Book Excerpt: Livelihood & Legacy

Many reprographics firms are family businesses, and managing family businesses is a topic IRgA Today will be exploring over the coming months. Below is an excerpt from Livelihood & Legacy: The NAPL Guide to the Family-Owned Business, a new book published by the National Association for Printing Leadership.

This excerpt explores one area of family business -- how to prepare the business for the eventual death of the founder. Of course, this is just one area of concern in a family business; if you would like to order a copy of Livelihood & Legacy for $29.95, click here to order it from NAPL.

In coming months look for regular articles about family business issues written by Chuck Gremillion, a long-time IRgA member who has personal experience dealing with family issues. Chuck's column will begin in late December.

THE ESTATE TRANSITION

       The management and ownership transitions are concerned with the transfer of power and control, but the principal focus of the founder’s transition is personal development and preparation for the future. All three are heavily weighted toward the “business first” side of the scale, but the estate transition is more directly one of “family first” than the other two. Its main concern may be stated as, “How will both our business and personal assets be distributed to our survivors at the time of our deaths?”

         At first blush, this may seem like nothing more than a matter of dividing assets equally and minimizing estate tax liabilities. Estate planning should, however, be based on a much broader spectrum of considerations about the financial and personal objectives of the owner and the owner’s spouse during their lifetimes. As such, planning for the estate transition ideally should begin early in the founder’s or owner’s life.

         This is particularly important because the family business, along with other assets associated with the business, often comprise a substantial portion of the owner’s net worth. Absent any planning, the owner, his/her spouse, and the family may all find themselves negatively impacted. The founder may, for example, be totally dependent on the continuing profitability of the business for retirement income, or the owner’s survivors may be forced to sell the business in order to satisfy estate transfer tax liabilities.

            Many people mistakenly view estate planning as nothing more than financial preparation for one’s death, but it can more accurately be viewed as a long-term process to assure the financial futures of individuals and the family—and to provide safeguards against financial problems encountered by the business.

            There are a number of responsible techniques and approaches that can be used to respond to the challenges of estate planning, but bear in mind that tax, financial, and estate planning are complex, interrelated subjects and should not be undertaken without the advice of competent, knowledgeable professionals who understand and are up-to-date on:

  • Alternative concepts and vehicles to be considered;
  • Laws and regulations governing their application; and
  • The need to develop plans that reflect both the family’s and the owner’s/founder’s own specific situation and objectives.

       It is wise to provide for financial security in retirement that is independent of the fortunes of the business. This typically means finding ways to free up part or all of the owner’s investment in the business to provide liquidity and a steady income stream. In the process, of course, it is vital to protect the financial health and stability of the business. And it is desirable to transfer assets that will be used in retirement by tax-efficient means.

       Among the techniques that can be utilized:

  • Increasing current compensation. The simplest and most direct approach to increasing income, it creates immediate tax liabilities that might be postponed using other methods.
  • Using tax-advantaged plans. A number of approaches are available to help owners take cash out of the business and dedicate it to a retirement nest egg without any immediate tax consequences. Among them: IRAs and qualified plans (including profit-sharing plans, pension plans, and 401k plans).
  • Non-qualified plans. Supplemental executive retirement plans (SERPs) can provide retirement benefits to selected individuals above and beyond those permitted by qualified plans. Deferred compensation arrangements can be used to delay receipt of current income after retirement or assure that income will be paid to an individual’s designed beneficiaries after his or her death.
  • Electing S corporation status. In a C corporation, any income paid to owners beyond that considered reasonable compensation by the Internal Revenue Service is subject to double taxation as dividends. An S corporation provides the possible advantage of having all income flow through to the owners for taxation at personal tax rates, which, at some income levels, may be lower than corporate rates. (Note: This is a cursory explanation of complex regulations and should not be viewed as professional advice. Seek the advice of competent tax, financial, and/or legal counsel before pursuing any of the approaches listed in this section.)
  • Selling stock to children. Selling all or part of the owner’s stock in the family business to his children during his (or her) lifetime is another way to generate liquidity and additional retirement income. Because it involves a transfer of ownership and affects control of the business, this approach should be coordinated closely with any decisions the owner and the owner’s family make about both the management and ownership transition elements of succession planning.

Bottom line: No matter which approaches advisors recommend, the earlier in the owner’s lifetime this type of planning is done, the more flexibility will be available.

PROTECTING THE VALUE OF THE ESTATE

          Federal and state taxes can leave large sums of money subject to taxation and take very large bites out of whatever portion of estate value is not exempted. It may be worthwhile, therefore, to consider strategies for the interim transfer of as much of an estate to the estate’s heirs as possible. Once again, there are numerous estate planning techniques available and they should be looked at only with the help of competent professionals.

