Selling a Business Getting What You Need

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1 Selling a Business Getting What You Need You Can Get Satisfaction Sir Michael Jagger, better known as Mick, led The Rolling Stones in proclaiming that You can t always get what you want but you just might find you get what you need. This trade-off applies to all things in life, including investments, and it has special validity when selling a private business. Although an owner s focus may be ongetting his magic number for the business up front, he may find that other alternatives offer acceptable, or even superior, trade-offs. We begin with the premise that business sales are typically complicated, and laden with emotional issues. The owner is selling his means of livelihood, and more the configuration of his financial portfolio: He ll have to make the transition from relying on business earnings to living off the pool of liquid investments generated by the sale. The good news is that sellers are not in the process alone, but generally represented by teams of advisors, usually quarterbacked by an investment banker and including a portfolio-management professional such as Bernstein (display below). The role of the investment manager is not to pass judgment on one or another term sheet, but to place each in the context of the seller s overall financial objectives. This can be done at any point in the deal but the sooner the better. Transaction Planning: A Holistic Approach IN THIS PAPER Selling a private business is best thought of as an ongoing planning process that begins well before the deal is consummated and ends well afterward. But at every point along this continuum, the owner and his professional team are grappling with and resolving both financial and personal issues. Bernstein s proprietary modeling capabilities can quantify the likelihood that a sale will meet an owner s critical financial objectives and help evaluate the trade-offs across different deal terms. Corporate Attorney Investment Banker Gregory D. Singer Director of Research Bernstein Wealth Management Group T&E Attorney Client Investment Manager Bernstein Expertise Long-term investment planning Asset allocation Brian D. Wodar Director Bernstein Wealth Management Group Accountant Multigenerational wealth transfer Bernstein does not provide tax, legal, or accounting advice. Business sellers should discuss their individual circumstances with professionals in those areas.

2 A Thicket of Questions Display 2 parses some of the interconnected financial and emotional issues that arise when selling a business. For example, whether the owner receives enough for his business depends onhowmuchitgeneratesinearnings 1 andhowmuchthemarket is willing to pay for those earnings. But directly connected are issueslikewhethernowisagoodtimetosell,whethertheowner wantstoretainaninterestinthebusinessforawhilelonger often a negotiable point and how the sale will impact the owner s family and employees. All of these issues affect owners personal lives as deeply as their financial wherewithal and on both sides of that equation professional planning can identify opportunities and help solve problems. Further, each of these questions leads to additional questions. Arriving at answers is made none the easier by the blizzard of alternatives often available, and frequently buyers and sellers find themselves in disagreement about deal terms, legalities, and tax-related matters. The job of the professional teams the seller s and the buyer s is to satisfy their respective clients, resolve as many issues as possible before the consummation of the deal, and monitor the transaction as it moves forward. And there are never one-size-fits-all answers. One seller may justifiably be anxious to consummate the deal before taxes go up in 2011; another may be willing to pay the higher levy if he expects his earnings to increase significantly in the near future, raising the value of the offers he ll receive. The question is whether the risk of waiting will pay off. We ll have more to say about this later. Display 2 Typical Business-Owner Questions Financial How much is my business worth? What s the best deal structure for me? Will I get enough to meet my needs? Is all-cash-now better than staged/contingent payments? Emotional Do I want to stay involved in the business? Do I have a plan for my life after the sale? What effect will the sale have on my family and employees? Do I have the risk tolerance to accept contingent deal terms? Professional planning is critical Whatabouttheenvironment?Isthisagoodtimetosell?Evidence of an economic recovery is mounting, but financing is still tight, andtherearenoassurancesaboutwhatthefuturewillbring.in addition, the profit dynamics of every industry and, more important, for every company are different. That last criterion is theonethattrulycountsforabusinessseller:it shiscompanyand hislivelihoodthatareatissue.thejobofhisprofessionalteamis tokeephimfromfallingintooneoftwotraps:rushingheadlong into selling now because the landscape looks good, or refusing tobudgebecauseitwasbetterseveralyearsagoandgoodtimes may be around the corner again. Still, owners need a touchstone for deciding whether to sell, and one metric might be if the proceeds whether all up front or parceled out over time are at least enough to provide for the owner s lifetime spending needs (his so-called core-capital SM requirements). Ideally, he d take home even more than that and generate excess capital (see Will You Get Enough? Core Capital vs. Excess, facing page). Non-Sellers Remorse During the boom years of the mid-2000s, many business owners were offered and refused term sheets, hoping to do better only to regret that decision when the bear market ensued. Consider John and Jane Commander (Display 3, page 4), who decided in early 2007 that they were ready to give up their business, which was earning more than $7.5 million a year, and represented the vast majority of their net worth (the rest of which was invested in two IRAs totaling $1 million). They wanted to sell the business for $60 million, which worked out to 8 EBITDA, a high multiple even by 2007 standards but were offered $48 million. They chose to pass. As we ll see, while more money is obviously better than less, they didn t need proceeds of $60 million to meet their financial objectives. Indeed, three years later new offers came in, but by now, in harder times, their earnings had declined to $6 million. They d have to sell at a lower multiple, yielding $27 million cash, leaving them with $23 million after taxes, including their IRAs. Should they sell this time? Could they, and meet their objectives: satisfying their core-spending needs ($500,000 a year, grown 1 Earnings are typically defined differently in different industries and for different purposes, but in many industries, earnings calculations for sale purposes are often before interest, taxes, depreciation, and amortization (EBITDA): in other words, the cash flow generated. Throughout this paper, earnings and EBITDA are used interchangeably. 