Unlocking Opportunity Series: Dealing with Disruption: Managing Transition Options Amid Uncertainty

All right, well, good afternoon and thank you for joining us today. I'm Carey Spencer, Family Wealth Strategist at Key Family Wealth. I am pleased to present our next topic for our 2021, Unlocking Opportunity Series for Business Owners, Dealing with Disruption, Managing Transition Options Amid Uncertainty. Joining me for today's discussion are Jeff Getty, Managing Director of our Family Wealth Consulting Practice, and Joel Redmond, also Director of Family Wealth Consulting. Jeff and Joel bring a unique blend of expertise to our business owner clients. Jeff's deep legal tax and transaction expertise, uniquely qualifies him in his role as Managing Director of Business Advisory Services. Joel, brings deep financial planning, analytical, and valuation expertise to our business owner clients. He is a chartered Financial Analyst accredited in business valuation by the AICPA, who teaches corporate finance to MBA students among other things. As Director of our Business Advisory Services Consulting Practice, Jeff, Joel and the rest of the BAS team are committed to serving as owner advocates, to provide unbiased advice and education well in advance of any planned transition or transaction. Key's Business Advisory Services Team has 8.5 billion worth of cumulative transaction experience. And works to help owners avoid predictable mistakes and suboptimal business transition outcomes. Their goal is to provide owners with an understanding of the risks that threaten their personal, financial, and business goals and share strategies to mitigate these risks. We look forward to sharing timely, actionable information with you today. So if you'd like to submit a question, please put the question in the Q and A box at the lower right of your screen, and then click send. I will ask the presenters your questions in the order received. We will answer as many questions as we can in the final few minutes of our discussion. Our agenda today will cover the most common exit options for business owners, the expected impact on each option in light of the impending tax law changes, and strategies business owners can adopt to deal with these changes. So Jeff and Joel, let's start today's program with a brief look at just what you mean by dealing with disruption.