           Planning the estate transition takes on some unique complexities when a family-owned business is involved, e.g.:

  • As noted above, the family business typically represents a valuable, but highly illiquid asset.
  • In order to protect that asset for the next generation, it is important that the owner and his or her family understand and provide for the anticipated need for liquidity to settle estate tax liabilities.
  • It is important to coordinate the estate transition with the management and ownership transitions.
  • For all of this to come together productively, the family must have mastered its management of the family/business relationship.

       Generally speaking, the disposition of the business following the owner’s death can go in one of three directions: liquidation, pre-arranged sale, or retention by the family. During his lifetime, the owner may want to consider some form of restructuring the business. (Other disposition alternatives, not necessarily related to the death of a major shareholder, include merging or “going public.”)

Liquidation. Liquidation of the business means the loss of its value as a going concern, the end to the income and asset appreciation derived from the business, and the forced sale of the assets at “fire sale” prices. If, given the nature of the business, liquidation is the inevitable consequence, it should be pre-planned so that it is an orderly liquidation. NAPL’s Business Advisory Team can offer business owners insight and advice on planning an orderly liquidation that will maximize the business’s value to the family. Go to www.napl.org/consulting or call (800) 642-6275 for information.

         If liquidation is the path followed, maximum use should be made of insurance and benefit plans that will provide the owner’s family with cash needed to pay estate taxes and support a continuing income stream. Vehicles for providing this cash may include qualified pension and profit-sharing plans and various forms of insurance products, including group term insurance and survivor income plans.

       If liquidation of the business is not a necessary consequence of the owner’s passing, and if the family wishes to retain the business, then steps should be taken early to avoid a forced liquidation.

Pre-arranged sale. In the absence of any prior arrangement, the sale of the business at the death of the owner is little more than a liquidation. Most pre-arranged sales are to other non-family owners/partners, or to employees. Experience has shown that few outsiders will be willing to pay what the family considers fair value.

          If it is the owner’s intent to enter into a prior arrangement to sell, a buysell agreement needs to be drawn and a value for the owner’s interest in the business must be established. Buy-sell agreements and business valuations are discussed in greater detail later in this chapter.

           In any event, it will be necessary to agree on the value of the business. This can be done by retaining professionals who specialize in the valuation and appraisal of businesses. NAPL business advisors with special knowledge of the printing industry can provide expert valuation and appraisal services based on a thorough understanding of the value placed on both tangible and intangible industry assets.

Retention by the family. Keeping the business is the usual “intuitive” desire for most families, particularly after the loss of a patriarch or matriarch who founded the business and guided it through good times and bad for a long period of time. For retention to be the most prudent course to take:

  • The business should be a viable entity with a sound strategic future.
  • There must be continuity of management succession and qualified successor managers.
  • The family/business dynamics must be understood and well managed.
  • The ownership interests of surviving family members should have been determined prior to the founder’s/owner’s death.

       If those conditions have not been met, it is likely that dissension and/or lack of business direction among family members could lead to the disruption or even destruction of the business.

       In order for future generations to retain the ownership of the business, the disposition of any portion of business ownership not already transferred to the owner’s heirs during his lifetime should be specifically provided for in his will. Further, if the owner desires to maintain the family principal of equality, the estate plan should assure that non-business assets of sufficient value are transferred to balance any inequalities in percentages of business ownership.

       A valuation of the business will be necessary to compute its value for estate planning and estate tax purposes, and can also be used to guide decisions concerning the disposition of non-business assets at present or in the future.

Restructuring. Corporate restructuring provides some creative alternatives to the disposition of the business when it is to be retained in the family.

      Some strategies in this vein that could be considered include:

  • Spinoff of a new business into a corporation owned by the next generation;
  • A similar spinoff of an existing division or product line with growth potential;
  • Distribution of appreciated real or other property to “devalue” the company;
  • Establishing a “shadow” business for the children and transferring growth to that business.

Mergers. In the right circumstances, a merger can be an effective business perpetuation strategy. Merging to achieve vertical integration or to expand a range of services can make it possible for a business to compete more effectively by providing its customers with a “one-stop shopping” opportunity. A merger that results in horizontal integration may also be intended to broaden the customer base and develop economies of scale.

        Once again, enlisting professional advice, particularly from associations such as NAPL, which offers expertise in both the M&A process and the graphic communications industry, is really a necessity if companies seek to use a strategic transaction approach. Before even entering the M&A arena, business leaders should keep a few basic points in mind:

Mergers must make financial sense. Look closely at comparative financial positions to make sure the company is not going to be saddled with unreasonable levels of debt, insufficient margins, substandard returns on assets, uncollectible receivables, etc. Get whatever professional help is needed to ensure that the “real” operating results and financial condition (current, and likely future) of the target company are understood, and know how both businesses will be valued.

Mergers must make strategic sense. Compare your company’s strategic business vision and plan with that of your intended merger partner. Are they congruent? Look carefully at the target company’s market position and reputation. Will they be a benefit or a liability? Consider whether the target company’s key executives will be staying or leaving. If the latter, how much of the business could they be taking with them if key clients defect?