2 Selling a Business: Getting What You Need

3 Will You Get Enough? Core Capital vs. Excess To distinguish between what you want and what you need, we ve developed a planning framework at Bernstein that identifies so-called core capital and excess capital (display below, left). The core amount is what you need to meet your spending needs, grown with inflation, for the rest of your life. Because no one wants to live with the threat of running out of money, we calculate the probability of sustaining core capital over an investor s lifetime using our Wealth Forecasting System SM (see page 4) at a very high degree of confidence: typically 90% or better. The amount depends mostly on the investor s age, spending rate, and portfolio risk level. We estimate, for example (display below, right), that a 65-year-old couple with a portfolio invested 60% in stocks and 40% in bonds will need $3.2 million of core capital for every $100,000 they spend annually, when factoring in a range of actuarial life expectancies. In general, the amount of required core capital at higher spending rates varies by age and allocation. For instance, if the couple were invested 60/40 but were 15 years younger, their longer time horizon would translate into Evaluating What You Need and What You Want roughly $4.3 million of core capital. These are scalable numbers: If the 50-year-old couple were also spending $400,000 a year instead of $100,000, they d need four times as much core, or $17.2 million. For more information on core capital and spending rates see Appendices 1 and 2 on page 12. Any amount left over in an investor s portfolio after the core-capital requirement is satisfied is the excess : used for extra spending, legacy provisions, philanthropy, and, in some cases, new business ventures. The relevant issues are how much is in the excess pool, and how the investor intends to invest and deploy it. Because excess capital is not a lifestyle requirement, it may be invested with more risk than an investor may be willing to take with his core capital i.e., more stocks or alternative assets. For many business sellers, it s key to come away with a deal that has the highest likelihood of meeting at least their core-capital requirements. If the sale generates excess also, so much the better.n Projected Core-Capital Amounts by Age Per $100,000 Annual Spending ($ Mil.)* Lifestyle Spending Personal Reserve Extra Spending Capital for Next Venture Children and Grandchildren Charity Core Capital Amount to ensure spending needs are met Often calculated at 90% level of confidence Excess Capital Amount for expanded opportunities How much do you spend? What is your age? What is your risk tolerance? How much? To whom? How quickly? How allocated? What strategies? Allocation (% Stocks/ % Bonds) 0/100 20/80 40/60 60/40 80/20 100/0 Age 50 $7.1 $5.6 $4.8 $4.3 $4.3 $4.3 Age Age *The core-capital requirements here are for couples and assume an allocation of globally diversified stocks and diversified intermediate-term municipal bonds in the proportions noted. Spending budgets are assumed to grow with inflation, and maintained with a 90% degree of confidence. Based on Bernstein s estimates of the range of returns for the applicable capital markets for the periods analyzed. Data do not represent past performance and are not a promise of actual future results. See Notes on Wealth Forecasting System at the end of this paper. Information on longevity and mortality-adjusted investment analysis in this study is based on mortality tables compiled in In our mortality-adjusted analyses, the life span of an individual varies in our 10,000 trials in accordance with mortality tables. Source: Society of Actuaries RP-2000 mortality tables and AllianceBernstein 3

4 Display 3 Case Study: John and Jane Commander Disappointment Or Opportunity? In 2007 Business earning $7.5 Mil./yr. Appraised at 6.5 earnings=$48 Mil. Commanders passed on a sale Their Questions: Will we have enough to support our core needs? Will we be able to buy a $3 million second home? Should we hold off selling again, and hope for better? How should we evaluate alternative deal terms? Will we leave a sizable estate? *Includes $1 million in IRAs In 2010 (65 years old) Earnings down to $6 Mil. Appraised at 4.5 earnings=$27 Mil. Net proceeds after taxes: $23 Mil.* with inflation), purchasing a $3 million vacation home they d had their eye on for decades, and establishing a substantial legacy for their two children? With so much money on the table, you wouldn t think that core capital would even be an issue, but the Commanders live an upscale lifestyle, and there are subtractions from the top. They d want to set aside their capital-gains tax bill in cash, for example, and the 10% of the purchase price that would go into escrow is never entirely safe. The couple and their team justifiably wanted a specific core number from us an estimate of how much they d need to support themselves even in dreadful markets. To answer that question, and others related to the deal, we input the Commanders goals, assets, risk tolerance, time horizon, and other data specific to their situation into our proprietary Wealth Forecasting System. SM The couple were fortunate enough to be able to consider three different deal structures, so