DIVERSIFICATION AND THE PRIVATELY HELD BUSINESS

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1 DIVERSIFICATION AND THE PRIVATELY HELD BUSINESS STRATEGIC CONSIDERATIONS FOR A HIGHLY CONCENTRATED ASSET CLASS For many of the world s most successful entrepreneurs, the creation of significant wealth was as much the byproduct of their business ventures as the goal. Most are driven by the need to create, to start with an idea and see it grow into a successful enterprise that changes industries, communities and hundreds, perhaps even millions, of lives. Their businesses become part of their family heritage, the source of justifiable pride as well as the source of income. There are approximately 7.4 million businesses in the US 1 Over 500,000 more are launched each year U.S. Census. 2 Brookings Institute, available at: testimony/2012/02/01-small-businessbaily. Accessed 12/15/13. As their ventures grow into a significant asset, the owners of highly successful businesses are unilaterally faced with an enviable problem. With the vast majority of their net worth held in a single asset, they are exposed to an exceptionally high level of concentration risk. Under adverse conditions, this risk could result in a significant erosion of the financial legacy they have worked so hard to establish. Establishing your goals The business you created is more than just an asset, and your decisions about its disposition should probably not be made on financial considerations alone. Determining the level of involvement you want to retain in a family business is a personal decision that has emotional and interpersonal components as well as purely financial inputs. The success of any major life decision, after all, should be gauged by the impact it has on your life and your family, not just your net worth. The optimal solution then becomes the one that allows you to support your lifestyle, philanthropy and wealth transfer strategies, while retaining whatever level of control you wish to exert over the enterprise you created. There are many ways to monetize a privately held business, every one of which carries its own advantages and limitations. Determining which strategies to explore may come down to one central question: How much control over and exposure to your family business do you want to retain? Answers to some of the following questions may help your make that determination: PERSONAL CONSIDERATIONS How long do you wish to continue your current level of involvement with the business?

2 DIVERSIFICATION AND THE PRIVATELY HELD BUSINESS MORGAN STANLEY PRIVATE WEALTH MANAGEMENT Private Wealth Management was founded in 1977 to meet the complex needs of Morgan Stanley s ultra high net worth clients. Private Wealth Advisors provide sophisticated solutions, through an open architecture, that leverage the intellectual capital and insight of Morgan Stanley s substantial global resources. Today, we help many of America s most illustrious corporate leaders preserve and grow their financial, family and social capital across generations. Over 350 Private Wealth Advisors. Approximately $200 billion in assets under management. Focused on individuals and families with $20+ million in assets. 40+ offices in key metropolitan areas across the United States. All information is as of 12/31/2013. Are younger members of your family interested in assuming control of the business? Do you have other enterprises or endeavors that demand more of your time? Is the growth and prosperity of your business still a primary source of personal satisfaction? Are you open to input, or directives, from new investors or owners? How will taking some chips off the table impact your motivation? What is your tolerance for risk? STRATEGIC CONSIDERATIONS: How quickly is your business growing? Do you need additional sources of capital to fund that growth? How much do you believe in the upside of your business and how confident are you in your projections? How susceptible is your business to significant value impairment from competitive innovation? Are there logical strategic partners and/or buyers for your business? How important is the appearance of your balance sheet to the ongoing performance of your company? How much of your overall net worth does the value of your business represent? Setting your course Whether you decide to sell your company outright, retain full control or anything in between, there are a number of strategies you can consider. All of these have serious tax, financial planning and other implications, so you should begin your planning well in advance and consult with your Private Wealth Advisor, lawyer and other professionals. Your Private Wealth Advisor can also introduce you to investment bankers 1 who can help you understand the pros and cons of various approaches and outline some of the steps you may need to take to maximize the value of your business. At the very least, you will want an assessment of whether your current financial recordkeeping is adequately robust and an understanding of what various types of acquirers look for in their target companies. Even if you intend to retain full ownership of your company, you should consider working with your management team and/or outside advisors to take the following steps: Have your financials audited. Take measures to lock-in key employees, and purchase keyperson insurance. Review contracts with key customers, vendors and suppliers to see if they contain change of control provisions. Do what you can to formalize and document your business processes. Identify and assess threats to your business and document what you are doing to mitigate them. Clarify your chief strategic priorities and assess whether they are aligned with what buyers want. 1 Employees of Morgan Stanley & Company. 2

3 STRATEGIES TO SELL YOUR BUSINESS IN WHOLE, OR IN PART INITIAL PUBLIC OFFERING (IPO) A strategy that may be more suitable for larger, privately held companies, an IPO offers the potential to raise significant capital and generate liquidity. You can leverage the knowledge of Morgan Stanley s experienced investment banking team or, when appropriate, third-party investment bankers to evaluate the IPO market and structure an offering that would benefit you, your employees and your investors. The upside Opportunities to diversify your holding over time. Facilitates lending as a liquidity option. Gain access to the public markets for capital needed to grow the business. Allows you to offer incentive contracts to key employees. Ownership is diluted. Significant regulatory and reporting requirements must be met on an ongoing basis. Likely increase in income tax burden if company shifts from a pass-through tax entity (LLC, S Corp) to a C Corp. The downside Relatively high transaction costs. 3

