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Complex Legal and Financial Challenges (and Opportunities) to Business Succession and Family TransitionsThursday, December 1, 2011

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FOR TODAY8:00 - Continental breakfast8:30 - Welcome and introductions9:00 – • Key Bank - Business succession and exit

strategies• Gallagher, Flynn & Co. - Tax planning

opportunities & business valuation• Dinse, Knapp & McAndrew - Legally, what you

need to know.12:30 – Lunch & the Mount Family Business story1:30 - Adjourn

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Corporate Banking/Private Banking

Don BakerSr. Vice President

Steve GurinSr. Vice President

Chris BixbyVice President

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Business Succession/Exit Strategies

• OUTRIGHT SALE TO A 3RD PARTY

• SALE TO EMPLOYEES• Management Buy-out• Employee Stock Ownership Plan

• BRING IN A NEW INVESTOR

• SALE TO FAMILY/NEXT GENERATION

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ISSUES THAT ARE CONSISTENT REGARDLESS OF STRATEGY

• SELLER’S FINANCIAL OBJECTIVES

• SELLER’S PERSONAL OBJECTIVES

• PRIORITIES

• WHO IS THE RIGHT BUYER?

• BUYER’S ABILITY TO OBTAIN FINANCING/CLOSE THE DEAL

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Business Succession/Exit Strategies

• OUTRIGHT SALE TO A 3RD PARTY

• SALE TO EMPLOYEES• Management Buy-out• Employee Stock Ownership Plan

• BRING IN A NEW INVESTOR

• SALE TO FAMILY/NEXT GENERATION

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SALE TO FAMILY/NEXT GENERATION

• MAXIMIZE RETURN vs. SET UP FOR SUCCESS

• EMOTIONAL CHAINS TO BUSINESS

• INTER-GENERATIONAL EMOTIONAL BAGGAGE

• FINANCING ASSISTANCE

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FINANCING ISSUES

• STOCK SALE vs. ASSET SALE

• BUSINESS VALUATION vs. BALANCE SHEET VALUE

• HISTORICAL/PREDICTABLE CASH FLOW

• BUYER EQUITY CONTRIBUTION

• BUYER MANAGEMENT EXPERIENCE

• OTHER CREDIT ENHANCEMENTS AVAILABLE

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Financial Planning Process

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Financial Planning Process

• Cash Flow Management– Budgeting– Debt Strategy– Retirement Withdrawal

Plan• Resource Allocation

– Investments– Real Estate– Business Assets

• Risk Mitigation– Insurance– Emergency Savings– Estate Planning

• Psychological Overlay– Goals and Assumptions– Risk Profile

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Tax Planning Opportunities and the IRS Voluntary Worker

Reclassification Settlement Program

Rick Wolfish, CPA

Gallagher, Flynn & Company, LLP

Tax Planning Opportunities and

the IRS Voluntary Worker Reclassification Settlement

Program

Rick Wolfish, CPA

Gallagher, Flynn & Company, LLP

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RICHARD G. WOLFISH, CPATax Partner

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New Voluntary Worker Classification Settlement

ProgramOptionalAllows employees to reclassify workers as employees for future tax periodsLimited federal employment tax liability for past nonemployee treatmentFile form 8952

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New Voluntary Worker Classification Settlement

ProgramPayment equal to little over 1% of wages paid to reclassified employee for past yearsAudit insuranceOn Nov. 17th, 2011, Vermont announced it will not piggyback this program. They may change their mind in the future.

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Tax Planning OpportunitiesAccrual basis business can take 2011 deduction for some bonuses not paid until 2012.Maximize domestic production deduction – 2011 deduction 9% of qualified production activates income.

Depreciation opportunities 2011 $5000,000 expensing 2012 $125,000 expensing

100% bonus first year depreciation expense 12/31/11

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Tax Planning OpportunitiesResearch and development credit expires 12/31/11.If you are an S-Corporation, make sure you have basis for losses. Consider lending the company money or making a capital contribution.File Quick Carrybook refunds for corporations (Form 1139) and Individuals (Form 1045).Claim deductions for disaster loss in 2010 or 2011.Make year-end gifts to family members.

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Importance of Business Valuations

Mark Beliveau, CPA CVA CFE

Gallagher, Flynn & Company, LLP

Importance of Business

Valuations

Mark Beliveau, CPA CVA CFE

Gallagher, Flynn & Company, LLP

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Mark Beliveau, CPA CVA CFEPartner

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Why a Valuation?• Succession Planning/Buy Sell

Agreements Insurance or other funding needs

• For estate planning, gifting and estate filing

• To evaluate potential sale/purchase of a business (or joint venture)

• Shareholder Disputes & Oppression (minority shareholder suit)

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Why a Valuation?• Determine economic damages

(before/after event)• Marital dissolution – value of

interest to be included in the marital estate

• Management – assessment of enterprise value and indicators that impact value of company

• ESOP – employee stock ownership

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Basic Valuation Questions to be

asked• Who is the client? Stockholder or Company• What is the specific interest being appraised?• What is the valuation date? Maybe dictated by

factors causing need for valuation.• What is the purpose of the appraisal? See Why(s)

above• What is the standard of value? Fair Market Value,

Fair Value• What type of report is needed? See next slide.

