frame, our analysis indicates that in this case the Flip NIMCRUT comes out on top. The bequest to charity is significant as well (Display 11). At year 30, with the post-transaction CRT, we estimate that the charity will have $5.2 million in the median case. With a pretransaction Flip NIMCRUT, the charity’s interest will have grown more than twice as much, to almost $11 million. DISPLAY 11 Median Value Received by Charity $10 Mil. Portfolio Year 30 $10.9 $ Million $5.2 $0 No CRT CRT PostFlip NIMCRUT Transaction Pre-Transaction (10% Payout) (10% Payout) Based on Bernstein’s estimates of the range of returns of the applicable capital markets over the next 30 years. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting Analysis, pages 20–22, for further details. Trade-Offs Nothing in this analysis is meant to suggest that establishing a Flip NIMCRUT is an open-and-shut case. The value of any CRT to a business owner is contingent on a number of factors, and special considerations apply if the owner is considering a Flip NIMCRUT. In particular, time horizon and near-term cash-flow needs are critical variables.15 A young entrepreneur with a large current-income stream can view this vehicle as a supplemental retirement plan that pays out later on when he needs it and will be taxable largely at long-term capital-gains rates. On the other hand, a retiree who needs to draw substantially from his assets may find this type of trust unsuitable. What the analysis does make clear is that a CRT, whether traditional or flip, can be a very valuable tool for some business owners—and one that should be considered in advance of a sale, whether the actual implementation comes before or after. Quantifying one’s spending and charitable goals can indicate which legacy and philanthropic strategies to pursue and how much to allocate to each trust. In the Flip NIMCRUT example above, we estimate that by setting up the trust before the sale, the owner would increase his personal wealth—exclusive of the philanthropic contribution—by 28% versus a straight sale over a 30-year period. And he’d have the additional satisfaction of donating millions of dollars to charity. 15 This can be done only with certain types of ownership structures. Consult your legal advisor. Bernstein Wealth Management Research 15 5. ALTERNATIVES TO A 100% SALE Thus far, we’ve been assuming that an owner is contemplating a full sale of his business, so we’ve discussed financial-planning strategies in that context. In fact, it is not uncommon to sell only a portion of a business. The owner may want to continue to work but would like to unlock some of the value in his equity. If the transaction market is especially strong, he may see an opportunity to sell a piece of the business for a great price. He may be considering an investment in another business venture—or ceding some of his current business to his children. In such cases, the owner is not yet willing to sell his whole firm but is drawn toward divesting a piece of it, whether it’s a minority or a majority interest. In all these instances, the critical question for the owner and his team of advisors is: What’s the right amount to satisfy his needs? Factoring in spending, taxes, and inflation, the results for the owner’s total wealth are revealing (Display 13). If he sold up to 40% of the business, we estimate that he could end up with as much as some $16 million or more, but on the downside he could wind up without enough to meet his spending requirements. This owner is cautious by nature and wants a higher level of confidence than this. Our model indicates that to ensure his portfolio would remain in the black with a 90% level of confidence he’d need to sell nearly half his stake—a bigger amount than he might have hoped. Level of Confidence DISPLAY 13 Portfolio Value After Taxes and Spending Value of Business: $30 Mil. Year 30 5% 10% 50% 90% 95% $25.1 Looking for Liquidity Consider an owner nearing retirement who is seeking to gain some liquidity from his retail business, appraised at $30 million (Display 12). He plans on working five more years, at which time he hopes to begin to pass a controlling interest in the company to his daughter, who will take over the day-to-day operations of the company. He wants to invest in a new home and a real-estate partnership, and fund a comfortable retirement. In addition to his company equity, he has $5 million invested in a very conservative stock/bond allocation. It has protected him from the risk inherent in his business, and it’s how he intends to invest the sale proceeds. He wonders how little he can pull from the business and still meet his goals. DISPLAY 12 $ Million $16.3 $7.7 $14.4 $5.6 $6.9 $0.1 $0 Sell 30% of Business $0 Sell 40% Sell 49% Reflects only owner’s liquid assets. Assumes remaining interest in business gifted to daughter over time. Based on Bernstein’s estimates of the range of returns of the applicable capital markets over the next 30 years. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting Analysis, pages 20–22, for further details. See Display 12 for spending assumptions. Case Study: How Much of His Business Should This Owner Sell? Near-Term Spending Plans Long-Term Spending Plans Current Liquid Assets Current Asset Allocation Current Salary *Growing with inflation $3 million for new home and real-estate investment Retire on $500,000 per year* $5 million 20/80 stocks/bonds $750,000 per year* The problem is the owner’s asset allocation. A very conservative stock/bond mix may have been prudent when so much of his net worth was tied to the equity in his business. But once he divests a large portion of his business, the role of his investment portfolio changes—from providing protection against company risk to providing long-term financial security. In that light, the conservative asset allocation is no longer appropriate, as it’s unlikely to provide the growth potential he needs. Further, as soon as the owner sells some of his company equity, he already reduces his risk; therefore, he should be willing to increase his allocation to stocks in a diversified portfolio of liquid assets. If he considers a more balanced mix of stocks and bonds (say, a 60/40 16 The Art Before the Deal: Maximizing Personal Wealth When Selling a Business Level of Confidence $ Million portfolio), our analysis indicates that he can then sell as little as 40% of his shares and still have a 9-in-10 chance of having at least $3 million in liquid assets left after 30 years (Display 14). And that’s on the downside; his upside potential is far higher. Armed with this analysis, the deal team might recommend a 40% sale for this owner. DISPLAY 14 Portfolio Value After Taxes and Spending Value of Business: $30 Mil. Sale of Business: 40% Year 30 5% 10% 50% 90% 95% $48.0 Some Other Strategies There are numerous routes that an owner and his deal team can pursue when considering a partial sale in light of the owner’s goals. In a recapitalization, for example, the company reallocates the equity and debt on its balance sheet. This opens up several $16.3 $7.7 $0 20/80 Stock/Bond Mix $20.2 $3.0 60/40 Stock/Bond Mix Reflects only owner’s liquid assets. Assumes remaining interest in business gifted to daughter over time. Based on Bernstein’s estimates of the range of returns of the applicable capital markets over the next 30 years. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting Analysis, pages 20–22, for further details. See Display 12 for spending assumptions. A Closer Look | Employee Stock Ownership Plans (ESOPs) A prime concern for many owners who have built up their businesses is continuity—of business practices, corporate culture, even key employees. Selling to an outside party might make preserving that connection more difficult. And while staged selling may be more advantageous to the seller, prospective purchasers may not be amenable. One exit strategy that can accomplish the objectives of such an owner is to establish an employee stock ownership plan (ESOP) and sell a piece of the business to it. ESOPs are commonly used as an employeebenefit or incentive plan, but they may also be used to purchase stock from the owner of the business. What’s more, if several conditions are met, the seller will incur no capital-gains tax on the sale of stock to the ESOP.16 One condition is that the seller must reinvest the proceeds of the sale in “qualified replacement property” (QRP). Several types of assets fall into this category, but the most popularly used—because they’re most effective in keeping the transaction tax-deferred— are very long-term floating-rate notes issued by a few U.S. companies (often called ESOP Notes). As long as the QRP is held, the gain is deferred. In fact, the gain could be eliminated if the QRP is held until death and the former business owner’s estate receives a step-up in basis. If the QRP is ever sold, the underlying gain will be realized. However, the ESOP investor is not forced into holding only floating-rate notes—which may not provide much diversification or return potential. He can