Great, thanks Carey. Good afternoon, everyone. Can we move forward the slide, please? Right. So yeah, when we say disruption that's usually taken in a negative connotation. But disruption actually has a wider transcending definition that isn't necessarily negative. And in fact, disruption right now is generally favorable for those scores of business owners who are looking at strategic options. Now there's some uncertainty coming into play right now, that kind of overlays all of the disruption that's going on, which may cause that continuing or actually move from what was now I would consider of a positive to a neutral or negative aspect. I'm gonna take just couple of minutes and talk about that before we get into the meat of what we mean by the different strategic exit options and how some of the things that are going on today, are impacting the decision tree around those. But I think it's really important to kind of take a step back and understand what are the areas of uncertainty or disruption that one must consider or evaluate today. The first one Carey mentioned. We have this significant possibility of a major tax policy or tax change on the horizon. We don't know exactly when that will be, when it will be the effective date, we don't know what the rates are gonna be, but we've got a fairly good idea and we'll get into some details around this. We're talking about different options today, and how in particular proposals are hitting. If you're on the webinar, we did a few weeks ago that was very specific to a deep dive around some of those tax issues or tax changes we anticipate. So if you want a really hardcore deep dive as to the taxes, that's available on our website. You can go find it and or we can send it to you a deep dive on the taxes themselves. But I will say this, at a minimum this uncertainty has accelerated, a lot of clients that we know to act right now and start to seriously consider doing a transaction today or a transition today, or at least get one started. So that's one issue. We have this tax policy or tax law change lurking out there on the horizon. The second issue we have is the overall economic conditions which is kind of interesting, 'cause this has been going on for a long time. We generally expect to see M and A Cycles move on a fairly consistent 10-year window if we start out with a sellers market, eventually it goes to net neutral, then it goes to a buyer's market, then back to a sellers market all within typically a 10-year timeframe. We're in like year 14 almost of a sellers market. So that's kind of interesting, that it's been going on that long. But what exactly does that mean? Well, one and what's driving some of that is low interest rates. It's inexpensive to obtain money for leverage deals. And leverage deals aren't the only deals out there, but they do drive a lot of the valuation and overall deal flow and metrics. So inexpensive money is a big key component in the sellers market world. There's a lot of what they call dry powder on the sidelines looking for deals. So, generally this means that there's been a lot of people, institutional or otherwise throwing money into typically PE back scenarios, or PE or private equity or private equity platform investment scenarios that are actively seeking deals. So if you're not familiar with private equity, typically what happens and it's a big generalization, but they raise money. PE firms raise money into deals that have 3 to 5-year time window to get a certain level of return for the investor. What's happening right now is, a lot of those deals are struck. A lot of those, sorry, firms are struggling to fund those deals. So they have the money come coming in to invest, they just can't find the investment. Again, that's a scenario that tends to drive more deals to happen and provides a higher valuation because there's more sophisticated firms chasing generally fewer and fewer quality businesses for sale. Overall, although it's somewhat limited to certain industries coming out through COVID, we've generally strong capital in financial markets. There's been some weakness identified in certain sectors and we're not gonna talk about that today, but overall, I would say, that the capital financial markets are fairly strong. The other piece we have which is we're gonna talk a little bit about today is the historically low tax rates. They make deals easier to get across the goal line. Which again, more deals, more volume tends to create an environment where sellers are feeling good and they're holding out for more money, which again, drives valuations up. And then the last piece that I've kind of alluded to this is this relatively small market of quality companies that are driving up valuation metric. So when you actually go into the systems that we utilize to evaluate comparables, the deals that are getting done tend to be better run companies, more of them for sure, but it's driving up overall methodology around valuation. And Joel's gonna talk about that a little bit, but that means really strong deals for the most part are getting done, and that puts up valuations. So all those economic conditions kind of drive towards this seller's market, which again, is a period of uncertainty or a period of disruption we wouldn't expect to see forever. The last piece I'm gonna talk about real quick is market as demographics. Most business owners are owned by baby boomers and there's a finite timeline for them to do something. Right now, more and more of them I'll say are rushing to market, that's a little strong. But all these factors I just mentioned, they are really pushing more and more people into that zone, to think about transactions. And once people start to think about 'em, they tend to and move forward. But what's the flip side of that is in any particular finite period of time, and we're talking right now like at 2021, there's only a certain number of deals whether they're sales recaps, transfers a family risk that they can get done. There's only so many resources of professionals out there to push things. So while there's almost always a market for quality, this enormous demographic shift that isn't really even fully developed yet, will likely create significant swings for the next couple of years. So I thought about this a lot, how I would tie that all together. And I don't know how many people would know about what we call the butterfly effect, but it's this popular quasi-scientific notion that a single butterfly flapping its wings, has the power to set off a chain of cascading events that can lead to the formation of a hurricane. It's actually not scientifically true. It's kind of a joke in scientific circles. So I would say that a slight variation of that probably is true though. If you could take the demographics of all the butterflies in let's say West Africa, which is where the butterflies typically starts in this scenario, and you had several hundred thousand of them or several million them, flapping the wings at the same time, in the same direction, you probably could create that critical mass of a series of events that could lead to a hurricane. And as we talk about this and think about this, this disruptive effect of this demographic, that's important to keep in mind. One person going to market doesn't change the market, but if there's let's say 500 firms in a particular industry and over 50% of them are baby boomers, and if all of them go to market at the same time, it will have a disruptive effect. So let's talk about these disruptive effects in the concept of a strategic options or strategic exit option. So next slide, please. So there's different ways you could do this. You could talk about different exit options, you could probably have anywhere from 5 to 13 or 14. We tend to focus on what we consider seven. And I'm a little bit of a Charles Dickens fan, and one of my favorite books is a Tale of Two Cities. So what we're going to talk about today, is a tale of the seven strategic exit options. Tax and interest rates fall, businesses and industry are born mature, disrupted, adapt, or die. But some of the fundamental truths we deal in and my colleague, Joel will talk about this in more detail is the answer to the most common and most important question our business clients ever ask us, what is my business worth? One that in just a moment, but for now, I just wanna highlight the seven paths that in our experience are the most common ways for owners to exit their business. Today we'll spend a bit of time talking about them, reintroducing them to those that aren't familiar with them at all, and discussing how the American families plan and a couple other factors are likely to change the relative attractiveness of each strategy. Tax tails do not wag the dog, so to speak. And you'll probably hear that analogy a couple times, but they do have the ability to directionally move people. And that's really what we're gonna talk about. Is that directional movement, is it severe or important enough that someone will actually choose or narrow their focus from A to B or from seven options where they only wanna talk about three? The answer to that question is, yes. And we're gonna talk about what this change in tax law is gonna do. As we discuss this don't worry if you miss something, we have a white paper on all of these options. And if you ask the person who invited you to this webinar, they'll be happy to send it to you. And it will give you a nice overview of each of those seven options, the features and benefits, the stakeholders, things like that, then be able to march you through in a very succinct way as to what these things mean, and that can help start having you evaluate does this sound like what I wanna accomplish or does it not? So with that, I'm gonna pass it off to my colleague, Joe, Joel, sorry.

