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Prospecting for new business is an inescapable part of being in the financial services industry. Everyone needs new clients to thrive.
That’s why advisors have long targeted successful entrepreneurs who have a large portion of their wealth tied up in the value of their business. The thinking, of course, is that even if they are cash-poor today, that’ll change the moment they sell their firm.
Some advisors, in fact, are so eager to work with such clients they will propose to oversee that sales process for free in exchange for the opportunity to manage the post-transaction assets. However, that can have disastrous consequences for business owner clients, who frequently need more than asset management-related services, thanks to their unique circumstances.
Indeed, deals involving tens of millions of dollars often require the expertise of a multi-disciplinary advisor. In other words, someone who can coordinate with other service providers like CPAs, M&A specialists and estate attorneys to implement pre-transaction planning strategies to help clients protect as much of their wealth as possible.
Here are some strategies to help paper-rich, cash-poor entrepreneurs make the most of a business sale.
Use valuation discounts when gifting assets. Assuming the business is an LLC, it’s possible to provide an heir with a considerable gift and then set up an arbitrage opportunity for the client once the transaction closes. This is how it works: Let’s say the business is worth $100 million. The owner can gift a child 10% of it via a trust. Since it’s a minority stake, it can get a minority interest and lack of marketability discount, meaning the gifted amount could get marked down. In this case, it’s likely to be about $8 million, which means they have more gifting potential in the future (the current lifetime exemption is $12.92 million per person). Moreover, the benefactor’s interest within the trust is still $10 million—and could be worth much more once the business changes hands again.
Charitable giving. There’s nothing novel about setting up a charitable trust or a donor-advised fund to support causes clients are passionate about. Still, for business sellers, the timing of when they do this is vitally important: It should happen before the transaction closes. That way, they can fund them immediately—allowing them to avoid capital gains taxes on their contribution and to take a charitable deduction on the fair market value of their gift. If they fund one of these vehicles after a transaction takes place, the impact from a tax perspective won’t be nearly as significant. Notably, advisors need to view the client’s charitable aims through the lens of their broader financial plan. The last thing you want to have to happen is for them not to have enough money left over to tackle their other life goals.
Qualified small business stock exclusion. This little-known quirk in the IRS tax code allows owners of qualified company stock—including founders—to avoid paying taxes on the first $10 million in gains on those shares. There are some conditions, including that the company cannot operate in a range of prohibited industries (though tech, wholesaling, retailing and manufacturing businesses are permissible) and it must be a C-Corp with fewer than $50 million in assets. Also, the owner needs to have owned the shares for at least five years—which highlights why pre-transaction planning can be crucial for business sellers. Imagine they were to sell their firm and a batch of company shares that are 4.5 years old.
Take a deep breath and wait. After years of having little liquidity, business sellers can find themselves suddenly flush in cash. This is obviously a good problem to have. The first step is to review current estate planning documents. Have their prior intentions changed given their newfound wealth? Another issue is since they no longer own a fast-growing asset, their balance sheet may be smaller than before. That’s why it’s a good idea to encourage these types of clients to observe a post-sale cooling-off period. Their friend who wants them to invest in a real estate fund? The big house or expensive sports car they want to buy? The nephew with a drone startup? All these things can wait until you can determine their goals and objectives. Similar to lottery winners after collecting a huge windfall, business sellers can be prone to make regrettable decisions in the immediate aftermath of a transaction going through.
Clearly, sellers of highly valued businesses have unique needs. But increasingly, they are not alone—clients of all types can be equally idiosyncratic, and that’s why advisors must have the necessary skills, relationships and experience to thrive in today’s landscape.
Ray Morill is a Senior Director, Wealth Management, with Choreo Advisors
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