Bernstein Selling a Business GWM LTR
Transcript of Bernstein Selling a Business GWM LTR
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Selling a BusinessGetting What You Need
You Can Get SatisfactionSir Michael Jagger, better known as Mick, led The Rolling Stones in proclaiming that
You cant always get what you wantbut 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 owners focus may be
on getting 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 morethe
configuration of his financial portfolio: Hell 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 sellers overall financial objectives. This
can be done at any point in the dealbut the sooner the better.
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. Bernsteins
proprietary modeling capabilities
can quantify the likelihood that a
sale will meet an owners critical
financial objectives and help
evaluate the trade-offs across
different deal terms.Transaction Planning: A Holistic Approach
Bernstein Expertise
Long-term investment planningAsset allocationMultigenerational wealth transfer
InvestmentManager
CorporateAttorney
T&EAttorney
Client
Accountant
InvestmentBanker
Bernstein does not provide tax, legal, or accounting advice. Business sellers should discuss their individual circumstances with professionals in those areas.
Gregory D. Singer
Director of Research
Bernstein Wealth Management Group
Brian D. Wodar
Director
Bernstein Wealth Management Group
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A Thicket of QuestionsDisplay 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
on how much it generates in earnings1 and how much the market
is willing to pay for those earnings. But directly connected are
issues like whether now is a good time to sell, whether the owner
wants to retain an interest in the business for a while longer
often a negotiable pointand how the sale will impact the
owners family and employees. All of these issues affect owners
personal lives as deeply as their financial wherewithaland onboth 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 teamsthe
sellers and the buyersis 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 hell receive. The question is whether the risk
of waiting will pay off. Well have more to say about this later.
What about the environment? Is this a good time to sell? Evidence
of an economic recovery is mounting, but financing is still tight,
and there are no assurances about what the future will bring. In
addition, the profit dynamics of every industryand, more
important, for every companyare different. That last criterion is
the one that truly counts for a business seller: Its his company and
his livelihood that are at issue. The job of his professional team is
to keep him from falling into one of two traps: rushing headlong
into selling now because the landscape looks good, or refusing
to budge because it was better several years ago and good times
may be around the corner again.
Still, owners need a touchstone for deciding whether to sell,
and one metric might be if the proceedswhether all up front
or parceled out over timeare at least enough to provide for
the owners lifetime spending needs (his so-called core-capitalSM
requirements). Ideally, hed take home even more than that and
generate excess capital (see Will You Get Enough? Core
Capital vs. Excess, facing page).
Non-Sellers RemorseDuring the boom years of the mid-2000s, many business owners
were offered and refused term sheets, hoping to do betteronly
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 standardsbut were offered $48 million. They
chose to pass. As well see, while more money is obviously better
than less, they didnt needproceeds 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. Theyd
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? Couldthey, and meet their objectives:
satisfying their core-spending needs ($500,000 a year, grown
Display 2
Typical Business-Owner Questions
Emotional
Do I want to stay involved inthe business?
Do I have a plan for my life afterthe sale?
What effect will the sale have onmy family and employees?
Do I have the risk tolerance toaccept contingent deal terms?
Financial
How much is my business worth?Whats the best deal structurefor me?
Will I get enough to meet myneeds?
Is all-cash-now better thanstaged/contingent payments?
Professional planning is critical
1Earnings 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.
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To distinguish between what you wantand what you need,
weve 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 investors lifetime using ourWealth Forecasting SystemSM (see page 4) at a very high
degree of confidence: typically 90% or better.
The amount depends mostly on the investors 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
Will You Get Enough? Core Capital vs. Excessroughly $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, theyd 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 investors portfolio after thecore-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 capitali.e.,
more stocks or alternative assets.
For many business sellers, its 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.)*
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 65 4.3 3.7 3.3 3.2 3.2 3.2
Age 80 2.3 2.1 2.0 2.0 2.0 2.1
*The core-capital requirements here are for couples and assume an allocation ofglobally diversified stocks and diversified intermediate-term municipal bonds in theproportions noted. Spending budgets are assumed to grow with inflation, andmaintained with a 90% degree of confidence. Based on Bernsteins estimates of therange of returns for the applicable capital markets for the periods analyzed. Data donot represent past performance and are not a promise of actual future results. SeeNotes on Wealth Forecasting System at the end of this paper. Information onlongevity and mortality-adjusted investment analysis in this study is based onmortality tables compiled in 2000. In our mortality-adjusted analyses, the life spanof an individual varies in our 10,000 trials in accordance with mortality tables.Source: Society of Actuaries RP-2000 mortality tables and AllianceBernstein
Evaluating What You Need and What You Want
Capital forNext Venture
Extra Spending
PersonalReserve
Charity
Children andGrandchildren
LifestyleSpending
Core CapitalAmount to ensure
spending needsare met
Often calculatedat 90% levelof confidence
Excess CapitalAmount for
expandedopportunities
How much doyou spend?