we studied all three term sheets, various asset allocations for the proceeds, and several what-ifs for their business earnings over the next five years. After subjecting these data to 10,000 simulated future returns in markets ranging from spectacular to dismal, we generated a probability distribution of outcomes (Display 4). We projected their required core at $16.6 million, but that was a function of how they invested the deal proceeds. Determining Allocation and Required Core Capital Like many business owners who can no longer rely totally on earned income, the Commanders had a conservative bent when it came to investing their sale proceeds a portfolio weighted toward bonds. We used our Wealth Forecasting System to evaluate the potential returns and volatility of a portfolio invested 20% in globally diversified stocks and 80% in bonds (Display 5). While the model suggested that the portfolio would almost never generate a peak-to-trough loss as great as 20%, that security came at a price: Bonds have limited growth potential. We projected that the couple s age, budget, and portfolio allocation would translate into a core-capital requirement of $18.6 million (at the 90th percentile of probability) and an expected portfolio value after 30 years of spending and taxes of $30.4 million. That doesn t sound at all bad but the Commanders and their team wondered if the couple could do even better. The Commanders were aware that stocks tend to grow more quickly than bonds, so they wanted to see how much more Display 4 Quantifying the Possibilities: The Wealth Forecasting System Family Profile Data Scenarios Bernstein Wealth Forecasting Model Distribution of 10,000 Outcomes Probability Distribution Financial Goals Assets Income Requirements Risk Tolerance Tax Rates Time Horizon Deal Terms Asset Allocation See Notes on Wealth Forecasting System at the end of this paper. 10,000 Simulated Observations Based on Bernstein s Proprietary Capital-Markets Research 5% Top 5% of Outcomes 10% 50% Median Outcome 90% 95% Bottom 5% of Outcomes 4 Selling a Business: Getting What You Need

5 Display 5 Core-Capital Requirements and Volatility: Three Representative Asset Mixes* % Stock/Bond Allocation 20/80 40/60 60/40 Core Capital Required $18.6 Mil. $16.6 Mil. $16.2 Mil. Probability of 20% Peak-to-Trough Loss, 30 Yrs. 2% 6% 33% Median Wealth, 30 Yrs. $30.4 Mil. $39.4 Mil. $48.8 Mil. *Core-capital assumptions are based on lifestyle spending needs of $500,000 per year, growing with inflation, and not including the $3 million vacation home or any legacy plans. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the next 30 years. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting System at the end of this paper. wealth they might accumulate over 30 years if they invested at a higher risk level. If we pushed stocks to 60% of the portfolio, we projected the 30-year wealth figure at $48.8 million $18.4 million more than a 20/80 mix. And with the extra growth of stocks, we d expect the Commanders to need less core capital $16.2 million. But the trade-off for stock growth is volatility. We estimated that the Commanders would face a one-in-three chance that at some point they d lose as much as 20%. This went far beyond the limits of their risk tolerance. The optimal solution for this particular couple turned out to be a bond-tilted 40/60 portfolio, which would require core capital of $16.6 million. Our analysis convinced the Commanders and their team that a 40/60 investment strategy could meet that hurdle even if markets were very poor, and with a very small risk (6%) of ever experiencing a 20% portfolio correction over the next 30 years. Our median 30-year wealth expectation was $39.4 million. Altogether, this was an attractive picture for the couple, one they could readily embrace as the centerpiece of their financial planning. The question is, would the deal net them their core capital, and an additional $3 million to fund the vacation home $19.6 million in all, plus enough extra to support a legacy for their kids? Take the Money and Run or Wait Awhile? And so the Commanders would have to work through different term sheets with their professional team, since they were considering three different types of transactions. It turned out that all were variants of cash deals, but the cash would come to them at different times and from different sources. n One offer was straight cash up front: $27 million. After paying capital-gains taxes at 15% on the federal level and 5% to their state, and assuming a zero cost basis in the business, the Commanders would have $23 million (counting their $1 million in IRA funds). It wasn t the $60 million they were looking for in 2007, but it was substantially more than their spending plans required. They could easily satisfy their core needs, buy the vacation home, and have $3.4 million left over for legacy purposes on Day 1 even in very poor markets and before any multigenerational planning. Why couldn t theytake the offer and walk away satisfied? The fact is, they could if they were willing to leave behind their disappointment about not garnering $60 million. In business sales, the financial and the emotional issues are inextricably tied to one another. There s another angle to consider about accepting a lower offer than the peak the couple had hoped for: Lower valuations for a business often coincide with lower valuations in the capital markets and hence higher return potential for the liquid portfolios that house business-sale proceeds. For the Commanders this could even translate into more wealth in the out years than if they sold at the higher 2007 offer. n Another sale alternative was a leveraged recapitalization. What if the company took on some debt in hopes of using the extra money to improve their operations, and hence their earnings? They might find a prospective buyer interested inthe growing potential of the business. In the deal the investment bankers laid out for the Commanders, a new partner would enter the business right away, with a 20% ownership interest in the Commanders shares. Under this structure, combining proceeds from the sale of equity and a substantial portion of the debt assumed by the business, the Commanders would come away with $13.5 million. 2 They d also be paid an annual salary of $400,000 for five years for continuing to participate in the company s operations. Meanwhile, the couple would be using their company s earnings to pay down the debt and work toward a profitable exit in this representative case, five years after inception of 2 The debt on the balance sheet is a double-edged sword. On the one hand, it would presumably be used to improve the business; on the other, much of the earnings would have to be used to pay down the debt which is why recaps tend to be so contingent on earnings. However, the Commanders would not be liable for any of the debt personally, which is an obligation of the business. 5