borrow against them in an amount up to 90% of their value and reinvest the proceeds in a diversified portfolio—without triggering the embedded capital gains. This monetization strategy comes with a cost, though: The interest paid on the loan often exceeds the interest received from the floating-rate notes. Is the tax deferral worth the cost? ESOP Trade-Offs Consider an owner who intends to sell a $10 million interest in his business to an ESOP and is eligible for tax deferral under the IRS regulations. He purchases $10 million of floating-rate notes, borrowing $9 million of their value to reinvest in a diversified 60/40 stock/bond portfolio. In our example, that would result in a fixed pre-tax cost of about 1.5% per year—although the after-tax cost of carry could be even lower, depending on the investor’s tax situation. What are the personal financial implications of choosing the ESOP versus selling the business interest in an immediately taxable transaction? 16 Conditions for tax deferral are under Section 1042 of the Internal Revenue Code. They include, but are not limited to: 1) the company must be a C-corporation; 2) the company cannot be publicly traded; 3) the ESOP must own at least 30% of the company immediately after the sale; and 4) the seller must reinvest the proceeds in qualified replacement property within a 15-month period ending 12 months after the date of sale. Other limitations exist. Please consult your legal and tax advisors. Bernstein Wealth Management Research 17 possibilities for the owner, including monetizing his equity, diversifying his portfolio, and transferring ownership to the next generation (by withdrawing a significant percentage of the cash value in the business while passing a majority interest on to heirs). Meanwhile, by maintaining some interest in the company, the owner retains the right to benefit from an IPO or the outright sale of the company later on. Identifying the right balance of debt to equity requires the expertise of investment bankers and other professionals. But there are critical financialplanning implications in recapitalizations as well: Is the owner withdrawing enough cash to cover his liquidity needs—or will he need to tap other sources as well? If he’s transferring the business to his heirs, should he think about restructuring his gifting or legacy plans? These types of issues are at the nexus of deal structures and personal goals. For owners concerned about maintaining control in their businesses, or preserving their corporate culture, an employee stock ownership plan may be ideal. About 11,000 U.S. companies have these plans, which allow the owner of a closely held company to sell all or part of his business interest to a plan that distributes ownership to employees through stock in the company (see “A Closer Look: Employee Stock Ownership Plans,” below). Accumulated Wealth ($ Million) Display 15 represents the median value of the two alternatives over the subsequent 30 years. The results indicate that the sale to an ESOP can offer greater financial benefit over the first 25 years of the analysis: Deferring the tax has been a valuable benefit. The crossover point—where the results of the two approaches are equivalent— occurs in the 26th year. Eventually, the cost of financing overwhelms the tax advantage. Clearly, the owner’s time horizon is key in determining whether an ESOP is a good choice. There are many factors to consider. The financial benefit of selling to an ESOP will depend in part on the business owner’s tax rate, his cost basis, the financing rate on the QRP, and his reinvestment plan. In addition, in the display we’re assuming that the ESOP would give the business owner the same proceeds as a third-party buyer. However, an outside buyer may offer greater pre-tax proceeds, which could shorten the 26year crossover point considerably. Additionally, an owner must consider the potentially hefty administration fees, and the more emotional issues centering on his continuing attachment to the company. For some owners, this bond is salutary; others may find that it embroils them DISPLAY 15 Portfolio Value After Taxes and Spending $40 30 20 ESOP Sell Outright 10 0 1 5 10 15 Years 20 25 30 Based on Bernstein’s estimates of the range of long-term returns for the applicable capital markets. Data do not represent any past performance and are not a promise of actual future results. In each alternative, proceeds available for diversification are reinvested in a 60/40 stock/bond asset allocation. See Notes on Wealth Forecasting Analysis, pages 20–22, for further details. in ongoing management matters they’d rather avoid. For all these reasons, an experienced team of professionals should be consulted before embarking on an ESOP strategy. 