What is your age? What is your risk
tolerance?
How much? To whom? How quickly? How allocated? What strategies?
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with inflation), purchasing a $3 million vacation home theyd
had their eye on for decades, and establishing a substantial
legacy for their two children?
With so much money on the table, you wouldnt think that core
capital would even be an issue, but the Commanders live an
upscale lifestyle, and there are subtractions from the top. Theyd
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 usan estimate of how much
theyd 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 CapitalLike 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 proceedsa 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 couples 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
doesnt sound at all badbut 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 3
Case Study: John and Jane CommanderDisappointmentOr 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?
In 2010 (65 years old)
Earnings down to $6 Mil.
Appraised at 4.5 earnings=$27 Mil.
Net proceeds after taxes: $23 Mil.*
*Includes $1 million in IRAs
Display 4
Quantifying the Possibilities: The Wealth Forecasting System
Family Profile Data Scenarios Bernstein Wealth Forecasting Model Probability DistributionDistribution of 10,000 Outcomes
10,000 Simulated
Observations Based on
Bernsteins Proprietary
Capital-Markets Research
10%
50%Median Outcome
90%
5%Top 5% of Outcomes
95%Bottom 5% of Outcomes
Financial Goals
Assets
Income Requirements
Risk Tolerance
Tax Rates
Time Horizon
DealTerms
AssetAllocation
See Notes on Wealth Forecasting System at the end of this paper.Source: AllianceBernstein
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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, wed 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 theyd lose as much as
20%. This went far beyond the limits of their risk tolerance.
The optimal solutionfor this particular coupleturned out to
be a bond-tilted 40/60 portfolio, which would require core
capital of $16.6 million. Our analysis convinced the Command-
ers 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 Runor 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 wasnt 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 1even in very poor markets
and before any multigenerational planning. Why couldnt
they take the offer and walk away satisfied? The fact is, they
couldif they were willing to leave behind their disappoint-
ment about not garnering $60 million. In business sales, the
financial and the emotional issues are inextricably tied to one
another. Theres 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 marketsand hence higher return potential for
the liquid portfolios that house business-sale proceeds. For theCommanders 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
in the 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 Theyd
also be paid an annual salary of $400,000 for five years
for continuing to participate in the companys operations.
Meanwhile, the couple would be using their companys
earnings to pay down the debt and work toward a profitable
exitin this representative case, five years after inception of
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 Bernsteins estimates of the range of returns for the applicable capitalmarkets over the next 30 years. Data do not represent any past performance and are nota promise of actual future results. See Notes on Wealth Forecasting System at the end ofthis paper.Source: AllianceBernstein
2The 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 beused to pay down the debtwhich 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 anobligation of the business.
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the recap.3 True, the up-front cash would fall short of
satisfying their spending needsbut the couple wouldnt
consider a leveraged recap in the first place unless they were
confident about their companys 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 asa 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 consult-
ing fees for five yearsnot 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 howthe business performed over the near termand like a recap,
the Commanders would have to be interested in staying
involved in business operations.
Working Through the Trade-OffsOf course, theres 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 withwhich is where
we and their other professional advisors came in. We knew,
though, that working together, wed enable the Commandersto 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
could take the all-cash $27 million up front and avoid the
uncertainties, a strategy that many business owners embrace.
Along those lines, we compare the up-front cash portion of each
offer in Display 7. The all-cash-now deal was the only one that
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 Com-
manders core needs at only 29%.) Deferring completion to a later
date would mean exposure to a whole host of issues outside the
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
$13.5 MillionUp Front
Salary:$400K/Year
80% RetainedEquity
$19 MillionUp Front
Consulting Fee:$400K/Year
Up to $12 Mil.in Earn-Outs
over 5 Years
Exit from Business Expected After Five Years Transaction Complete
$27 Million Up Front
3The 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.