6 the recap. 3 True, the up-front cash would fall short of satisfying their spending needs but the couple wouldn t consider a leveraged recap in the first place unless they were confident about their company s five-year earnings prospects. In a worst (and unlikely) case, if earnings plummeted enough, a deal would probably be worked out through negotiations between the would-be buyer and seller, albeit probably at a price that both sides would see as a compromise. n Finally, the Commanders received a so-called earn-out offer: also cash with a five-year contingency, but not as dependent as a recapitalization on an earnings upswing. In this transaction, the Commanders would give up their entire interest in the business in exchange for a share of the earnings: as much as $2.4 million annually over a five-year period. If post-sale earnings were to fall short of agreed-upon targets, the earn-out payments would be reduced proportionately. If the Commanders agreed to the terms, the couple would be offered $19 million on Day 1, plus $400,000 a year in consulting fees for five years not quite enough to meet their core needs and the cost of the vacation home at the critical 90% level of confidence, though close. But unlike all-cash up front, the final value of the earn-out would be dependent on how the business performed over the near term and like a recap, the Commanders would have to be interested in staying involved in business operations. Working Through the Trade-Offs Of course, there s no right alternative for every business owner. Some owners feel both emotionally and financially secure staying tied to their business for a longer period. Other owners are eager to take the cash immediately, if they can get it, and go on to the next phase of their lives (which may not be retirement but another business venture). Similarly, there was no perfect alternative for the Commanders. It depended on the trade-offs they were most comfortable with which is where we and their other professional advisors came in. We knew, though, that working together, we d enable the Commanders to identify the strategy best tailored to meet their goals. Display 6 lays out the issues in schematic form. But why all these complications? As we said, the Commanders couldtaketheall-cash$27millionupfrontandavoidthe uncertainties, a strategy that many business owners embrace. Along those lines, we compare the up-front cash portion of each offerindisplay7.theall-cash-nowdealwastheonlyonethat virtually ensured the couple would meet their needs in any plausible scenario; in the other two cases, a significant portion of the transaction involved contingent payouts.(with the recap, we estimated the chance of the up-front cash meeting the Commanders core needs at only 29%.) Deferring completion to a later datewouldmeanexposuretoawholehostofissuesoutsidethe scope of this paper, including future market conditions and buyer insolvency. Extreme cases, as we re-learned in 2008, do occur. Display 6 Three Representative Commander Sale Alternatives All Cash Now Leveraged Recap Earn-Out $27 Million Up Front $13.5 Million Up Front Salary: $400K/Year 80% Retained Equity $19 Million Up Front Consulting Fee: $400K/Year Up to $12 Mil. in Earn-Outs over 5 Years Exit from Business Expected After Five Years Transaction Complete 3 The ultimate buyer could be the 20% owner, but the final transaction is more commonly an outright sale of 100% of the business interests to a third party. 6 Selling a Business: Getting What You Need

7 Display 7 Up-Front Cash:* All-Cash vs. Leveraged Recap and Earn-Out $ Millions Commander Nominal Wealth Values, Year 30 After Taxes, Spending, and $3 Million Home Purchase % Stocks/60% Bonds The Icing on the Cake? But the case isn t closed. Often, business owners regard the contingency payouts as merely icing on the cake. But with our Wealth Forecasting System, we can help sellers systematically evaluate the sensitivity of different offers to varying earnings scenarios. The more the business earns over the contingency period, the more the sellers will benefit and the odds are generally in their favor. Display 8 adds the potential future proceeds fromthefinalsaleofthecommanderbusinessintherecapcase and from continuing distributions in the earn-out scenario, as well as the salary and consulting fee, respectively. For the immediatecash alternative, of course, there are no contingencies. Using this scenario analysis, we were able to help them stress-test different earnings outcomes versus the security of immediate cash. The leveraged recap and the earn-out both offered the opportunity for more upside and the potential forgreater downside as well. But because of its reliance on leverage, the recap was far more sensitive to earnings changes Immediate Cash Leveraged Recap Earn-Out Probability of Meeting Spending Needs 97% 29% 82% Level of Confidence 5% 10% 50% 90% 95% *Cash includes $1 million total in John and Jane s IRAs. Basis in business assumed to be zero. Spending assumed to grow with inflation each year. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the next 30 years. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting System at the end of this paper. on both sides. So, for example, we estimated that just 5% earnings growth would be enough to deliver a median result ofalmost $100 million and an upside above $175 million. 