Middle Market M&A: Unseen Deal Pros Have Biggest Impact On Value
I’ve advised founder/owner/entrepreneurs on more than 300 exits during my career and I tend to recall them as being part of one camp or another. No, I don’t think of them by industry groups. And no, not by the type of transaction – private equity, strategic buyer, employee stock ownership plan – chosen for the exit.
Rather, I tend to remember the sellers as having sophisticated and long-term estate planning in place, or not, simple as that.
Why? Because it really makes the most difference in determining the aftertax value a business owner and his or her heirs will realize. Yes, a good middle market M&A investment banker can help you attract the highest bids and see that they’re structured in the most tax-efficient form. We can also help you structure your relationship with your company going forward in ways that preserve and build upon your legacy.
But without astute tax and estate planning, from what I’ve seen, your exit will be worth a lot less in the long run. In Illinois, for instance, combined federal and state estate tax rates can add up to nearly 50%.
So, today I’m sharing a few estate planning insights courtesy of David Allen, a partner at the law firm of Katten Muchin Rosenman LLP in Chicago. (Future columns will feature other estate planning pros.) David’s practice focuses on estate planning for high net worth individuals. Katten’s overall estate planning practice is heavy with middle market companies. So, if you’re an owner of a middle market company, his observations may be useful to you, and certainly a discussion starter with your own professional advisors.
Estate planning, of course, achieves much more than saving money on taxes. When a family’s net worth – and, indeed, its identity — is heavily concentrated in a business, a big tax bill can force the sale of that business, undermining family finances and so much more.
–First, David notes, the current threshold of the federal government estate tax exemption—the amount an individual can leave to heirs upon death without having to pay federal estate tax—is $5.43 million per person in 2015. So a married coupled can leave $10.86 million to their heirs this year, federal estate tax-free. The federal estate tax exemption is reduced by lifetime taxable gifts. If an individual gives during lifetime or leaves to their heirs on death more than $5.43 million, he (or his heirs) will owe federal tax of up to 40% on the excess. Nineteen states plus the District of Columbia also have their own version of an estate or inheritance tax and can impose a top tax rate of 16%.
Many middle market companies, of course, obtain values of $50 million or far more. So, acting early is crucial. David says many business owners can gift partial ownership of their business to heirs while the value is lower. Then, the appreciation of that stake escapes future estate taxation, potentially forever.
To illustrate, David has seen an entrepreneurs gift interests in their business to trusts for the benefit of their families when the businesses are valued in the tens of millions of dollars but subsequently appreciate to hundreds of millions and even billions of dollars. Enormous tax savings. And he’s seen the opposite: elderly prospective clients with businesses valued above $100 million who’d done little estate planning and whose family was facing a very large tax bill.
–Governance: if you gift majority ownership of your company to your adult kids, are you now working for them? David explains that the business owner can gift non-voting shares and retain all the voting power. That keeps you in charge. It could also will likely depress the value of the gifted shares in the eyes of the taxman, which is a favorable treatment thereby using up less of your federal gift and estate tax exemptions.
–The business owner can also sell a stake in the business to a trust for the benefit of his or her family, taking a note back for most of the transaction’s value, David says. For a growing and profitable business, this approach can a.) move ownership to heirs, b.) provide partial liquidity for the seller and, c.) vastly reduce taxes. Just like a leveraged buyout, the company’s earnings over time could be used to pay down the debt.
–Planning can also help those beyond your family. Philanthropic urges are enabled by good planning. “Charitable trusts” can provide a unique estate planning solution. Charitable trust, can provide a unique estate planning solution. For example, an individual could leave assets to a “charitable lead trust,” that would pay out a modest portion of the trust assets annually to charities for a set number of years after the individual’s death. And then the balance of the trust assets would be distributed to the individual’s heirs. The individual’s estate would be able to claim an estate tax deduction equal to the present value of the future stream of charitable payments. Having the individual’s family private foundation receive the charitable payments could sweeten the deal even further by keeping the charitable money in the family’s control.
These are just four examples of estate planning moves. “There are many other estate planning solutions that can be tailor-made for each specific client’s particular needs,” David says. The most important thing is for business owners to start thinking early.
That way, when you’re ready to think about an exit strategy, you and your advisors can focus on that, knowing you’ve done the early work to maximize your company’s after-tax value to your family. I often tell clients, good investment bankers can steer you to the right buyer with a superior price, perhaps a 25% increase over mean values. And a good estate plan can add upwards of 50% economic value and superior alignment with personal goals for family, estate and charities. Imagine if you did both?