4 STRATEGIES TO SELL YOUR BUSINESS IN WHOLE, OR IN PART SALE TO A STRATEGIC ACQUIRER: Should you decide to sell your entire stake in your company, the greatest value is often found in selling to a well-capitalized strategic buyer: One who is seeking to enter or increase its share in your market, acquire your technology or intellectual property, or otherwise gain a competitive advantage through an acquisition. The upside The potential opportunity to generate income through an employment or consulting contract. Possible 20% long-term federal capital gains tax on the appreciated value. You get to walk away. Locks in the full, current value of your company. Immediate opportunity to create a well-diversified portfolio upon sale. No further capital gains potential upside from the business future appreciation. May have to manage a concentrated position in the acquiring company s stock. You may have to walk away. The downside 4

5 STRATEGIES TO SELL YOUR BUSINESS IN WHOLE, OR IN PART FINANCIAL SALE TO A PRIVATE EQUITY FIRM (LEVERAGED BUYOUT): Sales to private equity firms are typically highly leveraged transactions to buyers with purely financial objectives. The buyers typically look to buy a controlling interest in the company, seeking a profitable exit strategy in the form of an IPO, LBO or future sale. The upside Significant liquidity and wealth diversification. You may participate in future value creation, often realizing that value in 3 to 5 years. Capital providers favor transactions with private equity sponsors. May add a financial partner who is willing to fund industry consolidation. Private equity firm may provide additional industry and/or managerial expertise. You no longer control the company s strategic direction yet will likely be required to stay with the business for at least 2 to 3 years. Relatively limited future equity participation. May not achieve full liquidity at closing. Likely to realize a lower valuation than through a strategic sale. The downside 5

6 STRATEGIES TO SELL YOUR BUSINESS IN WHOLE, OR IN PART SALE TO AN ESOP: A tax-advantaged strategy to transfer ownership to your employees, an Employee Stock Ownership Plan (ESOP) can be an appealing option for those who intend to sell at least 30% of their company. The upside The flexibility to sell anywhere from 30% to 100% of your company. Provides strong incentives to your employees, as they are now your partners. Ability to defer capital gains tax and receive the full net proceeds of the sale, provided: You have owned the stock for at least three years and have not received it from a qualified retirement plan, or by exercising stock options. After the sale, the ESOP must own at least 30% of the company. The company must be organized as a C corporation at the time of purchase. You must reinvest the shares in what is called qualified replacement property within one year after the date of your sale (includes stocks, bonds, floating rate notes (FRNs) and a variety of other securities issued by US corporations). Reduced ownership share limits upside potential. The downside Valuation may be lower than a strategic sale. Your employees might not want to participate, particularly those who are ready to retire along with you. 6

7 Strategies to monetize your business without diluting your control. DIVIDEND RECAPTURE: Liquidity is achieved by leveraging up the company and using the proceeds to pay a special dividend to owners. THE UPSIDE: Provides partial liquidity to those shareholders preferring near-term liquidity. Preserves equity upside. Minimal due diligence and limited indemnification representations and warranties. THE DOWNSIDE: You bear the risk of future operating performance. Increased leverage may reduce ability to make strategic acquisitions. Reduced flexibility to weather deterioration in market conditions. Lenders typically have discounted debt multiples in recapitalizations. Lenders may insist on warrants, potentially diluting your equity. Strategies to transfer your business to family members. The following strategies allow you to pass equity to the next generations of your family on a transfer-tax-advantaged basis. FAMILY LIMITED PARTNERSHIP: Initial partners, typically parents, form a family limited partnership by contributing shares of a business and receiving partnership units in return, thereby assuming the role of general partner. Children or other family members are given limited partner units. General partners make all decisions related to the operation of the partnership, including investment of assets and distribution of income. Limited partners may receive distributions from the partnership but are not entitled to make operating decisions. As units given to limited partners are not readily marketable, nor do they entitle limited partners to participate in operating decisions, they may qualify for valuation discounts. THE UPSIDE: Allows you to maintain full control of the business while reducing the value of your taxable estate. Reduces the value of assets placed in the partnership for tax purposes via valuation discounts. (Similar valuation discounts may also occur through the use of an LLC.) Protects limited partners against creditors and litigation. THE DOWNSIDE: May create complex family dynamics and wealth transfer issues if all of your children are not equally involved in the family business. Greater audit risk than other gifting strategies due to perceived abuses of valuation discounts. SYSTEMATIC GIFTING: Current federal law allows you to make annual gifts of $14,000 a year ($28,000 per married couple) to as many people as you wish without incurring gift tax. This Annual Exclusion Amount (AEA) may be applied to the transfer of shares in your company. Beyond the AEA, taxpayers may also transfer up to $5.34 million in Using valuations discount may enable you to reduce the value of your gift for tax purposes due to lack of marketability or recipient control. (Consult with your attorney for details.) THE UPSIDE: Gets relatives involved in running the business while you re there to train them. Maintains more control and provides you with time to transition ownership comfortably. Removes future appreciation on gifted shares from your estate. May be able to take advantage of valuation discounts that reduce the value of the gift for gift tax purposes. THE DOWNSIDE: Even with valuation discounts, transfer of shares may be subject to annual and lifetime gift caps for larger enterprises. May create complex family dynamics and wealth transfer issues if all your children are not equally involved in the family business. You cede control of your business to your family members in proportion to the shares you have gifted, although gifts may be made to trusts governed by provisions and trustees selected by you. Future appreciation and income on gifted shares pass to the beneficiary of such shares. GRANTOR RETAINED ANNUITY TRUST (GRAT) GRATs allow you to transfer future appreciation (above an IRS mandated hurdle rate) to beneficiaries, free of estate and gift taxes. Property, including an interest in your business, can be transferred into the GRAT in return for an annuity for a set number of years. As the success of the strategy depends upon you surviving the term, shorter terms of as little as two years are generally preferred. The value of the annuity is based on an IRS discount rate and is typically structured to be nearly equal to the value of the property transferred into the trust, so that there is no or little taxable gift made to the trust. When the term of the annuity ends, any property remaining in the trust is paid to one or more remainder beneficiaries free of estate and gift taxes (often children or a trust for children). A GRAT can produce estate and gift tax savings if the donor outlives the annuity term and the trust property produces an annual return in excess of the discount rate over the term of the annuity. 7