4 A10% earnings decline, on the other hand, would leave the Commanders with about $8 million of excess capital in downside markets not a dismal outcome by any means, but the Commanders wouldn t want to test a recap much beyond a 10% earnings falloff. As we ve said, they wouldn t want to take the risk of a recap unless they were quite sanguine about the future of their business. An earn-out is also sensitive to profits, as its name implies but less so. The earn-out considered by the Commanders would Display 8 Adding In Future Earnings: Cash vs. Leveraged Recap vs. Earn-Out $ Millions 0 Commander Nominal Wealth Values, Year 30 After Taxes, Spending, and $3 Million Home Purchase Immediate Cash 97% % Decline % Stocks/60% Bonds* 5% Growth Earnings: Leveraged Recap % Decline Earnings: Earn-Out Probability of Meeting Spending Needs 95% >98% 96% % Decline >98% Level of Confidence 5% 10% 50% 90% 95% *See second footnote to Display 7. Leveraged recapitalization examples assume five years of annual pretax salary income at $400,000, annual rates of growth or decline in EBITDA as noted, and pretax sale proceeds at Year 5 of $12,484,000 and $34,030,000, respectively. Earn-out examples assume five years of annual pretax consulting income at $400,000 and annual rates of decline in pretax payments related to the earn-out schedule. All sale proceeds are assumed to be taxed at the capital-gains rates in effect upon distribution. See Notes on Wealth Forecasting System at the end of this paper. 4 Assuming that the business was now valued at 5 EBITDA rather than 4.5, reflecting the improved earnings 7

8 How Much Taxes Count The Tax Code has already built in large increases in an array of taxes for 2011, with an incremental hike in 2013 to support healthcare reform (display below). The maximum federal capital-gains rate the key tax for business sellers is scheduled to climb from 15% today to 20% in 2011 and to 23.8% two years later. Altogether, the levy is scheduled to increase by more than half over the three-year period.* So suppose the Commanders waited a year or more to allow their business to grow. And what if it didn t? The display to the right illustrates the 30-year wealth consequences for four different capital-gains rates: 1) 15% in Year 1 and 20% thereafter; 2) 20% each year; 3) 23.8% each year, reflecting the surcharge for high-bracket taxpayers to help defray the cost of healthcare reform; and 4) 28% each year; to our knowledge, no proposal for a 28% gains tax is on the table, but we ve seen that rate historically.** Taxes Slated to Increase Capital Gains Dividends Taxable Interest Earned Income % Top Marginal Tax Rates % % Change 2013 (2013/Current) 23.8% 59% Based on recent healthcare legislation; assumes joint filers with annual income above $250K or single filer with income above $200K. Increase in Medicare tax of 0.9%; currently, Medicare tax is 1.45%, so the new Medicare tax would total 2.35%. Including ordinary income tax and Medicare tax, the effective tax rate in 2010 is 35% % = 36.45%; in 2013, the top rate would be 39.6% % = 41.95%, and the change would therefore be 15%. Figures exclude Social Security tax and state income tax Two conclusions emerge from the display. First, taxes have a significant impact on wealth accumulation no surprise there. For a business sold at $27 million with liquid proceeds invested in a 40/60 construction, the difference in median wealth between a 15% gains tax in the first year and a 20% levy would amount to $6.2 million after three decades: a 16% gap. Still, in each of these tax scenarios, the Commanders would meet their spending needs at the 90th percentile of probability albeit with little to spare if gains taxes were as high as 28%. The Impact of Taxes: Growth in Assets $ Millions 0 Commander Business Sold for $27 Million Nominal Wealth Values, Year 30 After Taxes, Spending, and $3 Million Home Purchase % Stocks/60% Bonds % 20% 23.8% 28% Federal Capital-Gains Tax Rate Level of Confidence 5% 10% 50% 90% 95% Basis in business assumed to be zero. Spending assumed to grow with inflation each year. In 15% tax case, federal capital-gains tax on the transaction and the liquid portfolio is 15% in Year 1 and 20% thereafter, consistent with current tax law. In the 20%, 23.8%, and 28% tax cases, federal capital-gains tax on the transaction and the liquid portfolio is at those rates in Year 1 and in each year thereafter. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the next 30 years. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting System at the end of this paper. *For a detailed study of the investment implications of the coming shift in the Tax Code, see our April 2010 white paper, Investment Opportunity amid Tax Uncertainty? **Aside from the analysis in this box, we have not accounted for the Medicare surtaxes in this paper. Further, in all analyses, we assume a 5% state capital-gains tax, and we assume ordinary-income tax on dividends starting in In the 20%, 23.8%, and 28% scenarios for capital-gains tax, we assume that the tax rate is in effect the year the sale is consummated and remains constant thereafter. 8 Selling a Business: Getting What You Need

9 Comparisons based on taxes are revealing. To realize the same after-tax proceeds on a $27 million sale in 2010, a business would need to sell for $28.9 million in 2011 and $30 million two years later. If earnings are used as the metric, EBITDA would have to increase by a cumulative 11.7% for anowner selling in 2013 to break even after taxes versus consummating the deal for $27 million pretax in 2010 (display below). Even if he waited only until 2011 to sell, his earnings would have to jump substantially. Alternatively, earnings multiples would need to accelerate by the same amounts, or a combination of earnings and multiples would have to achieve that rate of growth. It s no revelation for business owners or their professional teams, but tax planning can make millions of dollars of difference. And so, all else equal, an owner would be well-advised to sell in 2010 rather than later. But in fact, all else is rarely equal, and each sale needs to be evaluated in its own right including the prevailing tax rate, among many criteria. We would emphasize, though, that