18 The Art Before the Deal: Maximizing Personal Wealth When Selling a Business 6. SUMMARY: WHERE THE PERSONAL MEETS THE FINANCIAL Emotions run high at the prospect of the sale of a business: excitement over the possibility of a financial windfall, anxiety over whether the deal is optimal, concern about loss of control over income and legacy. And there can be a huge amount of money at stake. The latest data available suggest that U.S. families have some $5.7 trillion in net worth tied up in private businesses.17 For sellers, these deals necessitate the most important financial decisions they’ll ever face—in most cases, the determinants of their long-term financial condition. By defining personal goals and using them to lay out a financial plan prior to the sale, business owners are far more likely to have their concerns and objectives met. We’d emphasize these elements of the process: • Tax, legal, investment-banking, and financialplanning experts can each play a critical role in preparing for a transaction. An integrated team is, in our view, imperative for putting in place the most effective strategies. • With financial goals clearly defined, the advisory team can best weigh the effects of different deal terms on the owner’s long-term wealth. Quantifying the impact of various strategies can supplement the work of the deal team and give comfort to the owner that the deal contemplated is the best for his or her needs. For example, high spending requirements and fewer outside assets may call for more conservative terms for the seller— more cash, shorter lockups on acquired stock, less contingent compensation, etc. On the other hand, sellers with substantial additional resources may be able to withstand greater deal risks in order to pursue higher returns; such strategies may entail accepting more stock, longer lockups, and seller financing. • The plan may well take advantage of trust vehicles (or other wealth-transfer vehicles) to help achieve the owner’s financial goals. Practically speaking, the potential of these vehicles to add millions of dollars in value for the owner and his family is much greater if they are implemented prior to the sale. Identifying one’s spending, legacy, and philanthropic needs ensures that the right amounts are allocated to each trust so that all of the owner’s goals can be satisfied. • Given the wide range of personal situations, taxand trust-planning alternatives, tolerance for risk, and deal terms, a quantitative framework for understanding the trade-offs is essential. An analytical model that quantifies the costs and benefits of each choice in a host of market environments—in effect, allowing a business owner to evaluate alternatives prior to implementing them—can help owners and their advisors make the best decisions in each unique case. That goes a long way toward providing peace of mind and getting the deal done. ■ 17 As reported by the Federal Reserve in June 2004. 20 The Art Before the Deal: Maximizing Personal Wealth When Selling a Business Notes on Wealth Forecasting Analysis 1. Purpose and Description of Wealth Forecasting Analysis Bernstein’s Wealth Forecasting Analysis is designed to assist investors in making their long-term investment decisions as to their allocation of investments among categories of financial assets. Our planning tool consists of a four-step process: (1) Client-Profile Input: the client’s asset allocation, income, expenses, cash withdrawals, tax rate, risktolerance level, goals, and other factors; (2) Client Scenarios: in effect, questions the client would like our guidance on, which may touch on issues such as when to retire, what his cash-flow stream is likely to be, whether his portfolio can beat inflation longterm, and how different asset allocations might impact his long-term security; (3) The Capital-Markets Engine: a model that uses our proprietary research and historical data to create a vast range of market returns, which takes into account the linkages within and among the capital markets (not Bernstein portfolios), as well as their unpredictability; and finally (4) A Probability Distribution of Outcomes: Based on the assets invested pursuant to the stated asset allocation, 90% of the estimated range of returns and asset values the client could expect to experience are represented in