That's all right. So next slide please, Carey or Michael, excuse me. So one of the things that happens when we engage with a business owner and they come to us and we get to meet and explain the work that we do every day, we highlight an answer and it's kind of a lawyerly answer that we can give when someone asks us, what's our business worth, what's the business worth? And the answer is, it depends. An alternative answer is, for fear of us being kind of flippant about that, we could say, well who's it being valued for and what's the goal of the valuation? And so what you see kind of on this screen is, it's almost an analogy for beauty is in the eye of the beholder. Value is in the eye of the beholder. And specifically as in the eye of the transaction channel or the transfer channel, as you can see up on here. So this is just kind of like an example of the same business and how the same business might possibly sell for three, four or five or even six or more different values, depending on what the purpose of the valuation of the business is for, and on who is ultimately going to receive that business. So we're not really in the business of valuation. It's not what business advisory services does, but valuation hinges in very heavily in owners' minds. And one of the things that we wanna do and one of the concepts we generally try to introduce to them is, the concept of a range of values. Which means that not only is the value of the business that, you know, if you're an owner or an operator or you have a business and you're listening on this call, not only does it change based on the point in time that you're in, it changes based on who the ultimate transferee is going to be of that business, if you're going to transfer. And when Jeff talked about the seven strategic exit options, there's an even simpler grouping that we can make when we talk about those, and we can group them into internal transfers to family, which we'll get into them a little bit. Internal transfers to management, to employees, which we'll also get into, or external transfers, when we involve a third party. As you can begin to get an idea of it as you look at this, the bottom three values on here, this negotiated, auction, and public, the last three rows in this value continuum, those three values have the highest values. This just underscores the general truth that a third party sale, whether it's to one party that you just negotiate or deal with, whether there's multiple potential buyers involved, or whether it's a big, huge public company maybe gobbling the business up, generally the proceeds will likely to be higher than if it's an internal sale to employees i.e through an ESOP, for example, a management buyout or maybe even a transfer to partners internally under not such favorable circumstances, under a buy-sell agreement. So as we go through the channels, one of the critical points to kinda keep in mind is, bear in mind that as an owner you're choosing a value when you're choosing the channel. So those changes and one of the things that we'll talk about is change with respect to not only COVID-19, but with respect to also that the tax law changes and the other fact that Jeff mentioned. We're gonna talk about the relative attractiveness of one option over another, and how they might ship under these kinds of disruptions, as we term them. So again, you get an idea. Higher part of the page, internal transfers, lower part of the page, external transfers. Now there's a number of transfer channels that aren't pointed out on this slide, and to get into all the specific permutations is probably beyond the scope of what we wanna do tonight. But we do wanna talk in some detail about transfers to family members because that's a foremost item in people's minds. Many people wanna get the next generation involved in the business, if they're not, and wanna transfer the business to the next generation if they are, again, internal transfers. And then there's some other ideas and other things that I'll kind of set the table for Jeff to talk about in a little bit where you might wanna prepare and get ready even if you decide you might not want to transact immediately right now. I also just wanna highlight one more time. We do have that white paper that highlights more of the options that you saw on the last slide. And again, that's easy to get to you as kind of a followup. So with that, I'll pass it over to Jeff for a look at that discontinued transaction hierarchy. Next slide please, Carey or Michael.

Yeah, so real quick, I wanna do a quick sidebar here because some of you might be sitting on this listening or now we're in the future, and say, well, I'm not really ready to have this conversation. I'm not really at the point where I'm ready to start thinking about this. Point well taken and we bump into this a lot which this is fascinating, but. So for those of you who are in that, this is fascinating but or maybe it's not fascinating. There's two major things we wanna talk about if you're not ready to really seriously consider a transition or transaction option. And the good news is, if you do them you will be more attractive to a transition or an acquisition target. Or if you wanna transfer it to kids or employees or something like that, it'll be a better business to transact. And it's two thought threads or concepts that you should be thinking about. Becoming an absentee owner and conducting a recapitalization analysis. We've been doing this a long time, I've personally done a long time. And one of the hardest things business owners struggle getting their heads around is becoming an absentee owner. The best businesses, whether you plan on giving it to your kids, selling it to your management team, or selling it to the third party, the ones that are the most ready to be successful after you're out of the picture and when you've stepped away from the picture, is ones that are run by an absentee owner. It's counterintuitive, I get it. But you actually do every one in the mix a favor by extracting yourself from the business over a period of time. Empowering your people, whether they're friends, employees, friends in the business employees, children, whoever it is that's going to be there after you are not or after you're not there day-to-day, you wanna give them the ability to be decision-makers and start to run the business without you. It does a lot of things, but think about it. If you have someone who is super hands on about everything, and something happens to him tomorrow, the business probably won't survive let alone thrive. That same business with a business owner who says, hey, I'm not ready to transact, I'm not ready to transition but boy, I'd like to work four days a week instead of seven or three days a week instead of seven, or I'd like to take a three-week vacation with my spouse and spend some time traveling. The ones who can actually accomplish that and walk away, they're more in tune and that business is better prepared to be run by someone else. And that is a key component. Again, whether you're gonna give it to the kids, sell it to the kids, sell it to a management team, sell it to a third party, that's what all of those things that common thread they all have is they have an owner. If you wanna be most successful, who at some point in the processes become less important to day-to-day operations. Not necessarily strategic operations or strategic decisions, but stepping away. So that's an important point to keep in mind if you're not ready to do something. The other one is recapitalization analysis. And look, there's a whole bunch of reasons why some would look at recapitalization right now. And for those of you who don't know exactly what that is, it's basically where you take some of the equity in the business. You borrow some money at the business level and then the business declares a dividend, and you exchange some equity for cash. It does a lot of things. Most importantly, it takes some of the risk off the table for you. So you're tying less of your net worth to the personal balance sheet of the business. It provides liquidity that can strengthen your cash flow requirements and help you monetize what is probably your largest asset at some point in the future. And it provides you with enough of a stake for you to be at your best in the business and maximize in the second bite of the apple, if there's a private equity underwriter involved. But it really is a nice, more importantly it's probably a nice bridge to the gap for people starting to exit who weren't really ready to sell or transfer to a third party. It's a way of just recapitalizing the company, and taking something off the table, taking some of the risk off the table. So even if the business were to give in some trouble down the road, you've at least extrapolated out some piece, some net worth out of that deal. Icing on the cake, bring it back to taxes before I pass it back to Joel to talk about the transfer channels is, you know, right now a lot of those dividends are considered qualified dividends which means they're taxed at a 20% tax rate, plus the surcharge tax, so like 26, like 23%. If you consider taking 30 40% of your business value off the table and dropping onto your personal balance sheet at a 23% tax rate, that's a lot more attractive right now than what's likely to happen next year, where that tax rate may be as high as double that. So there's a pretty nice incentive and it nicely aligns with the idea of an absentee owner because you're starting to extrapolate yourself a little bit from that business, you're starting to see there's a life beyond operations day-to-day. So with that quick sidebar, and it was designed to be quick, let's take a look at some of those transfer channels. Can we do the next slide, please.

