June 17, 2011
Exit Planning for the
Professional And Service Firm
Steve Parrish, JD*,CLU®,ChFC®
National Advanced Solutions Consultant
Principal Financial Group
*Does not practice law on behalf of Principal Financial Group
For CLE ONLY. Not for use in sales situations
Disclosure
While this communication may be used to promote or market a transaction or an idea that is
discussed in the publication, it is intended to provide general information about the subject matter
covered and is provided with the understanding that the speaker is not rendering legal, accounting,
or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal
Revenue Code. You should consult with appropriate counsel or other advisors on all matters
pertaining to legal, tax, or accounting obligations and requirements.
Although the speaker is employed by Principal Financial Group, none of the information
necessarily represents the opinions or products of The Principal Financial Group or its
subsidiaries.
No part of this presentation may be reproduced or used in any form or by any means, electronic or
mechanical, including photocopying or recording, or by any information storage and retrieval
system, without prior written permission from the speaker.
For CLE ONLY. Not for use in sales situations
Agenda
• Financial and Tax Challenges
• Exit Planning Principles
– Common concerns and solutions
– Resources
• Special issues and solutions for
Professional and Service firms
For CLE ONLY. Not for use in sales situations
Business Transition
• Seven in 10 small business owners have
thought about who would run the business
in their absence
• Only 25% have formal retirement
succession plans
• Only 35% have formal continuation plans
in the event of their deaths.
Source: LIMRA, Small Business Owners: Full Report,
2009
For CLE ONLY. Not for use in sales situations
Financial Issues
•
•
•
•
Cash flow, credit and receivables
Compensation and fringe benefits
Business valuation and continuation
Financial Gaps and Rebuilding
For CLE ONLY. Not for use in sales situations
The Retirement Gap
filling the gap that Social Security and your qualified plan doesn’t cover
For CLE ONLY. Not for use in sales situations
The Market Gap
filling the investment gap that the recent market downturn has created
For CLE ONLY. Not for use in sales situations
The Business Value Gap
Helping to secure the gap between your business’s
fair market value and your book value
For CLE ONLY. Not for use in sales situations
The Government Gap
filling the gap in your plan caused by reduced government benefits
For CLE ONLY. Not for use in sales situations
The Yin and Yang of
Budget and Taxes
FEDERAL BUDGET
FEDERAL TAXES
• Bush Tax Cuts remain
• Budget Deficit: $1.65
through 2012. Cost of
trillion or 9% of GDP
extending income tax
• National Debt: $14.3
for 2 years is approx.
$100 billion
trillion
• Social Security payroll
• Four Largest
tax reduction 2011 only
Expenditures: Debt, Social • Estate Tax increased $5
Security, Medicare, Defense
million exemption for 2
years, then reverts to
• Medicare Solvency
$1 million at 55%
– With ACA: 2029 (now
2025)
– Without ACA: 2017
For CLE ONLY. Not for use in sales situations
2010 Tax Relief Act Cumulative
Rates
2010
2011
2012
2013
Earned Income
Top Marginal Bracket1
36.45%
36.45%
36.45%
41.95%
Unearned Income2
35%
35%
35%
Up to 43.4%
Qualified Dividends3 15%
15%
15%
Up to 43.4%
Not for15%
use in sales situations
15%
Up to 23.8%
Capital Gains4
For CLE ONLY.
15%
Special Tax and Exit Issues:
Professional and Service Firms
•
•
•
•
•
Employment taxes and flow through taxation
Flat tax for P.C.s
Accumulated Earnings
Fringe benefits for flow through entities
Special as to exit
–
–
–
–
Discipline involved
“Of Counsel”
Earn outs
Non-competes
For CLE ONLY. Not for use in sales situations
For CLE ONLY. Not for use in sales situations
Step 1: Business and Personal Survival
Financial Analysis
BUSINESS
•Business
Valuation
•Benefits Review
Firm Dynamics Analysis
PERSONAL
•Financial Needs
•Financial Gaps
•Firm/Family Issues
Integrate with
Overall Business
Plan for the Firm
For CLE ONLY. Not for use in sales situations
Step 2: Exit Plan for Owners/Partners
Determine Objectives
Assess Exit
Techniques
• Maximize value
• Sale
• Minimize taxes
• Capital transfer
• Maximize flexibility
• Gift
For CLE ONLY. Not for use in sales situations
Step 3: Funding Transfer Plan
1. Determine Funding
Events
Target Dates
(retirement,
sale date, etc)
Contingent Events
(Death, Disability,
Divorce)
2. Funding Opportunity
Review
3. Create Funding Plan
4. Pre-Funding
5. Execute and Monitor
For CLE ONLY. Not for use in sales situations
Business Liquidity Needs when
Owner is Exiting
•
•
•
•
•
Costs of disruption
Lost loyalty (revenues and receivables)
Debt called or not extended
Costs of fulfilling sale/transfer
Possible estate taxes
For CLE ONLY. Not for use in sales situations
Business Liquidity Sources when
Owner is Exiting
1. Funding from
Cash Flow
2. Sell the Business
3. Borrow at Exit
4. Borrow from
Government
5. Borrow now
(recap.)