selling a business and investing the proceeds in a liquid portfolio is a risk-reducing diversification strategy, decreasing dependence on one source of wealth. In that light, selling earlier rather than later tends to make more sense, especially when taxes are scheduled to rise imminently. n Commander Earnings Required to Sell for $27 Million Pretax $6.0 Mil. $6.4 Mil. $6.7 Mil. Assuming capital-gains tax rates of 15% in 2010, 20% in 2011, and 23.8% in 2013 allow for an earnings decline as large as 20% and still be comparable to the all-cash offer while retaining some upside in good markets. All the alternatives cash, recap, and earnout were viable options that might be appropriate depending on the Commanders priorities and risk tolerance. They might not have gotten what they wanted (i.e., $60 million), but they would find that they got what they needed. Setting the Table for the Family As we ve said, the Commanders wished to transfer some of the excess capital from their proceeds to family beneficiaries. Addressed early enough, planning before the sale can be especially important. One effective means of transferring wealth is to gift shares. For gift-tax purposes, the value of the transfer will be based on a current or recent appraisal generally lower than the value assigned at sale because pre-sale shares are illiquid and essentially unmarketable. In addition, if the gift represents a minority interest in a private company, for gift-tax purposes the value could be further discounted because the beneficiaries have no control over the illiquid shares. If the business is indeed sold for significantly more than the valuation at appraisal, the beneficiaries would end up with more than the appraised value of the gifts. For example, if the owner uses his $1 million lifetime applicable gift-tax exclusion amount to transfer shares of his company that ultimately benefit from a 30% discount at the time of sale, he s actually transferring $1.4 million. However, to take advantage of a discount, there needs to be a sufficient time interval between the gift and the sale agreement. 5 Adding the Power of GRATs A grantor-retained annuity trust, or GRAT, can leverage gifting substantially. Here s how it works: The owner contributes shares of his business to the trust and receives annuity payments back that equal his gift plus an amount of interest determined by the IRS Section 7520 rate. If the assets in the GRAT appreciate at a rate faster than the 7520 hurdle, the GRAT succeeds and all extra appreciation passes to the beneficiaries free of transfer tax. At today s low interest rates, the GRAT bogey is especially low. (As of June 2010, the Section 7520 rate was 3.2%.) Further, donors pay the income and capital-gains taxes from 5 Consult a valuation specialist to determine the appropriate discount in your situation. 9

10 Display 9 What a Difference a Discount Makes: A Short-Term Trust $ Millions Nominal $6 Million Three-Yr. GRAT Remainder Values After Taxes Year 30, 100% Bonds Post-Transaction in GRAT 0 30% % Stocks/20% Bonds Thereafter* % Discount 50% outside the GRAT, enhancing the amount transferred. Because the statute of limitations on the valuation of the shares is three years (during which time GRAT distributions can be adjusted if the IRS disputes a claimed value), professional teams often recommend a three-year GRAT when contributing assets whose value is questionable. 6 Contributing discounted shares of a business, depicted in Display 9, increases the potential benefit if the company is sold within the three-year period. 7 The realization of the full value of the discount helps the assets in the GRAT appreciate rapidly, making it very likely to outperform the 7520 rate. In this case, we presume that a three-year $6 million GRAT invests its Level of Confidence 5% 10% 50% 90% 95% *Basis in business assumed to be zero. Assumes GRAT remainder is transferred to an irrevocable trust that pays its own taxes (i.e., a non-grantor trust). Bonds are 100% intermediate-term diversified municipals for the first three years. Thereafter, the allocation is 80% globally diversified stocks and 20% intermediate-term diversified municipal bonds. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the next 30 years. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting System at the end of this paper. proceeds from the business sale in bonds for the safety of locking in returns. Once the trust expires after three years, the proceeds intended for the children are invested for the next 27 years in an 80% stock/20% bond portfolio suitably stock-heavy if you assume that the beneficiaries have a long time horizon. The display makes clear how the advantage of discounting builds. If the $6 million of shares in the GRAT were subject to a 30% discount, we d expect the median value of the 80/20 portfolio to be $15.6 million after taxes and fully $7.8 million in very poor markets. Had the shares been discounted by 40%, we d project a $24.2 million median and a $12.0 million downside case. Discounting can be a powerful tool when put to use in a GRAT. Quantifying the Advantages of Planning Assembling a legacy plan yields notable benefits. Returning to the Commander case study, let s assume the couple sold the business for $27 million in cash and did no planning prior to or after that point. Recall that on Day 1, they d have $3.4 million to set aside for legacy. In the absence of any estate-planning techniques, we d project that even in dismal markets the legacy would grow to $13.2 million the amount left over at the 90th percentile of probability before any estate taxes (refer back todisplay 8, page 7). But in the median case (Display 10, left side) we projected that again, making use of no planning tools they d leave a hefty amount to their heirs at the end of 30 years: $18.8 million after estate taxes. But they d cede even more to the government. Suppose, though, that the couple s legacy strategy was, pre-sale, to fund a three-year GRAT with $6 million in company shares, 30% discounted (Display 10, right side). Assume the Commanders invested the proceeds in a liquid portfolio over the 27 years following the GRAT s term. Our