Great, thank you, Jeff. So anecdotally, one of the most fascinating pieces of information with respect to private middle market business owners, is that as many as half think that generation II or generation III will enter the business, but less than a third, actually do. In other words, there's a huge disconnect between owners that think the next generation wants to enter the business, and their plans even in their mental models to try to figure out how to transfer that business to them, and the discussion as to whether or not the next generation actually wants to enter that business. So with that in mind, that said, there are the cases where this is true. And you can see that these intarfamily transfers fall into kind of two broad categories. The case on the bottom here, this green bar where family members are gifting. Owners are gifting to family members and the others in which they might have more arms-length arrangements where they set up some kind of sale. And so we'll take a quick look or a quick recap as to let's recall the tax environment and that piece that we're heading into. We're probably looking at a capital gains tax heading from 20% to the highest bracket bears now it's almost 40% 39.6, as Jeff mentioned, the net investment income surtax added on top of that. One other thing that is, in the administration, the Biden administration has slated at being worth over $40 billion is the elimination in the step-up in basis. We're not 100% there yet. We don't when this is active, we don't know 100% with certainty when this is starting, but if that's what the tea leaves are beginning to indicate, then that's immaterial. That step-up in basis would be essentially eliminated for appreciated property over certain amounts. For a married couple about $2 million, anything over that that's where the step-up in basis would be eliminated and there'll be a capital gains tax. And then there'd be another allowance for the Section 120 exclusion, where you get that savings in capital gain on a personal residence for half a million. And finally, the biggest other component of the change in the tax was certainly, the Section 1031, tax deferred exchange. The removal of that, deferral of gain in excess of half a million dollars. Now the great news, that's three kind of bullets which is, it's almost like a one, two, three punch, and that's pretty painful. The great news is that it looks like still that the artificially high or abnormally high, I don't wanna say artificially, but abnormally high lifetime exemption amounts for transfer taxes look like they're staying where they are or just a little bit long. They're still gonna fall back. You know, $11.7 million can still be passed free of gift, a state or generation skipping transfer tax. Those revert in the beginning of 2026, back down to an inflation adjusted amount of 5 million, probably around 6 million around there. So what does all this mean for intrafamily transfers? That's kind of the backup. I think we have the next slide, and we'll talk a little bit about these in a little bit more detail. So these are examples. I'm not gonna go through all of these, but this gives you kind of an at a glance shift at typical transfers to family members, ranging from outright gifts up on the top to some other types of vehicles that you can see in these next sort of five rows. And again, I'll just pick kind of one or two of these in the interest of time. The first one that I just wanna highlight for a second is the disappearance of or the attrition of outright gifts to family members, is definitely, that's greatly exaggerated, and that's to paraphrase Mark Twain. Our gifts are likely to be as attractive as ever and there are a number of reasons. One of them is, if you think about it when you bequest assets to someone, someone who bequests a million dollars of assets to an heir, that's taxed right now. Assuming that's fully taxable at the federal level at the highest bracket. It's taxed at 40% which means the SCIN leaves $1 million to beneficiary. Beneficiary and that's $600,000. By way of contrast, if during life that person gives a million dollars in an outright gift to the beneficiary, the tax on the gift is not counted in the body of the gift tax. Which means the beneficiary nets about 715,000 versus 600,000. So there's a savings that many people don't realize when you make an outright gift versus a bequest. Thumb pounding this is the ability still to have valuation discounts when you're giving gifts. It's true there's a carry over basis. You know, you'll have the carry over basis issue still without right gifted assets, but we're not seeing indications right now that there's any indication of a cap gains tax for a gift. It's only through a bequest, is what we've seen so far. So it's just an example to kind of highlight that. You can see some of these other ones. What's interesting is in some of the initial proposals, from not only President Biden's Team, but other Members of Congress, we saw things like potentially the elimination of strategies like zeroing out grantor retained annuity trust, which allow wealthy people with appreciating assets to make tax-free gifts to kids without using any annual exclusion amount or lifetime exclusion amount. And we haven't seen yet that that's part of the proposal to get rid of. So there are still things on here that are going to be attractive. And you can see as a whole, for high, most of these are moderate to high or high. You can see not a ton of these have changed. Some of them have changed a little bit, but the unbalance we're almost a net-to-net neutral in terms of the gifting. And for outright gifts, it's probably a slight net positive. Next slide. Transfers to family are relatively straightforward although there are a lot of misconceptions that undermine them. When we're talking about transfers internally, we have two broad channels that we talk to business owners about often. When you have a management buyout, which is kind of on this bottom item here, many times the management of the company that's making the acquisition or basically making the purchase, doesn't always have in funds internally. So what happens is you go back to that exogenous factor that Jeff talked about is part of disruption. We might see interest rates rise I mean, they've been artificially low for an awfully long time. There's probably a point that those rates are gonna go up again. When that happens, that's likely to have an impact on cost of funding. The impact on cost of funding is going to make and that'll have an effect on management buyouts. It's just undoubtedly because the amount of dry powder out there, there is an enormous amount. We'll talk about it in some detail how much in a few moments. But that capital has to earn a return. And if the set of factors that Jeff is talking about, too many investors chasing too few deals, drives up valuations and drives up the values of these businesses that are sold. Continuing this, the kind of be a seller's market at least for a time, we don't know how long, then you could begin to see some inflation, right? You could see prices go up, you can see rates go up and you can see the cost of acquisition for deals like this go up. ESOP's are a little bit different animal. And part of the reason is there's a huge tax component for employee stock ownership plans. And typically what you see is a not uncommon kind of back pattern is, you have a situation where there's an owner. The owner wants to make a partial or even a full exit, and the owner can get a huge tax benefit that's a Subchapter C Corporation by basically selling that interest in the company contributing to the ESOP trust, taking in exchange investing in qualified replacement property. You know, corporate bonds, stocks, essentially and then deferring that capital gain indefinitely. And even then maybe they hold that till death and the kids get a stepped up basis, no tax. Well, that's going away. So the factor of anyone thinking of an ESOP is gonna lose potentially at step-up in basis at death. They'll still enjoy, if they're in that situation, the deferral of tax but there's going to definitely be a need for people considering ESOPs to take in to balance a number of different things. Is the tax benefit still worth it for them, is the cost of funds because many of these ESOPs are funded with leverage, can the company handle the cost of bonds and maybe shocks and interest rates. So there's kind of that feasibility piece. Now there's also the offsetting proposition that the interest deductibility is pretty generous with ESOPs. So more interest basically, needs a bigger interest tax shield for companies using. So these are all kinds of things to think about. We have the next slide. So if we kinda take a quick glance at these transfer channels, you can see kind of, again, not a massive shift. I mean, for management buyouts and buy-ins driven largely by the cost of that, probably from high to moderate to high. With ESOPs, we see potentially again, heightened tax attractiveness due to all of the kind of the complexity in ESOPs in one thing. But it's almost like that old phrase where it's there's opportunity in complexity. Lot of dry powder out there. I mean, there's probably to Jeff's point, we have about two and a half trillion on corporate balance sheets, as of the end of last year. We have about 2.4 trillion, almost as much in private equity money out there waiting to be deployed. We've got six and a half trillion of net new borrowing. Now a lot of that's public companies. That's the public space, that's not the private space. It's not the space we're primarily dealing with. But those three items alone, that's a third of the SMP's value . I mean, you talk about share buybacks. We can buy back a lot. So there's a lot of capital out there. The change in that cost of capital is gonna have a huge impact on these strategies, possibly even more so than the changes in that rise. And with that, I'll pass it back to you.