a graphic output. We focus on the 10th, 50th, and 90th percentiles to understand the range of outcomes representing upside, median, and downside cases. However, outcomes outside this range are expected to occur 10% of the time; thus, the range does not establish the boundaries for all outcomes. Expected market returns on bonds are derived taking into account yield and other criteria. An important assumption is that stocks will, over time, outperform long bonds by a reasonable amount, although this is in no way a certainty. Moreover, actual future results may not meet Bernstein’s estimates of the range of market returns, as these results are subject to a variety of economic, market, and other variables. Accordingly, the analysis should not be construed as a promise of actual future results, the actual range of future results, or the actual probability that these results will be realized. 2. Rebalancing Another important planning assumption is how the asset allocation varies over time. We attempt to model how the portfolio would actually be managed. Cash flows and cash generated from portfolio turnover are used to maintain the selected asset allocation among cash, bonds, stocks, and real estate investment trusts (REITs) over the period of the analysis. Where this is not sufficient, an optimization program is run to trade off the mismatch between the actual allocation and targets against the cost of trading to rebalance. In general, the portfolio will be maintained reasonably close to the target allocation. In addition, in later years, there may be contention between the allocation of the total relationship and the allocations of the separate portfolios. For example, suppose an investor (in the top marginal federal tax bracket) begins with an asset mix consisting entirely of municipal bonds in his personal portfolio and entirely of stocks in his retirement portfolio. If personal assets are spent, the mix between stocks and bonds will be pulled away from targets. We put primary weight on maintaining the overall allocation near target, which may result in an allocation to taxable bonds in the retirement portfolio as the personal assets decrease in value relative to the retirement portfolio’s value. Positions in a single stock are not rebalanced. Bernstein Wealth Management Research 21 Notes on Wealth Forecasting Analysis (continued) 3. Expenses and Spending Plans (Withdrawals) All results are generally shown after applicable taxes and after anticipated withdrawals and/or additions, unless otherwise noted. Liquidations may result in realized gains or losses, which will have capital-gains tax implications. 4. Modeled Asset Classes The following assets or indexes were used in this analysis to represent the various model classes: Annual Turnover Rate 30% 30 15 15 15 20 0 Asset Class Intermediate-Term Diversified Municipals Intermediate-Term Taxables U.S. Value U.S. Growth Developed International Emerging Markets Single Stock (Avg. Volatility) Modeled as... AA-Rated Diversified Municipal Bonds of 7-Year Maturity Taxable Bonds of 7-Year Maturity S&P/Barra Value Index S&P/Barra Growth Index MSCI EAFE Unhedged MSCI Emerging Markets Free Index (Renamed Emerging Markets Index 1/29/04) Volatility: 30%; Dividend: 1.7%; Beta: 1.0 5. Volatility Volatility is a measure of dispersion of expected returns around the average. The greater the volatility, the more likely it is that returns in any one period will be substantially above or below the expected result. The volatility for each asset class used in this analysis is listed in Note #9 on the next page. In general, two-thirds of the returns will be within one standard deviation. For example, assuming that stocks are expected to return 8.0% on a compounded basis and the volatility of returns on stocks is 17.0%, in any one year it is likely that two-thirds of the projected returns will be between (8.9)% and 28.9%. With intermediate government bonds, if the expected compound return is assumed to be 5.0% and the volatility is assumed to be 6.0%, two-thirds of the outcomes will typically be between (1.1)% and 11.5%. These ranges are slightly skewed relative to what you might expect because the volatility calculation assumes the returns are log-normally distributed. Bernstein’s forecast of volatility is based on historical data and incorporates Bernstein’s judgment. It should also be noted that volatility varies in different time periods, particularly for inflation and fixed-income assets. 