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Value DefinedFair Market Value–

“…the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.

(Article 20.2031-1(b) of the Estate Tax Regulations and Revenue Ruling 59-60, 1959-1 C.B. 237)

Fair Value—The price that fairly compensates an owner who was

involuntarily deprived of the benefit of his ownership interest where there is neither a willing buyer nor a willing seller.

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Types of ValuationsFull Appraisal

Takes in to account the 3 major methods (to be discussed a bit later) to determine value

Used primarily for:LitigationFilings with governmental agenciesContentious situation

Calculation Report Utilizes single agreed-upon method to determine

value Not as comprehensive as full appraisal Used primarily in non-contentious/friendly

situationsBack of the Envelope/Rules of Thumb

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Professionals Involved in Process

• Attorney – usually. If litigation-based may want to have Valuator engaged by Attorney

• Valuation Professional Appraiser Skills, Knowledge, Certification,

Objectivity & Bias• May need to involve real estate or

machinery and equipment appraiser

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Business Valuation Professional

OrganizationsNACVA – CVA or AVAAICPA - ABVASA - ASAIBA – CBA

Each organization has their own professional business valuation standards

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ESTIMATING THE VALUE

Valuation Approaches• Asset Approaches• Market Approaches• Income Approaches

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ASSET APPROACH – WHEN TO USEAppropriate when valuing:

• Marginally profitable companies (better dead than alive?)

• Asset-heavy companies• Holding companies and non-profits• Controlling interests

Generally not useful:• When significant intangible value exists• For valuing service companies• For valuing professional practices• When considering minority interests

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ASSET APPROACH

Liquidating or Distressed Value

Liquidating – restate value of assets and liabilities at date of valuation to fair market value, less costs to dispose

Distressed Value – fair market value does not apply here

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MARKET APPROACHES:Guideline Publicly Traded Company MethodUsing information from publicly traded, similar companies, determine “multiples” to apply to the subject company’s operating results to obtain a value

Completed Transactions MethodSimilar to GPTCM – based on sales of business interests in the market (M&A)Data Sources

Institute of Business AppraisersBizcomps©Pratt’s Stats©Mergerstat©

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Market (continued)Guideline public companies• Search databases for

“comparable” publicly traded companies

• Multiple (price to earnings, price to sales, etc.) applied to same measures of subject company

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Guideline Public CompaniesStrength:

• Value is based on current market activity

Weakness:• Often difficult to find true guideline

companies• Extensive analysis needed

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The Income ApproachMost commonly used methodology

StrengthsGrounded in finance theoryThe most widely recognized approachWeaknessesPast isn’t indicative of future – reliance on historical data

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The Income Approach…• Value today is the Present Value of

future benefits• Considers time value of money and

risk• Use history to project future cash

flows• Cash flows are converted to PV using

capitalization rate or discount rate

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Present ValueWould you rather have $10,000 now, or $14,025 five years from now?

$10,000

2011

$14,025

2016

Future Value

Present Value

Investment Yield5%7%10% ?

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Time for Some Valuation Buzz Words

Equity - Also called “net book value,” “net asset value,” or “shareholder’s/owner’s equity.” Assets less Liabilities = Equity

Cash flows to equity – those cash flows available to pay out to equity holders (in the form of dividends) after funding operations of the business enterprise and making necessary capital investments

Discount rate - Rate of return that converts a series of expected future returns on an investment to a present value

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Time for Some Valuation Buzz Words

Capitalization rate - Rate of return that converts a single period of earnings or investment amount to a present value

Cost of capital - The expected rate of return that the market requires in order to attract funds to a particular investment

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ANALYZING THE INFORMATIONFinancial Analysis:

• Common-size analysis• Comparative analysis• Trends

Non-financial analysis• Management• Competition• Products & Quality• Customer/supplier concentration

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The Income Approach

Capitalization of Earnings

PV of anticipated benefits =

Economic benefits (cash flow) Capitalization rate

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The Income Approach

Developing the NUMERATOR…

The approach is forward looking but.. past performance is often foundation for projecting future economic benefits.