Yeah, so can we go ahead and move forward the slide, please. Actually, one more. Wanna make sure we leave lots of time for questions. So, our group does a lot of work in this last piece, which is the transaction space. And one of the things I've found in my career, I've been doing this long enough to see tax rates. We're at historical loss as of today, overall. And what that's done, it's created this such an artificial situation whereby, even though we talk to clients about pre and post sale tax planning, the necessity to reach an optimal outcome has diminished over the past decade or so. It's just not as important with the historical low rates. We're going to see that change today. As a quick aside, usually when I talk to clients about tax strategy and planning, and as I say, look most deals we see with no tax planning, you're gonna pay. And today's law, today's rates, let's say somewhere in the 30% plus range between federal and state local taxes. Some states are less, some are more. I usually use that 30s kind of middle of the fairway number. And our goal, when we talk to a client about tax strategies that we will show you a way to get down to the single digit, to get below 10% effective rate. Now you may not like exactly all the hoops you have to jump through where all the money goes, but that's pretty easy in some ways to achieve. So that's been a big talking point for awhile. It's going to become bigger when we go from a effective 30% to maybe as high as 50, 55%, the philosophical viewpoint of, wow, I need to do something. Again, coming back to the demographics in the other factors that could change on a dime for people, it becomes less of a seller's market valuation, start to look worse or start to trend downward instead of upward. This concept of what should you put in your pocket, which is what you get post tax, not what you're offered, becomes ever more important. So this concept, when we talk about external transfers, this tax planning philosophy, this is a major shift we expect to see starting next year. However, the countervailing balance to this and why we say we believe most of these third party deals or sales will be neutral to positive or probably positive to neutral, is abstinent change in interest rates as Joel mentioned. The interest rates are more likely to call them an activity than tax rates. Somebody isn't gonna not sell their business, is not going to sell their business because rates went up 10%. That's kind of unlikely if they're the right demographic. If they're 25 years old or 30 years old, they might. But if they're 70, 75, 80 years old, they probably won't. The offer's good, it's the right time, top of the market, whatever. So we really see the interest rate environment to be more likely to change things. And that's because of this concept of how many deals rely heavily on leverage to close. So it's kind of important to understand. And a lot of deals happen with private equity that they want an expected 30, 35% return. If their debt cost on that deal is 2%, they can offer you $10 million. If that debt service goes up to 3%, 4%, 5%, the value they're going to offer will start to drop. So this debt service issue is probably a bigger issue to look at and would be a factor on this slide to look at and say, hey, if interest rates go up, that it's likely that moves from a positive to a neutral or even possibly negative. So it's really important that as you think about this concept of transitions or transactions and disruptions, this is a big potential disrupting event. And there are some interesting ways you can view interest rates in terms with tax rates and how these things intersect or don't intersect. So point is, I don't think anybody's gonna be less likely to sell on a go forward, but the impact the taxes will impact, it will change the financial analysis and evaluating offers. So if you're not doing something, if you're headed down, the thing about the path of my best option is to sell which by the way, we expect historically overlaying it with historical metrics versus the go forward, we would expect somewhere between 55 to 70% of all businesses will end up selling to a third party for a variety of reasons. That's what they need out of the deal, most of their net worth is tied up hence they have to get the top dollar. That's where the top dollars are right now. We would expect to see that trend to continue. It will just be probably harder to get those deals done with a higher tax rate environment. But most of that, if not all of that can be mitigated by good tax planning that starts further back than 60 days before the transaction is supposed to close. That's when things get really tough. So with that, Joel, and I could probably talk for hours about taxes, taxes, taxes. We purposely left a ton of time open for questions. So Carey, I'm gonna turn it back to you, to see what we came in on our Q and a box. And Carey, you're on mute.

