Avoid the top 10 continuation-planning mistakes

By Mark Wyzgowski, managing partner, Clifton Gunderson, Cedar Rapids

Only about a third of all privately held family businesses ever make it to the second generation. There are many reasons for this.

One of the most important is a failure on the part of the business owner to develop a plan to cover all of the possible risks when he or she dies, retires or otherwise moves from the company.

Here are 10 common mistakes that can derail even the most profitable company:

1. FAILURE TO DEVELOP A PLAN

This seems obvious, but it bears repeating: Putting off planning is a serious mistake. Nothing will happen until fears are pushed aside and the owners begin the difficult work of considering what happens to the business after they are gone.

2. CHOOSING THE WRONG TYPE OF CONTINUATION PLAN

A buy-sell agreement is the linchpin of succession planning. A number of factors go into determining the best type of buy-sell arrangement, including the type of business structure and the number of owners.

There are two primary forms of business continuation plans:

• Redemption plan - Often used when the company has more than one shareholder. The terms of the agreement generally specify that the company will redeem a shareholder's stock when a triggering event occurs.
• Cross-purchase plan - In this type of arrangement, remaining business owners agree to purchase the interests of departed shareholders when a triggering event occurs. This plan can involve complex life insurance planning.

In a redemption plan, remaining shareholders have increased ownership percentages but no change in their tax basis in the business. By contrast, remaining shareholders in a cross-purchase plan have both increased ownership and increased tax basis.

Substantial amounts of capital can be lost to taxes as a result of improper buy-sell plan selection.

3. NOT PLANNING FOR ALL CONTINGENCIES

Death and retirement are the two most common triggering events, but there are others that should not be overlooked. Each creates its own concerns and should be addressed in a comprehensive plan.

Most plans cover:

• Death
• Retirement

Plans should cover:

• Death
• Retirement
• Disability
• Bankruptcy
• Divorce
• Third-party offer

Concerns:

• Heirs acquire shares
• No transition plan
• Incapacitated owner
• Lender acquires shares
• Ex-spouse acquires shares
• Unknown owner(s)

4. INAPPROPRIATE VALUATION METHOD

The best way to assure that you have an accurate and appropriate business valuation is to involve a valuation expert. An improper value has consequences throughout the plan.

There are three basic valuation methods:

• Asset based - Value is based on the fair market value of the company's assets, less its liabilities. Used when no goodwill or blue sky is present in the company.
• Income based - Appropriate for operating entities; focuses on historical and future earnings.
• Market based - Probably the most misused approach by casual valuators, it is appropriate for larger operating entities.

5. NOT CONSIDERING KEY VALUE DRIVERS

There are no boilerplate answers when it comes to valuation. For a valuation to truly represent the company, it must consider many unique factors, including earnings, growth, customer relationships, risk, discounts and levels of ownership.

6. NOT USING DIFFERENT LEVELS OF  OWNERSHIP FOR INTRA-FAMILY TRANSFERS

All shareholders are not created equal, and that gives a business owner flexibility to transfer ownership to family members over a specified time period without actually relinquishing control of the company.

Three Levels of Ownership

Control Value

• More than 50 percent of voting shares
• May require a small marketability discount

Blocking

• 50 percent/50 percent
• Is non-controlling, so will have discount for lack of control and marketability, though smaller discounts than straight minority ownership

Minority

• Less than 50 percent voting or any non/voting/limited partner block
• Full discounts for lack of control and lack of marketability

The goal in gifting is to move the stock at the lowest tax value possible, which would include minority blocks of voting shares, and blocks of non-voting shares.

7. CREATING RED FLAGS FOR THE IRS

Many transition agreements set a fixed value for transfers, with the intent of minimizing the transfer costs and avoiding gift taxes. In the end, this may not reflect the “fair market value” that is required by the IRS, resulting in unexpected tax consequences.

Get a formal appraisal by a qualified appraiser to support the transaction price, especially for transfers between related parties.

8. NOT ACTING TO RETAIN KEY EMPLOYEES

Key employees who are not owners will be concerned with the death or departure of the owner. Depending on the person and the position, retention strategies may be instituted, including non-qualified deferred compensation plans, stay bonuses, long-term incentives, stock ownership plans and phantom stock plans.

Some strategies, such as non-qualified deferred compensation plans, may create liabilities that reduce fair market value. Be sure to explore all of the valuation and tax consequences.

9. FAILING TO FINANCE THE PLAN

Continuation plans often fail because there

is not enough personal capital or capital within the company to complete the agreement between remaining shareholders. A common strategy to ensure cash is available is to purchase life and/or disability insurance policies on the owner(s).

Whether the business owners choose to “self insure” the risk or transfer it to an insurance company, it is critical that assets be available to complete the purchase when an owner leaves the business.

10. NOT UPDATING THE PLAN

A business continuation plan should be flexible enough to accommodate all of the changes in the lives of business owners.

Key documents, insurance policies and other funding strategies should be reviewed at least every two years.