8 DIVERSIFICATION AND THE PRIVATELY HELD BUSINESS THE UPSIDE: Removes future appreciation of business interests from your estate. Future appreciation of business interest may be transferred gift-tax-free. You receive the initial value of your contribution, plus interest, over the term of the trust. THE DOWNSIDE: Annual valuations are required. Donor has to survive the grant term in order for the remainder to pass gift-tax-free The advisory team planning approach. The success of any monetization strategy depends on the contributions of a diverse team of professionals that may include a tax accountant, trust and estate attorney and corporate legal counsel in addition to Private Wealth Advisors. Your Private Wealth Advisor typically takes a lead role in coordinating the team s efforts, helping you identify and implement the strategies best suited to help you and your family reach your goals. They also provide access to specialists to help you evaluate various strategies to determine which best meet your personal goals and your aspirations for the ongoing business after your departure. Preparing for the transition. Regardless of which particular strategy you decide to pursue, it takes careful planning to monetize your company in a way that achieves your financial objectives, preserves business value and positions your wealth to achieve your legacy and multigenerational goals. Waiting until after the transaction to deal with wealth management issues can be costly in terms of taxes and lost planning flexibility. It pays to begin your planning process at least a year, and preferably at least two years, before you intend to act. That will provide you and your family with the time to identify your key advisors, plot a careful strategy and ultimately implement a plan designed to fulfill your personal and business goals. FOUNDATION TO MONETIZATIONS: TYPICAL FINANCING PHASES FOR EMERGING GROWTH COMPANIES FOUNDERS ROUND At formation, founders stock (common stock, most or all of which is subject to vesting) is issued to the founders for a nominal price, typically a fraction of a penny. An equity incentive plan is usually set up with common stock reserved for grants of restricted stock, RSUs or options to future employees, contract workers, consultants, advisors and directors. SEED ROUND Most companies issue convertible notes to raise startup capital from friends and family or angel investors. This is a simple way to avoid valuing the company. The notes typically convert into preferred stock when the company completes its first preferred stock financing and professional investors determine an appropriate valuation. To compensate early investors for the risk of investing at an earlier stage, convertible notes typically provide a kicker in one of two ways: The note converts into preferred stock at a price discount (e.g., 20 percent) Warrants (essentially options to buy common or preferred stock) are issued along with the convertible note to provide extra upside potential. PREFERRED STOCK FINANCINGS When the company is able to attract angel investors and/or VCs, it can raise capital through convertible preferred stock financings: If the company is doing well, each successive round of financing is represented by a new series of preferred stock, sold at increasingly higher prices per share. If the company is not doing well, it may have to raise capital with a down round where the new series of stock is priced lower than the previous series. IPO OR ACQUISITION The final financing phase for most emerging growth companies typically involves either a strategic acquisition, leveraged buyout, ESOP or IPO. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide tax or legal advice. This material was not intended or written to be used, and it cannot be used, for the purpose of avoiding penalties that may be imposed on the taxpayer. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters. Diversification does not assure a profit or protect against loss in declining financial markets. Morgan Stanley Smith Barney LLC ( Morgan Stanley ) is a registered broker-dealer, a member SIPC, and not a bank. Where appropriate, Morgan Stanley has entered into arrangements with banks and other third parties to assist in offering certain banking related products and services. Unless specifically disclosed in writing, investments and services offered through Morgan Stanley are not insured by the FDIC, are not deposits or other obligations of, or guaranteed by, a bank and involve investment risks, including possible loss of principal amount invested Morgan Stanley Private Wealth Management, a division of Morgan Stanley Smith Barney LLC. Member SIPC. CRC (3/14) PWM CS /14