models suggest that their heirs could expect the GRAT combined with the rest of the Commanders assets after estate taxes to produce $11 million in 6 As of this writing, Congress is considering GRATs and may require that all such trusts have terms no shorter than 10 years. In that event, a business owner may opt for a 10-year GRAT or use another strategy. The most likely candidate is an installment sale to an Intentionally Defective Grantor Trust (IDGT). With this strategy, an outright (potentially taxable) gift of 10% of the overall transfer of the shares is made to the trust (a general rule under prevailing practice: No tax or legal authority expressly sanctions 10% as a necessary or sufficient amount). The remainder of the assets is sold to the trust in exchange for an interest-bearing note. The growth of those assets can pass to the beneficiaries free of additional transfer tax if they appreciate at a rate higher than a hurdle interest rate. (The Applicable Federal Rate [AFR] is lower than the Section 7520 rate for any loan of nine years or shorter. As of this writing, the mid-term AFR for June 2010 is 2.72%.) There are, of course, advantages and disadvantages of both GRATs and installment sales to IDGTs. For example, if the GRAT donor dies during the term of the trust, part or all of the trust assets revert to the donor s estate and might not be gifted to a beneficiary free of transfer taxes. Advice from the business owner s professional team is critical in putting trust vehicles to best use. Our May 2010 white paper, Transfer Opportunities in Advance of Legislative Change: An Interim Approach to Planning with GRATs, evaluates gifting alternatives in light of the possibility that the minimum GRAT term will be extended to 10 years. 7 Assuming that the GRAT was funded long enough before the sale to take full advantage of the discounted shares (see above and page 9). 10 Selling a Business: Getting What You Need

11 additional wealth. 8 Through the single action of funding a trust before the sale with discounted shares and then investing the proceeds appropriately the couple would be able to increase the legacy to their children by more than 50% and reduce their estate-tax liability by nearly $6 million. The benefit derives from removing appreciating assets from the Commanders estate, decreasing their estate taxes, and setting that 80/20 risk level for the children s portfolio rather than their own more conservative 40/60. If the couple were uneasy about leaving their children somuch money, or wanted to do even more planning, pre- or post-sale, for any reason, there would be a variety of multigenerational and philanthropic strategies at their disposal. Such strategies using vehicles including direct gifts, private foundations, charitable remainder unitrusts (CRUTs), and charitable lead annuity trusts (CLATs) could be used for philanthropic purposes alone or for wealth transfer to both the family and charity. Each such strategy would absorb some of the Commanders gifting capacity and reduce their estate-tax bill. These techniques lie beyond the scope of this study, but the same basic principles apply relying on professional counsel, considering various trust vehicles, and carefully timing all strategies. Even when a deal is complete, it s not too late to plan for legacy-building; it s doing nothing with excess capital that can incur a large opportunity cost. Conclusion We conclude with these thoughts about the intricacies of selling a closely held business: n Planning for personal as well as financial issues in a business sale can help the owner feel secure about completing a deal. Emotions count for a lot, whether they re centered around the effects of the sale on family and staff, the owner s desire (or lack of it) to close out a phase of his life, or any other issue not directly related to the proceeds. n Rigorous scenario analysis is critical in understanding the impact that uncertain future earnings, valuations, and tax rates have on different deal structures that owners may be considering. Display 10 Reducing Tax Impact on Legacy To Gov t $27 Million Sale: Distribution of Family Wealth, Year 30 After Spending and Taxes in Typical Markets* No Planning (½ to Government) $20.6 Million $39.4 Mil. $18.8 Million Left for Heirs $6 Mil. Pre-Sale GRAT, 30% Discount (More Wealth, ¼ 3 to Gov t) To Gov t $14.9 Million $29.8 Million $44.7 Mil. Left for Heirs *Median results. See footnote 6 on page 10. Assumes that the spouses die in same year, and that $1 million per person is exempt from estate taxes. The remaining estate is taxed at a 55% rate. In the GRAT case, term of trust is assumed to be three years. Median senior-generation wealth before estate taxes is $29.1 million, and median remaining trust assets are $15.6 million.the analysis on the left assumes that with no lifetime wealth transfer the remaining assets after estate taxes pass to the children. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the next 30 years. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting System at the end of this paper. n Owners are well-advised to revisit their plans continuously throughout the sale process (before, during, and afterward). As for the Commanders, they were strongly considering the leveraged transaction to recapture the level of upside they had in But ultimately they opted for an all-cash up-front deal and they decided to initiate a pre-transaction GRAT, a combination that provided them with peace of mind and virtual certainty of leaving a significant legacy for their children. They and their professional team knew they were trading off some good things for others they rated even better. Sir Michael would approve. The authors would like to acknowledge Cory Dowell, a Director of Bernstein s Wealth Management Group, and Matthew J. Teich, an Investment Planning Analyst in the Group, for their invaluable insights and quantitative research. 8 Assuming that the GRAT proceeds were invested in an 80/20 stock/bond mix, and that the Commanders portfolio was allocated 40/60 for the full 30 years. 11