6. Technical Assumptions Bernstein’s Wealth Forecasting Analysis is based on a number of technical assumptions regarding the future behavior of financial markets. Bernstein’s Capital Markets Engine is the module responsible for creating simulations of returns in the capital markets. These simulations are based on inputs that summarize the condition of the capital markets as of May 3, 2004. Therefore, the first 12-month period of simulated returns represents the 22 The Art Before the Deal: Maximizing Personal Wealth When Selling a Business Notes on Wealth Forecasting Analysis (continued) period from May 3, 2004, through May 3, 2005, and not necessarily the calendar year of 2005. A description of these technical assumptions is available on request. 7. Tax Implications Before making any asset-allocation decisions, an investor should review with the investor’s tax advisor the tax liabilities generated by the different investment alternatives presented herein, including any capital gains that would be incurred as a result of liquidating all or part of the investor’s portfolio, investments in municipal or taxable bonds, etc. 8. Tax Rates* Bernstein’s Wealth Forecasting Analysis has used the following marginal tax rates for this study: Start Year End Year Federal Income-Tax Rate Federal Capital-Gains Tax Rate Qualified Dividend Rate State Income-Tax Rate State Capital-Gains Tax Rate 2004 2008 35.00% 15.00% 15.00% 6.00% 6.00% 2009 2010 35.00% 20.00% 35.00% 6.00% 6.00% 2011 2033 39.60% 20.00% 39.60% 6.00% 6.00% 9. Assumptions: Capital-Markets Statistics Annualized Compound Return Int.-Term Diversified Municipals Intermediate-Term Taxables U.S. Value Stocks U.S. Growth Stocks Developed International Stocks Emerging-Markets Stocks Single Stock (Avg. Volatility) Inflation 3.5% 4.9 8.2 8.2 8.5 7.5 5.3 2.4 Average Annual Return 3.7% 5.1 10.0 10.3 11.4 12.0 10.2 2.5 Average Annual Income 3.6% 4.9 2.6 1.4 2.8 1.7 2.2 N/A 30-Year Annualized Equivalent Volatility 4.8% 5.9 12.8 15.2 13.6 21.7 27.5 6.8 1-Year Volatility 4.3% 5.2 17.9 19.4 21.6 27.8 30.7 1.3 *The federal income-tax rate represents Bernstein’s estimate of either the maximum marginal tax bracket or an “average” rate calculated based upon the marginal rate schedule. The federal capital-gains tax rate is represented by the lesser of the maximum marginal income-tax bracket or the current cap on capital gains for an individual or corporation, as applicable. Federal tax rates are blended with applicable state tax rates by including, among other things, federal deductions for state income and capital-gains taxes. The state tax rate generally represents Bernstein’s estimate of the maximum unified rate, if applicable. New York Boston Chicago Dallas 212-486-5800 617-788-3700 312-696-7800 214-860-5200 832-366-2000 310-286-6000 Houston Los Angeles Miami 305-530-6200 612-758-5000 Scheduled to open in 2004 415-217-8000 Minneapolis Philadelphia San Francisco Seattle Tampa 206-342-1300 Scheduled to open in 2004 202-261-6700 561-820-2100 Washington, DC West Palm Beach www.bernstein.com © August 2004, Alliance Capital Management L.P. All rights reserved. PRETRANBLKBK0804 Bernstein Wealth Management Research 1 TABLE OF CONTENTS Significant Research Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . 1. The Problem and the Opportunity . . . . . . . . . . . . . . . . . . . . . . Owners selling their businesses often direct their full attention to the amount of the deal, but addressing long-term financial concerns early on can add critical value. 1 2 2. Setting Goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from a business sale can go only four places; where they do go depends on the owner’s priorities and advance planning. 3 3. Matching Deal Terms to the Owner’s Personal Needs . . . . . . . . . . . . . Quantifying a business owner’s ability to meet his goals can help the advisory team tailor a deal uniquely suited to his circumstances. A Closer Look: Getting Paid in Installments . . . . . . . . . . . . . . . . . . . 5 8 4. Orchestrate Trust Strategies—at the Most Opportune Time . . . . . . . . . . Estate planning prior to the sale of a business may allow the owner to pass far more wealth on to her family and charity. 10 5. Alternatives to a 100% Sale . . . . . . . . . . . . . . . . . . . . . . . . . . Owners may not be ready or willing to sell everything; planning is crucial when transferring a little or a lot of company equity. A Closer Look: Employee Stock Ownership Plans (ESOPs) . . . . . . . . . . . . . 15 16 6. Summary: Where the Personal Meets the Financial . . . . . . . . . . . . . . 18