Mergers must make operational sense. Is the target company’s operating philosophy similar to yours? It should be! Is its plant and capital equipment state-of-the-art or obsolete, well maintained or not? Are its systems and procedures well designed and compatible with yours? Upgrading plant and equipment and/or updating or changing systems and procedures can be costly.

Mergers must make management sense. Mergers involve more than money, machines, and marketing. They ultimately involve human resources and organizations. Ultimately, it is the people who need to make the merged organizations work together smoothly, effectively, and profitably, so be sure to take a long, careful look at vital factors such as:

  • The quality and compatibility of management philosophy;
  • The “climate” of the organization (employee attitude and morale);
  • How the merged companies will be organized and staffed;
  • Where, and in whom, management responsibility and control will be vested.

       Experience suggests that these issues are frequently overlooked because they are seen as “soft” or qualitative, but these are the issues that most often result in the failure of mergers that seemed to make sense in every other regard.

        As in any transaction where the stakes are high, it is in your enlightened self-interest to obtain the best-qualified advisors you can find. Once again, trade associations such as NAPL can be of considerable help in securing the requisite expertise.

Going public. For more substantial family businesses, going public can be a good way to achieve liquidity for the existing shareholders and to provide additional business capital. Family shareholders can retain enough of the stock to maintain effective control of the business, even with only partial ownership.

       While this approach may sound attractive, it isn’t for everyone. There are some considerations in going public that some family businesses may view as significant disadvantages:

  • Market conditions must be favorable to new stock issues;
  • If your offering is substantial, you will be accountable to a large group of public shareholders.
  • The value of your business will now be determined by the open market rather than by more direct measures such as profitability, assets, and business conditions.
  • Complying with initial disclosure requirements and the increased formalities of administration, management practices, compensation, etc., can be more difficult and more costly than anticipated.

BUY-SELL AGREEMENTS

       There are a number of reasons for establishing a buy-sell agreement. In general, however, such agreements serve to define who may own shares and under what conditions shares may be acquired.

        There are two common approaches: The cross purchase agreement, which provides for surviving shareholders to purchase stock from the estate of a deceased shareholder, and the stock redemption plan, which is used if the corporation itself is to be the buyer of stock interest.

       Buy-sell agreements may also provide for voluntary sales of stock—either to other shareholders or to the company. Funds to purchase the stock of deceased shareholders can come from the company’s cash flow, directly from individual purchasers, or can be funded by the purchase of life insurance.

VALUING THE BUSINESS

       Business valuations may be done for various purposes, among them:

  • Sale of the business;
  • Estate planning and/or estate taxes;
  • Gift taxes;
  • Transfers among shareholders; and
  • Charitable gifts of stock.

       When accomplished for purposes of negotiating a sale, the fair market value of any asset, business or otherwise, is “the hypothetical price at which a willing buyer and a willing seller (both of whom are fully informed...and neither of whom is under any compulsion) would engage in a transaction.” Valuations done for tax purposes must comply with IRS requirements.

       In publicly traded companies the open market provides a ready means of valuation. In privately owned companies, including most family businesses, the definition of value is more problematic. The IRS requires that valuation be based on factors such as:

  • The nature of the business;
  • The general economic outlook and the economics of the specific industry;
  • Book value and financial condition;
  • Earnings capacity;
  • Capacity to pay dividends;
  • The presence of goodwill and other intangible value;
  • The market price of similar businesses that are publicly traded

     Valuations for purposes of transfer of partial ownership typically include minority interest discounts. The most common valuation methods include:

  • The asset approach, which establishes values for the assets in the business;
  • The market approach, which looks at price as a function of various financial ratios relative to sales of comparable companies;
  • The income approach, which discounts projected future earnings streams to arrive at a current value.

     No single approach is considered “the best.” Typically, a valuation opinion will be based on the combined results of a variety of approaches. When a valuation is required for tax purposes, owners would be well advised to retain the serves of a qualified valuation firm, consultant, or industry association such as NAPL.

SUMMARY

     To provide for an effective estate transition:

  • Estate planning earlier in your life rather than later;
  • Develop and maintain open dialogue regarding the family/business relationships so that all factors are clearly understood and can be considered;
  • Know the family’s strategic vision for the business;
  • Make sure that, if the family wants to retain the business, management and ownership transitions have been properly planned and implemented;
  • Be aware of the tax implications of transition decisions, but ensure that estate planning decisions take family and business considerations into account and are not solely tax driven;
  • Use qualified advisors to steer you through the maze of tax rules, help you understand options, and make provisions for the liquidity needed to implement the transfer of business ownership and pay estate taxes.

This excerpt from Livelihood & Legacy was published with permission of the National Association for Printing Leadership. To order a copy of the book, click here.