12 Appendix 1: Sustainable Annual Spending Rate* by Allocation and Investor Age Allocation (% Stocks/% Bonds) 0/100 20/80 40/60 60/40 80/20 100/0 Age % 1.8% 2.1% 2.3% 2.3% 2.3% Appendix 2: Core-Capital Requirement by Allocation, Investor Age, and Annual Spending Budget ($ Millions) Annual Spending Budget $100,000 $250,000 $500,000 $750,000 $1,000,000 $100,000 $250,000 $500,000 $750,000 $1,000,000 0% Stocks/100% Bonds 20% Stocks/80% Bonds Age 50 $7.1 $17.9 $35.7 $53.6 $ $5.6 $13.9 $27.8 $41.7 $ Age 40% Stocks/60% Bonds 60% Stocks/40% Bonds Age Age 50 $4.8 $11.9 $23.8 $35.7 $ $4.3 $10.9 $21.7 $32.6 $ % Stocks/20% Bonds 100% Stocks/0% Bonds Age Age 50 $4.3 $10.9 $21.7 $32.6 $ $4.3 $10.9 $21.7 $32.6 $ *Spending is grown with inflation; spending rates assume maintaining spending with a 90% level of confidence. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the periods analyzed at the 90% level of confidence. Data do not represent any past performance and are not a promise of actual future results. See Notes on Wealth Forecasting System at the end of this paper. Source: Society of Actuaries RP-2000 mortality tables and AllianceBernstein 12 Selling a Business: Getting What You Need

13 Notes on Wealth Forecasting System The Bernstein Wealth Forecasting System SM (WFS) is designed to assist investors in making a range of key decisions, including setting their long-term allocation of financial assets. The WFS consists of a four-step process: (1) Client Profile Input: the client s asset allocation, income, expenses, cash withdrawals, tax rate, risk-tolerance goals, and other factors; (2) Client Scenarios: in effect, questions the client would like our guidance on, whichmay touch on issues such as which vehicles are best for intergenerational and philanthropic giving, what his/her cash-flow stream is likely to be, whether his/her portfolio can beat inflation long term, when to retire, and how different asset allocations might impact his/her long-term security; (3) The Capital Markets Engine: our proprietary model that uses our research and historical data to create a vast range of market returns, taking into account the linkages within and among the capital markets (not Bernstein portfolios), as well as their unpredictability; and (4) A Probability Distribution of Outcomes: based on the assets invested pursuant to the stated asset allocation, 90% of the estimated returns and asset values the client could expect to experience, represented within a range established by the 5th and 95th percentiles of probability. However, outcomes outside this range are expected to occur 10% of the time; thus, the range does not establish the boundaries for all outcomes. Further, we often focus on the 10th, 50th, and 90th percentiles to represent the upside, median, and downside cases. Asset-class projections used in this paper are derived from the following: US value stocks are represented by the S&P/Barra Value Index, with an assumed 50-year compounding rate of 8.9%, based on simulations with initial market conditions as of December 31, 2009; US growth stocks by the S&P/Barra Growth Index (compounding rate of 8.5%); developed international stocks by the Morgan Stanley Capital International (MSCI) EAFE Index of major markets in Europe, Australasia, and the Far East, with countries weighted by market capitalization and currency positions unhedged (compounding rate of 9.2%); emerging markets stocks by the MSCI Emerging Markets Index (compounding rate of 7.2%); municipal bonds by diversified AA-rated securities with sevenyear maturities (compounding rate of 3.9%); taxable bonds by diversified securities with seven-year maturities (compounding rate of 5.4%); and inflation by the Consumer Price Index (compounding rate of 3.0%). Expected market returns on bonds are derived taking into account yield and other criteria. An important assumption is that stocks will, over time, outperform long-term bonds by a reasonable amount, although this is by no means a certainty. Moreover, actual future results may not be consonant with Bernstein s estimates of the range of market returns, as these returns are subject to a variety of economic, market, and other variables. Accordingly, this analysis should not be construed as a promise of actual future results, the actual range of future results, or the actual probability that these results will be realized. Mortality Assumptions: Mortality is modeled using our proprietary simulation model, which creates a range of death ages for a given age. The outcomes of the mortality simulation model are then combined with the outcomes of the Capital Markets Engine on a trial-by-trial basis to produce summarized mortalityadjusted results. Mortality simulations are based on the Society of Actuaries Retirement Plans Experience Committee Mortality Tables RP n 13

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15 Global Wealth Management Client-Centered Wealth Management Solutions At Bernstein, we are dedicated to providing our clients with wealth management solutions tailored to their unique circumstances. We start with robust planning, to identify each client s needs for lifetime spending, retirement, multigenerational wealth transfer, and philanthropic pursuits. We then stress-test a range of investment strategies, including asset-allocation approaches, to arrive at a plan for achieving these goals. Then we implement the client s plan through our proprietary platform of investment services, each reliant upon dedicated research teams and managed by dedicated portfolio management teams. In managing a client s plan over time, we employ active management within each service, also rebalancing to maintain the overall portfolio s profile and, if appropriate, managing taxes to mitigate their impact on a client s after-tax returns. We also place a high degree of emphasis on informing our clients, providing transparent and realtime performance reporting via our website, and having frequent discussions on portfolio strategy. Throughout, we aim to meet our clients objectives and their expectations. Wealth Planning Client Reporting INFORMING PLANNING Comprehensive Solutions Asset Allocation Performance Monitoring MANAGING Portfolio Selection Tax Management, Rebalancing, and Currency Management 14 Publication Title