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The Icing on the Cake?But the case isnt 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 benefitand the odds are
generally in their favor. Display 8 adds the potential future proceeds
from the final sale of the Commander business in the recap case
and from continuing distributions in the earn-out scenario, as well
as the salary and consulting fee, respectively. For the immediate-
cash 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 upsideand the potential
for greater downside as well. But because of its reliance on
leverage, the recap was far more sensitive to earnings changes
on both sides. So, for example, we estimated that just 5%
earnings growth would be enough to deliver a median result
of almost $100 millionand an upside above $175 million.4
A 10% earnings decline, on the other hand, would leave
the Commanders with about $8 million of excess capital in
downside marketsnot a dismal outcome by any means, but
the Commanders wouldnt want to test a recap much beyond a
10% earnings falloff. As weve said, they wouldnt 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 impliesbut
less so. The earn-out considered by the Commanders would
Display 8
Adding In Future Earnings:
Cash vs. Leveraged Recap vs. Earn-Out
Commander Nominal Wealth Values, Year 30
After Taxes, Spending, and $3 Million Home Purchase
40% Stocks/60% Bonds*
05%
Decline20%
Decline5%
Growth10%
Decline
Earnings:Leveraged Recap
Earnings:Earn-Out
ImmediateCash
5%
10%
50%
90%95%
Level
of
Confidence
85.2
39.4
13.2
66.4
30.4
8.2
178.0
94.8
50.0
104.8
51.4
22.0
78.4
36.011.4
>98%96%>98%95%97%
Probability of Meeting Spending Needs
$Millions
*See second footnote to Display 7. Leveraged recapitalization examples assume fiveyears of annual pretax salary income at $400,000, annual rates of growth or declinein 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 pretaxconsulting income at $400,000 and annual rates of decline in pretax payments relatedto the earn-out schedule. All sale proceeds are assumed to be taxed at the capital-gainsrates in effect upon distribution. See Notes on Wealth Forecasting System at the end ofthis paper.Source: AllianceBernstein
Display 7
Up-Front Cash:* All-Cash vs. Leveraged Recap and Earn-Out
Commander Nominal Wealth Values, Year 30
After Taxes, Spending, and $3 Million Home Purchase
40% Stocks/60% Bonds
85.2
39.4
13.2 9.80.0
41.8
14.2
0.0
82%29%97%
$M
illions
Level
of
Confidence
0.0
Probability of Meeting Spending Needs
5%
10%
50%
90%95%
Immediate Cash Leveraged Recap Earn-Out
Level
of
Confidence
0
*Cash includes $1 million total in John and Janes IRAs.Basis in business assumed to be zero. Spending assumed to grow with inflation eachyear. Based on Bernsteins estimates of the range of returns for the applicable capitalmarkets over the next 30 years. Data do not represent any past performance and are nota promise of actual future results. See Notes on Wealth Forecasting System at the end ofthis paper.Source: AllianceBernstein
4Assuming that the business was now valued at 5 EBITDA rather than 4.5, reflecting the improved earnings
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Taxes Slated to Increase
Top Marginal Tax Rates
15
15
35
35
%Capital Gains
Dividends
Taxable Interest
Earned Income
2010
20.0
39.6
39.6
39.6
%
2011
23.8
43.4
43.4
40.5
%
2013
59
189
24
16
%
% Change
(2013/Current)
Based on recent healthcare legislation; assumes joint filers with annual incomeabove $250K or single filer with income above $200K.
Increase in Medicare tax of 0.9%; currently, Medicare tax is 1.45%, so the newMedicare tax would total 2.35%. Including ordinary income tax and Medicaretax, the effective tax rate in 2010 is 35% + 1.45% = 36.45%; in 2013, thetop rate would be 39.6% + 2.35% = 41.95%, and the change would thereforebe 15%. Figures exclude Social Security tax and state income tax.Source: AllianceBernstein
*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 weassume ordinary-income tax on dividends starting in 2011. In the 20%, 23.8%, and 28% scenarios for capital-gains tax, we assume that the tax rate is in effect the year thesale is consummated and remains constant thereafter.