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The Income Approach

Most common methodologies for estimating future economic benefits from historical data Current earnings method – used in example Simple average method – averaging the benefits provided during the study period Weighted average method – applying a weighting to benefits provided during the study period

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The Income Approach

Our example will use a single amount of tax -affected cash flow….Because cash flow and reported earnings or net income are not the same AND…Investors purchase the opportunity to receive cash flow.

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The Income Approach

A proxy for cash flow:

Pre-tax “normalized” earnings+ Depreciation and amortization expense

Normalized cash flow

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Normalizing Adjustments

Normalization Process– Adjust financial statements for nonrecurring, non-operating, or unusual items to eliminate anomalies and arrive at an indication of the “economic reality” of the business.

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Normalizing Adjustments

Failure to develop the appropriate normalizing adjustments may result in a significant overstatement or understatement of value

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Normalizing AdjustmentsCommon income statement adjustments:

Excess compensation or fringe benefits relative to individual’s roleAbove or below market rental payments to related partiesNonbusiness expensesDepartures from GAAP

Common balance sheet adjustments:Excess and/or non-operating assetsRelated party loansEconomic value of property & equipment

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Relationship Between Discount Rate and Capitalization Rate

Discount RateLess: Long-term sustainable

growthEquals: Capitalization Rate

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Quantitative “build-up” methodRisk-free long-term U.S. government bond rate 4.6%

Add: Equity risk premium 6.3%

Size risk premium 9.8%Equals: Expected total return-small publicly

traded stocks 20.7%Add: Company specific risk premium 3.0%Equals: After-tax discount rate 23.7%Less: Long-term sustainable growth rate 4.0%Equals: After-tax capitalization rate for next year 19.7%

Divide by: 1 + growth rate 104%Equals: After tax capitalization rate for current year 18.9%

Capitalization factor (1/.189) 5.3

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Capitalization of Earnings v. Discounted

Cash Flow Capitalization of earnings method can be used where economic benefit (cash flow, earnings etc.) to owner is steady and increases annually at the same growth rate.Discounted Cash Flow method is used where amount of economic benefit is expected to vary from year to year and/or growth rate is expected to change significantly over time.

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The Income ApproachAbout the DENOMINATOR…

Discount or capitalization rate is function of risk-free rate of return and real/ perceived risk premium required to induce buyer (investor)In a purchase transaction, discount rate is the BUYER’S cost of capital

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Example of Income ApproachCapitalization of Earnings method – information used:Company’s pretax accounting income = $195,000Depreciation = $10,000Grandma on payroll = $20,000Below market rent paid = $15,000 under marketTax rate = 40%

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Income Statement Basics

Revenue: $6,000,000

Less Cost of Goods Sold $4,500,000Equals: Gross Margin $1,500,000

Less Operating ExpensesSelling Expenses

$435,000General Expenses

$435,000Administrative Expenses

$435,000Equals: Operating Profit $195,000

Plus/minus Other Income/Expenses $0

Pre tax income $195,000

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Example of Income ApproachPretax income

$195,000Normalizing Adjustments:Remove Grandma 20,000Rent to market

(15,000)Normalized pre-tax net inc $200,000Add: Depreciation

10,000Pre-tax cash flow to equity $210,000

Keep going….there’s more………

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Example of Income ApproachPre-tax cash flow to equity 210,000Income tax (on $200K @40%)

(80,000)After-tax gross cash flow base 130,000Less: Additional WC requirements -Less: Net capital expend required (20,000)Ongoing after-tax cash flow to equity$110,000

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Example of Income ApproachUsing cap rate computed earlier:

After-tax cash flow to equity$110,000 / .189 = $582,000

-or-Using capitalization factor:

$110,000 x 5.3 = $583,000(Difference is due to rounding)This is the value of a 100% interest in the Company without discounts

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DiscountsTwo biggest issues:Minority/Lack of Control - reflects the decreased value of shares that do not convey control of a closely held business.Lack of Marketability - reflects no ready market for shares in a closely held business and time to turn share into cash

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CONTROL AND MARKETABILITY

Controlling Interest Value

Marketable Minority Interest Value(“WSJ Listed Price”)

Nonmarketable Minority Interest Value

Control Premium Minority Interest Discount

Discount for Lack of Marketability

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Discount for Lack of Marketability

Factors Affecting Marketability

Lead to smaller DLOM

APublicly traded

BNo

restrictions on sale

CRegistered securities

DActive market

Lead to larger DLOM

Closely held

Restrictions on sale

Unregistered securities

Thin market

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Application of Discounts and Premiums

Value on a control, marketable basis $583,000

Less discount for lack of control @ 25%

146,000

Value on a minority, marketable basis (rounded)

437,000

Less marketability discount @ 30% 131,000

Value of minority, non-marketable interest (rounded) (47.5% overall discount)

$306,000

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QUESTIONS…….

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Mark LanganTax Attorney

Dinse, Knapp & McAndrew