Thank you. Thank you so much, very informative. And yes, I do see several questions have come in. If you would like to submit a question though, please type the question in the Q and A box at the lower right of your screen, and then click send. And I will ask both presenters to answer the questions in the order received. And again, we will answer as many questions as we can in the final few minutes of our discussion. So the first question that I received is, if I'm not ready to seriously consider any of these transfer channels now, an ESOP, an MBO, or third-party sale, et cetera. But I feel like I ought to do something to get ready today. What should it be?

I'll run at this one, Carey. I kind of covered this a little bit, so there'll be a little bit of repetition here. But I would say first and foremost, if you're listening to this, you're taking the right first step. You really need to educate yourself on what's your option are and how those options impact you and how unrelated forces can impact those options. Changes in tax rates, financial markets issues. So educating yourself is probably the first step. And consider for a moment how most deals start, would then third-party sales, they're an unsolicited offer. So the question you need to ask yourself, so if someone were to come to you right now with a really big, what I call the big fat stupid offer, what would you do? How prepared are you to start negotiating and prepping for due diligence? Now on the flip side, if you're leaning more towards an internal transition to kids or management to step in, again, it's an education process. How do you prep yourself, your business, and the people who ultimately gonna run that business and ultimately own it, ready to step in and have the company thrive versus survivor worse. So if you really wanna achieve optimal outcomes, education, education, education is super important. So you understand the decisions you make today as you head down a particular path, where you're likely end up. Just a quick recap on the answer to this question that we went through before, and it's related to all this absentee owner thought process. How can I get to the point where my business doesn't need me here seven days a week, you know, 12, 13 hours a day? How can I start to get people prepared to start taking over some of that stuff? And then I also am a big fan of particular right now with tax rates going up with this recapitalization. It's kind of an interesting way to kind of put your toe in the water, maybe get halfway there. So it can also give you a fresh infusion of capital if you wanted to, if you do it through like a private equity group. So I don't wanna overstate that, but if it's something that you're kind of thinking, oh, I'm going to transact in the next or transition the next three to five years, education, start looking at becoming an absentee owner, start looking about let's say taking some chips off the table. Recaps a good way to do it but there's other ways to do it too, so.

All right, thank you, Jeff. So our next question is, how can I really get around this step-up in basis?

Carey, I'll think about that one. So the first thing you could do is think about the extremes. So the extreme is ignore it completely or sell it all right now. So if we ignore it completely, we go into next year and you have a highly appreciated asset and your cap gains tax, forget about state for a minute, went from 20 to 40. So the cap gains tax gain. You pass away, your kids inherit that. Your kids are gonna have a really big capital gains tax either on inheritance of that asset or maybe if there's compromise in law, maybe it's when they sell. But let's assume for now that it's one they inherited. Well, and I've heard owners say this, it's more than I started with. What they get net is more than I started out. So that's fair enough, that's one philosophy. The other philosophy is sell it all right now. Absorb that yourself at the lower 2021 rates at that 20% rate and then do that. So you're probably paying and then gift that proceeds. You could also just gift them the asset or gift them part of the asset, but we'll kind of forget about that piece format. In either one of those extremes, probably is not right. And we've got two sets of taxes to deal with. We've got a transfer tax and we've got an income tax. The transfer tax piece, the good news again, is managing the transfer tax piece is relatively straightforward. I mean a simple go-to move that we've been kind of pounding on many clients is just make full use of those lifetime exemptions because they're not gonna stay forever. They're not gonna stay this high forever. Even if there is a height and they went up the next year and have the inflation adjustment, and go up from 11.7 million to a slightly increased number, that's not staying around forever. So spousal lifetime access trust, other ways that we can just make use of those exemptions are definitely a message that we've been sounding . Charitable gifts are likely to be attractive as well. So some of the simplest approaches are using lead and remainder trusts either now during life, making gifts now, or even making a partial sale and contributing the cash to some of these vehicles to get a higher deduction and to avoid the potential tsunami down the road of selling an asset today, paying a 20% cap gains rate versus deferring the tax by putting it in a charitable trust, for example and then having to pay 40% on those distributions coming out. Now on the income tax side, there's some more technical things we can work with. We don't get into this a ton, but people I suspect are going to look at provisions in the code that might allow asset purchases to become stock purchases, or for a stock purchase to become treated like an asset purchase. And without getting too much in the weeds, generally sellers like stock sales because they sell the stock, it's one simple capital gain on the increase in the stock. Buyers like asset purchases because they get a new step up basis for assets, they can depreciate and recover. We have situations that sometimes come up where we can treat those simultaneously like a stock sale to the seller and an asset purchase to the buyer, so we can get kind of So, and then the final answer, of course, is get an idea of just some pro forms. Meet with the tax team, meet with the tax counsel and just talk with and see, what does it look like if I do this, if I do that, just do some scenario. So I think those are some of the biggest skills.