6. Capital Markets
7. ESOP
8. Life Insurance
For CLE ONLY. Not for use in sales situations
Special Considerations for
Professional (and service) Firms
• Ownership – Founders vs Partners vs
Associates
• Governance
• Licensure
• Franchise / Dealership
• Multi-owner nature
• Cash flow and capitalization
• Valuation
For CLE ONLY. Not for use in sales situations
North American Industry Classification System
(NAICS):Professional, Scientific & Technical Services
• 541191 Title Abstract &
Settlement Offices
• 541199 Other Legal Services
• 541211 Offices of Certified
Public Accountants
• 541214 Payroll Services
• 541219 Other Accounting
Services
• 541511 Custom Computer
Programming
• Services
• 541512 Computer Systems
Design Services
• 541519 Other Computer
Related Services
• 541613 Marketing Consulting
Services
• 541614 Process, Physical
Distribution, &
• Logistics Consulting Services
• 541618 Other Management
Consulting Services
• 541921 Photography Studios,
Portrait
• 541922 Commercial
Photography
For CLE ONLY. Not for use in sales situations
Valuation of Professional Practices
Expertise
Education
Reputation/Recommendations
Substitution
Maintenance of Expertise
Goodwill
For CLE ONLY. Not for use in sales situations
Rules of Thumb
• Dental Practice: 1–1.5 X annual net earnings plus
fixtures, equipment, inventory
• Law Practice: 0-100% annual fee revenue,
dependant on client retention
• Accounting Practice: 1-1.5X gross annual
revenues
• Medical Practice: 1.5–3 X annual net earnings,
plus fixtures, equip. &inventory
• Real Estate Agency: 20-50% gross annual
commissions
For CLE ONLY. Not for use in sales situations
Current Business Valuation
Issues
• Multiples
• Discounts
– Judicial
– Legislative
• Life Insurance
• Formula or Amount in Buy Sell?
For CLE ONLY. Not for use in sales situations
Buy Sell Review Principles
• When is
disposition of the
business? (“5 Ds”,
etc)
• Correct parties to
contract? (should
spouse sign?)
• Valuation (Amount,
Formula,
Reference to life
insurance)
• Does agreement
work with the
chosen entity type
(S, C, LLC)?
• Is Life Insurance
ownership
compatible?
For CLE ONLY. Not for use in sales situations
Exit Planning Resources
• Business Enterprise Institute –
John Brown
• Robert Gelder - CBIZ
• John Warrilow – Built to Sell
• Christopher Meyer
• Pinnacle Equity Solutions –
John Leonetti
For CLE ONLY. Not for use in sales situations
Exit Planning Solutions
•
•
•
•
•
•
•
Cross Purchase versus Entity
Multi-owner Buyout
Stay bonus
ESOP
Control: Nonvoting shares, Partnership
Select Reward Plan to fund buyout
Reduced value sale with additional
benefits
For CLE ONLY. Not for use in sales situations
BCGP How it Works
For CLE ONLY. Not for use in sales situations
Multi-Owner Buyout Strategy
GOAL: Provide the liquidity necessary to owners departing a business while
protecting the viability of the business for younger owners.
Business
(Remaining Owners)
Common Triggering Events
Owners Near Retirement
Financing:
Sinking Fund
•Death
•Disability
•Divorce
•Dissolution
•Departure
Newer Owners
Financing:
Life Insurance
For CLE ONLY. Not for use in sales situations
Multi-Owner Buyout Strategy:
Cash Flow for Continuity Plan
Sinking Fund and
Life Insurance
Cash Flow
Funding
Year-by-year exits: retirements, deaths, terminations, disabilities, etc
For CLE ONLY. Not for use in sales situations
Example: Litigation Law Firm
• High, but fluctuating value
• 2 founders, wanting $7.5 MM buyout
• Result:
– $10 million on founder partners
– $5 million on other partners
– $1.2 million annual premium
– Ancillary funding: Disability Income, etc
For CLE ONLY. Not for use in sales situations
Family or Internal Management Sale
Selling at Lowest Defensible Cost
Transaction:
Results:
• Value sale by note at lowest
defensible valuation
• For Owner
• Payments to owner tax
deductible to the company
• Lower net outlay for
purchase by children or
management
• Life insurance is corporate
paid and can help in living or
death buyout. Can fund the
deferred comp as well
• Beware: IRC 2703
– Deferred Compensation
– Consulting and noncompete agreement
• Fund agreement with Life
Insurance, etc.
For CLE ONLY. Not for use in sales situations
Selling to Family / Internal Management
Selling at Lowest Defensible Cost
High
Payments
Cap Gains
Estate Tax
True
Value
$1 MM
Defensible
Value
$800 K
Deferred
Comp
$200 K
For CLE ONLY. Not for use in sales situations
Lower
payments
Lower
Taxes
Buyer Tax
Deductions
Spreads gain
Stay Bonus
• Problem – non-owner key employee
retention after loss of owner
• Solution – stay bonus for period of time
• Profile – family owned, special expertise,
transition planning
• Implementation – side fund, life insurance
(company or ILIT owned)
For CLE ONLY. Not for use in sales situations
Funding the Stay Bonus
Practice
Purchase or Loan
ILIT
Death Proceeds
Additional Income
Key
E’ee
For CLE ONLY. Not for use in sales situations
Internal Sale
• Closely held corporation funds a deferred
compensation account for current executives
who are potential future owners
• The account is set to vest and distribute on a
Change in Control of the company
• Provides incentive/reward for key executives
and retains options for current owner
For CLE ONLY. Not for use in sales situations
Internal Sale
Example:
Sale of
Business
Change of
Control
Vesting
YES
Account vests and distributes to
executives and is used to execute
purchase
Sale to
outsiders
YES
Account vests and distributes to
executives as reward for years of
service
NO
NO
Optional triggering event can be
retirement
Sale to
insiders
For CLE ONLY. Not for use in sales situations
Equity versus Ownership: Control
• Ownership:
– Shares: voting, nonvoting
– General and Limited Partners
• Equity
– Bonuses –current and LTIP
– Deferred compensation
– “Non-partner” career track
For CLE ONLY. Not for use in sales situations