The Impact of Taxes: Growth in Assets
Commander Business Sold for $27 Million
Nominal Wealth Values, Year 30
After Taxes, Spending, and $3 Million Home Purchase
40% Stocks/60% Bonds
85.2
39.4
13.2
74.8
33.2
51.6
21.4
0.6
63.8
27.6
4.9
Federal Capital-Gains Tax Rate
$Millions
8.80
15% 20% 28%23.8%
5%
10%
50%
90%95%
Levelof
Confidence
Basis in business assumed to be zero. Spending assumed to grow with inflation eachyear. 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 the20%, 23.8%, and 28% tax cases, federal capital-gains tax on the transaction and theliquid portfolio is at those rates in Year 1 and in each year thereafter. Based on
Bernsteins estimates of the range of returns for the applicable capital markets over thenext 30 years. Data do not represent any past performance and are not a promise ofactual future results. See Notes on Wealth Forecasting System at the end of this paper.Source: AllianceBernstein
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 ratethe key tax for business sellersis
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 didnt? 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 weve seen that rate historically.**
Two conclusions emerge from the display. First, taxes have a
significant impact on wealth accumulationno 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 probabilityalbeit withlittle to spare if gains taxes were as high as 28%.
How Much Taxes Count
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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. Allthe alternativescash, recap, and earn-
outwere 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 FamilyAs weve 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 appraisalgenerally 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,
hes 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 GRATsA grantor-retained annuity trust, or GRAT, can leverage gifting
substantially. Heres 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 todays 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
5Consult a valuation specialist to determine the appropriate discount in your situation.
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
an owner 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, hisearnings 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. Its 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
rightincluding 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
$6.7 Mil.2013
$6.4 Mil.2011
$6.0 Mil.2010
Assuming capital-gains tax rates of 15% in 2010, 20% in 2011, and 23.8%in 2013Source: AllianceBernstein
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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
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 portfoliosuitably
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, wed 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%, wed project a $24.2 million median and a $12.0 milliondownside case. Discounting can be a powerful tool when put to
use in a GRAT.
Quantifying the Advantages of PlanningAssembling a legacy plan yields notable benefits. Returning to
the Commander case study, lets 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, theyd have $3.4 million
to set aside for legacy. In the absence of any estate-planning
techniques, wed project that even in dismal markets the legacy
would grow to $13.2 millionthe amount left over at the 90th
percentile of probability before any estate taxes (refer back
to Display 8, page 7). But in the median case (Display 10,
left side) we projected thatagain, making use of no planning
toolstheyd leave a hefty amount to their heirs at the end of
30 years: $18.8 million afterestate taxes. But theyd cede even
more to the government.
Suppose, though, that the couples 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 Command-
ers invested the proceeds in a liquid portfolio over the 27 years
following the GRATs term. Our models suggest that their heirs
could expect the GRAT combined with the rest of the Com-
manders assets after estate taxes to produce $11 million in
6As 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-yearGRAT or use another strategy. The most likely candidate is an installment sale to an Intentionally Defective Grantor Trust (IDGT). With this strategy, an outright (potentiallytaxable) 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 necessaryor 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 additionaltransfer 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 orshorter. 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. Forexample, if the GRAT donor dies during the term of the trust, part or all of the trust assets revert to the donors estate and might not be gifted to a beneficiary free of transfer taxes.
Advice from the business owners professional team is critical in putting trust vehicles to best use. Our May 2010 white paper, Transfer Opportunities in Advance of LegislativeChange: 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.7Assuming that the GRAT was funded long enough before the sale to take full advantage of the discounted shares (see above and page 9).
Display 9
What a Difference a Discount Makes: A Short-Term Trust
Nominal $6 Million Three-Yr. GRAT Remainder Values After Taxes
Year 30, 100% Bonds Post-Transaction in GRAT
80% Stocks/20% Bonds Thereafter*
32.2
15.67.8
49.8
24.2
74.8
36.4
18.0
50%40%30%
Discount
$
Millions
12.0
0
5%
10%
50%
90%
95%
Level
of
Confidence
*Basis in business assumed to be zero. Assumes GRAT remainder is transferred to anirrevocable 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, theallocation is 80% globally diversified stocks and 20% intermediate-term diversifiedmunicipal bonds. Based on Bernsteins estimates of the range of returns for the applicablecapital markets over the next 30 years. Data do not represent any past performance andare not a promise of actual future results. See Notes on Wealth Forecasting System atthe end of this paper.Source: AllianceBernstein
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additional wealth.8 Through the single action of funding a trust
before the sale with discounted sharesand then investing the
proceeds appropriatelythe 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 childrens portfolio rather than their own more conservative
40/60. If the couple were uneasy about leaving their children
so much money, or wanted to do even more planning, pre- or
post-sale, for any reason, there would be a variety of multigener-ational and philanthropic strategies at their disposal.
Such strategiesusing 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 applyrelying on professional counsel, consider-
ing various trust vehicles, and carefully timing all strategies. Even
when a deal is complete, its not too late to plan for legacy-build-
ing; its doing nothing with excess capital that can incur a large
opportunity cost.