Thank you, Joel. So our next question is, I've been making annual exclusion gifts to my kids for a long time, will this still work?

I'll take a crack at this one. I'd love when I get one question like this as the lawyer in me comes out. The answer is it depends, you know, and it really does. Like we don't really exactly know what's gonna come out of the proposed tax law, but a couple of threads that are important to keep in mind, and I'll give you some action steps out of this. You know, there's some discussion about the current law says that a married couple can give $30,000 per year through a joint gift to an unlimited number of donees. In other words, I give 15, my wife gives 15 to each of our three kids, each kid gets $30,000. This has been used effectively for a long time for people over an extended period of time to make very significant transfers of wealth, whether it's business interests or just cash marketable securities. There has been some talk about limiting that, for example to a hundred thousand dollars per year for a married couple. There's also been a discussion about the lifetime exemption, to be decoupled from the GST and estate tax exemption and making it reduce to 1 million. So right now you could utilize that 117 exemption either during life as a gift or at your passing as a state deduction. We don't know how that's all gonna work out, but you know first and foremost do it now. That's an obvious, I think an obvious one before the law changes, if it does indeed change. And if you're doing an annual anyway, just do it earlier this year, do it now. If it does kind of pass or some of those issues kind of pass, we've talked a lot about internally about changing over gifting strategies to for example, long-term installment sales to family members, which are highly attractive with the federal rate that's imposed upon those being so low. So for example, a $50,000 gift easily handles the annual debt service of an interest only loan at like 1.5, I think we just calculated this at 1.5, $1.6 million at 3%. So you can do things like that, leverage in a different way. With valuation discounts that be also as an impact here. That's one of the other proposals out there is, will we still be allowed to discount? The answer is again, it depends. It depends on whether or not that gets passed. And then two, what sort of exemptions are carved out? So there has been discussion about certain types of assets, closely held business interests, things like that could be carved out. So maybe that'll still be in play. But another piece that's that's going out or potentially being removed from through a policy change is getting rid of the zeroed out grand strategy, which Joel referred to before the so-called Walton wrap series where, and I don't wanna get too far in the weeds with this, but it's a very effective wealth transfer technique that they're talking about doing away with because it can be fairly aggressive or kind of abusive. Okay, well, right now, you can do a zeroed out collapse strategy or charitable lead annuity trust. I won't get into how the math on that works but it's almost as attractive, right? And there's no discussion about them getting rid of that and unlikely they would because at the end of the day, their charity is a big beneficiary of that. So at the end of the day, one door closes another one opens. Good firms, ours included, are doing some very significant what if scenarios planning this out for clients. We've been doing a lot of work with clients recently about these types of strategies say, okay, this year we're going to look at doing X. And if the law changes to this next year with this type of rate, we'll have to do Y. And if it's this versus this type of rate, we'll have to look at Z or, you know just different scenario analysis. That's the important part here. There's nothing more disconcerting than I don't know what's gonna happen, but I feel like something bad's gonna happen and I'm not doing anything about it. You know, if you're a business owner, you're a person of action anyway. Be a person of action here, pick up the phone, talk to somebody, hey if this changes to this, what does that mean to me? Or should I be doing something different than I've done historically, yeah. And if you don't get the answers to those questions, call someone else. Personally, we'd love those questions on my team. We really enjoyed digging into this stuff and figuring out what is the future look like? How do we change things? How do we change our approach? This area of practice evolves so much on certainly over my career and involves a lot sometimes over an annual basis. So this is good heady stuff. And it isn't the end of the world if taxes go up. There's always going to be ways to continue to do significant tax planning with good and decent outcomes. So, hopefully it answers the question. I'm sorry, I know I went off a little bit.

No, thank you, Jeff. We do have several more questions. I'm looking at the time. I'm gonna try to throw out maybe one or two more. The next one I see is, how does this legislation affect ESOPs?

I'll grab that one, Carey.


