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Avoid These Seven Planning Mistakes Before a Transaction
Entrepreneurs and executives of privately-held companies who are able to successfully monetize their businesses are in a rare and coveted position among their peers. Often, a keen focus on the company’s outcome distracts the leader from focusing on key planning opportunities that could be beneficial from a personal financial planning perspective. Driving a company to a transaction is a lengthy and grueling process. Avoiding these seven pitfalls can help you maximize your personal outcome:
7. Not Having an Accurate Understanding of What Your Company or Equity is Really Worth
The importance of having and maintaining an accurate valuation of your company cannot be emphasized enough. An informal valuation is often completed based on metrics such as future earnings or revenue. Comparisons to other companies in your industry may be useful,
but by no means should they serve as benchmarks for determining your company’s true value. This is where a third-party M&A advisory firm comes into play. Using a variety of industry metrics can help assemble an accurate value of the business at different points in its growth stage. This offers the leadership team and founders a clear sense of what the business means in the context of their personal net worth. It also serves as a foundation
for allocating equity to new executives and can help you track the value of the equity as the company matures.
As you approach a transaction, knowing the acquisition price of each portion of equity is critical—the difference between the acquisition price and the transaction
price is the portion that will be subject to taxation.
6. Not Understanding Stock Options
The use of stock options versus common equity is becoming more popular as a means of attracting and retaining new talent. There are two different types of stock options—incentive stock options (ISO) and nonqualified stock options (NSO). As an executive, it’s also critical to understand the tax implications of your stock options,
as well as how these options impact your personal financial plan. Because of the holding benefits of ISOs,
an often underused but effective planning strategy is to simultaneously exercise and sell the NSOs, using the cash to exercise and buy out the ISOs. This starts the clock for long-term capital gain treatment. It is also a good idea to obtain a copy of your firm’s stock options plan. This plan will outline holding requirements and gifting parameters that will be relevant to wealth transfer planning.
5. Not Having a Qualified Advisory Team in Place
It is important to plan for a potential liquidity event
and a range of outcomes. A liquidity event is generally defined as a substantial realization of wealth from a direct sale, merger, acquisition or initial public offering (IPO). Ultimate realization of wealth from an IPO or sale can take years, and until the stock or company is sold and the taxes are paid, this wealth is not considered spendable money. While the outcome of a sale can
lead to true financial independence, it may serve as
the inflow needed to fund your current lifestyle or outstanding debt instead. Proactively working with a team of key advisors can help you align your goals with potential outcomes and identify tax and investment solutions to help you maximize your outcome.
Even if a transaction is estimated to be two to three
years away, it is crucial to begin assembling a full advisory team. This team should consist of a qualified tax accountant, estate-planning attorney, M&A advisor, CERTIFIED FINANCIAL PLANNERTM practitioner and insurance advisor. Each of these professionals should represent an area of competency that can help you make thoughtful decisions about key planning concepts. These concepts include 83(b) elections, grantor retained annuity trusts (GRATs), spousal lifetime access trusts (SLATs), gifting and philanthropic planning.
The ideal time to begin collaborating with this group of advisors on strategic planning needs is about 18 to 24 months before a transaction. Starting this early allows the group to gain a clear picture of what you are trying
to accomplish, create a formal, integrated plan with multiple outcomes and begin overseeing implementation.
4. Being Exposed to Concentration Risk
Concentration risk can complicate a transaction. One form of concentration occurs when a company relies on a single product or offering to determine its outcome. Concentration can also occur in a client base when a small number of clients make up a significant portion
of a company’s revenue. Concentration of key decision- makers—for example, when one or two individuals are driving the majority of the company’s outcome—can also pose a significant risk. The reduction in concentration risk from a buyer’s perspective has historically helped increase valuation. Any efforts you can make to diversify your product line to increase revenues may prove fruitful. It also may help if your sales and marketing team focuses on growing your customer base and reaching different markets. Finally, deepening the leadership team to increase the overall talent pool may help provide
you with a higher valuation and better outcome.
3. Not Implementing Tax-Planning Strategies
One of the most important goals of pre-transaction planning is to minimize the impact of income
and capital gains taxes. When implemented
before a transaction, the following key strategies may meaningfully increase your yield:
• 83(b) Election—This strategy offers an employee or founder of a company the option to pay taxes on the fair market value of the equity immediately,
even before the vesting period starts. An 83(b) election is a good tactic if you are fairly certain the value of the shares will continue to increase in the future, or if the value of the shares reported is small at the time of the grant. With the 83(b) election, you pay all the taxes up-front at the full market value on the date of the grant. You’ll be taxed at ordinary income rates, but the 83(b) election starts the clock for long-term capital gains treatment.
The highest marginal income tax rate for a married individual filing jointly is 37%. The highest long-term capital gains plus health care tax is 23.8%. These differences can lead to meaningful tax savings.
• Leveraging a 0% Capital Gains Tax Rate—For individuals who support adult family members, like parents or adult children over age 24, gifting highly appreciated company stock can be an effective wealth transfer strategy. Single filers who make less than $39,375 and married people who file jointly and make less than $78,750 are subject to a 0% capital gains tax rate and are optimal recipients for this strategy. This is a tax-efficient way to gift to loved ones while eliminating potential tax liability on appreciated stock.
• Philanthropic Planning—Philanthropic planning can be a very appealing strategy to offset tax liabilities for people who are charitably inclined. Similar to
the strategy of gifting to loved ones, gifting highly appreciated shares into either a charitable remainder annuity trust (CRAT) or donor advised fund (DAF) can help reduce a tax burden. If the transaction
has not yet occurred, the appreciated shares will
be deducted from the sale proceeds, but the donor will also receive a tax deduction for the amount
of equity placed into the CRAT or DAF. While the funding processes are similar for both, a CRAT provides an income stream to the founder over his
or her lifetime with the monies not distributed to
the charity until the founder’s passing. A DAF also books a needed tax deduction in the current year, but its corpus can be given to a multitude of charities over an indefinite time frame. The DAF continues
to grow tax-free as it is distributed over time.
2. Not Having a Contingency Plan
Even with thoughtful business planning and a focus
on capital raising, transactions are often delayed or postponed. While it is important to remain optimistic and keep the end goal in mind, it’s critical to have a clear plan
B in place if the transaction does not occur in the expected timeframe. Contingency plans may involve accessing additional capital and debt sources or requiring a change in the leadership team. To provide continuity of leadership, plans should also be documented in case one of the senior leaders passes unexpectedly, becomes disabled or gets divorced. An optimal solution to help with this objective is a well-written and funded buy/sell agreement, which will provide direction and capital for the remaining leaders.
1. Not Fully Considering the Implications of Multiple Outcomes
In our team’s experience, executives most often fall prey to this challenge. It is often said that the hardest part
of closing a deal is the last few feet before the finish line. In your advanced planning, our team suggests
that you fully consider three possible outcomes—a strong one, a mediocre one and a poor one (in which the deal falls apart). Each scenario has ripple effects
on your own personal outcome. Identifying realistic conditions and parameters for each outcome can
help you develop income tax, estate tax, gifting and insurance-planning strategies specific to each outcome. As one of these potential outcomes draws nearer, our team can hone in on specific details and strategies that may help provide you with a more fruitful outcome.
Executives are often so focused and involved in the day-to- day aspects of their company that they may overlook ways to help maximize their own benefits from a successful liquidity event. Taking the time to think and strategize
with partner advisors on ways to take full advantage of monetizing your equity component can have long-lasting positive effects on your family and charities that are
Gregory C. Sarian CPWA®, CIMA®, CFP®, ChFC®, CEPA® CEO & Founder