ConclusionWe 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 theyre centered around
the effects of the sale on family and staff, the owners desire
(or lack of it) to close out a phase of his life, or any otherissue 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.
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
2007. 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 Bernsteins Wealth Management Group, and Matthew J.
Teich, an Investment Planning Analyst in the Group, for their
invaluable insights and quantitative research.
Display 10
Reducing Tax Impact on Legacy
$27 Million Sale: Distribution of Family Wealth, Year 30
After Spending and Taxes in Typical Markets*
To Govt
Left for
Heirs
No Planning( to Government)
$6 Mil. Pre-Sale GRAT, 30% Discount(More Wealth, to Govt)
$20.6
Million
$18.8
Million
To Govt
Left for
Heirs
$14.9
Million$29.8
Million
$44.7 Mil.$39.4 Mil.
3
*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 istaxed 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 medianremaining trust assets are $15.6 million.The analysis on the left assumes that with nolifetime wealth transfer the remaining assets after estate taxes pass to the children. Basedon Bernsteins estimates of the range of returns for the applicable capital markets over thenext 30 years. Data do not represent any past performance and are not a promise ofactual future results. See Notes on Wealth Forecasting System at the end of this paper.Source: AllianceBernstein
8Assuming that the GRAT proceeds were invested in an 80/20 stock/bond mix, and that the Commanders portfolio was allocated 40/60 for the full 30 years.
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Appendix 2: Core-Capital Requirement by Allocation, Investor Age, and Annual Spending Budget ($ Millions)
AnnualSpendingBudget $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 Age
50 $7.1 $17.9 $35.7 $53.6 $71.4 50 $5.6 $13.9 $27.8 $41.7 $55.6
65 4.3 10.9 21.7 32.6 43.5 65 3.7 9.3 18.5 27.8 37.0
80 2.3 5.7 11.4 17.0 22.7 80 2.1 5.2 10.4 15.6 20.8
40% Stocks/60% Bonds 60% Stocks/40% Bonds
Age Age
50 $4.8 $11.9 $23.8 $35.7 $47.6 50 $4.3 $10.9 $21.7 $32.6 $43.5
65 3.3 8.3 16.7 25.0 33.3 65 3.2 8.1 16.1 24.2 32.3
80 2.0 5.0 10.0 15.0 20.0 80 2.0 5.0 10.0 15.0 20.0
80% Stocks/20% Bonds 100% Stocks/0% Bonds
Age Age
50 $4.3 $10.9 $21.7 $32.6 $43.5 50 $4.3 $10.9 $21.7 $32.6 $43.5
65 3.2 8.1 16.1 24.2 32.3 65 3.2 8.1 16.1 24.2 32.3
80 2.0 5.1 10.2 15.3 20.4 80 2.1 5.2 10.4 15.6 20.8
*Spending is grown with inflation; spending rates assume maintaining spending with a 90% level of confidence.Based on Bernsteins 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
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
50 1.4% 1.8% 2.1% 2.3% 2.3% 2.3%
65 2.3 2.7 3.0 3.1 3.1 3.1
80 4.4 4.8 5.0 5.0 4.9 4.8
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Notes on Wealth Forecasting SystemThe Bernstein Wealth Forecasting SystemSM (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
clients 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,
which may 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 canbeat 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 seven-
year 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, outper-
form long-term bonds by a reasonable amount, although this is
by no means a certainty. Moreover, actual future results may not
be consonant with Bernsteins 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 proprie-
tary 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 mortality-
adjusted results. Mortality simulations are based on the Society
of Actuaries Retirement Plans Experience Committee Mortality
Tables RP-2000. n
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8/6/2019 Bernstein Selling a Business GWM LTR
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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 identiy each clients needs or lietime spending, retirement, multigenerational
wealth transer, and philanthropic pursuits. We then stress-test a range o
investment strategies, including asset-allocation approaches, to arrive at a plan
or achieving these goals. Then we implement the clients plan through our
proprietary platorm o investment services, each reliant upon dedicated researchteams and managed by dedicated portolio management teams. In managinga
clients plan over time, we employ active management within each service, also
rebalancing to maintain the overall portolios profle and, i appropriate, managing
taxes to mitigate their impact on a clients ater-tax returns. We also place a high
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on portolio strategy. Throughout, we aim to meet our clients objectivesand
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AssetAllocation
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Tax Management,Rebalancing, and
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