So a lot of times people who have entertained ESOPs in times in the past, and you know maybe you're an owner and you had this discussion and it just seemed like it's too complicated, I'm not sure we can make the debt service. I don't like the regulatory aspect, what have you. People are probably gonna have to start looking at those hard again. And part of the reason is it's a little bit if you think about it, these are question it's a little bit like the capital structure question. And the capital structure question is on a bigger picture, how much debt do we use? Like as a company, we have this debt and if we issue debt and we pay interest on that, we get to deduct that debt. Well, if the corporate rate goes up from 21 to 28%, if that goes up, we get a bigger tach. But that doesn't mean we'll go to 100% debt. It's just a factor, it's a factor that will play into it and we'll probably think about it a little bit. In a similar sense, the tax benefits of an ESOP just mathematically, they're gonna go up when tax rates go up. I mean, it's just that's simple. So from the owner's perspective, they could go up materially because on the cap gain side, deferral of that capital gains benefit for the selling owner now, when they buy qualified replacement property and they can defer the gain on their disposition of shares, that benefit potentially becomes double what it previously has. So there's all of these kinds of facts fitting together to show one, the tax piece and the increased rate for the attractiveness of the ESOP. Two, the deductibility of the interest in those, that interest expense possibly rising because of base rate and a greater tax benefit because of a higher base rate on that deductibility on. So I think at worst, or at the very least they're gonna warrant some serious re-analysis for companies that have looked at them and companies that haven't looked at them. Probably gonna start looking at them.

Thank you, Joel. I think we have time for one last question. I thought this one was interesting. If I have an offer in hand, or I know I can get one even if it isn't perfect, should I take it now?

Great question. We love this and it goes right back to our philosophical viewpoint of where do most deals start. You know, call us. We do this all the time for clients. Contact us offline, walk us through where your head is, share with us the offer if it's in writing, or if it's been in writing previously, we'll help you evaluate it. We'll tell you if we think it's a good deal or bad deal. We'll tell you how we think you can sweeten it and help get that across the finish line. Most deals I've said this before, start exactly that way. And a lot of them get done, a lot of them don't get done. Usually they don't get done because the person who's the recipient of the offer is not prepared for it or doesn't have the right advisory team or team of people to help them truly evaluate and negotiate in a highly effective manner. Part of this valuation methodology, does this number make sense? Deal structure methodology, does this deal really look as good as it sounds or as bad as it sounds for that matter? And three, what sort of tax play do I have and how does that match up? I'll give you one quick example. And I just calculated this for a client so I know it off the top of my head. They're looking at a deal right now where they think if they wait 18 months, they can get their business value up to $300 million. Now, by the way that's a little bit of a high number for us typically. Typically, you know a lot of our deals are well below that number, but they're saying, hey, if I hold this for 18 months, I'm pretty sure I can get up to 300 million. Now, whether I agree with that or not, it's irrelevant for the purposes of this calculation. I said, based on where we believe rates are headed, that would equate to today taking a deal for about $220 million. So about a third of the purchase price less, that's a fairly reasonable number for this business or in their current ballpark, and think about what the next 18 months has to look like. They're gonna have to take on additional debt to do some significant growth to get some additional deal flow. It's possible, but it's a risk. And is it really worth it? Because at the end of the day, it's not what you get offered, it's what you get to keep. So happy to take that question all day long. Not the best forum for that kind of question, and I didn't wanna group haul like this. But if you have one of those, absolutely call one of us we're happy to talk to you about it offline.

Well, thank you both. It was really quite informative, and thanks to all for the great questions. Just in closing, there's three kinds of business owners we tend to get involved with. Those who make things happen, those who wait for things to happen, and those that wonder what the heck just happened. And you don't wanna fall into the third category. We wanna provide you with the advice and guidance you need to begin to work with your legal and tax advisor, to analyze the various impacts on you and your business. And most importantly, develop a plan which you can implement quickly should the law pass in September or later in the year. Given the potential impact, we expect end of year planning to be extremely busy and challenging to complete if you begin too late. If you'd like to have follow-up call to discuss your particular business and situation, please reach out to your Key Bank personal or commercial relationship manager, or you may reach out directly to Jeff and or Joel, to schedule a call. Thank you for participating in today's call. We hope you will join us on June 24th at three o'clock for our next topic, unlocking opportunity series, the top 10 questions regarding transitions and transactions. Thank you for joining us, and have a good afternoon.

Roughly 1.2–1.5 million baby boomers with businesses valued between $2 million and $100 million will attempt to sell by the year 2030. Unfortunately, 70-80% of businesses do not transact due to a host of complex issues. Only one in every eighteen will transact at their target price – in the pre-COVID world, that is. Between 2021 tax proposals, COVID-19, and other conditions, the waters have only been muddied further for these owners. Fortunately, there are more ways to transition a business than they may know.

Family Wealth Strategist Carey Spencer hosts this fast-paced discussion with Managing Director of Family Wealth Consulting Jeff Getty and Consulting Director Joel Redmond as they outline the disruptors and misconceptions swirling around business transition options. Listen in as our team reviews the strategies discussed in our previous webinar, “Top Financial Moves to Stay Ahead of 2021 Tax Proposals,” and the environmental, global, industry, and political disruptions that have fundamentally shifted the landscape of transition.

Discover what you need to do to prepare for transition in the face of these headwinds – and achieve your own goals for a successful transition of the asset you may have worked your entire life to build.

To understand more about how 2021 tax proposals may impact your business, contact our speakers through our Business Advisory Services team mailbox.

Any opinions, projections, or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.

This material is presented for informational purposes only and should not be construed as individual tax or financial advice.

KeyBank does not provide legal advice.

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