For CLE ONLY. Not for use in sales situations

Steve Parrish, JD*,CLU®,ChFC®National Advanced Solutions Consultant

Principal Financial Group

*Does not practice law on behalf of Principal Financial Group

Exit Planning for the Professional And Service Firm

June 17, 2011

For CLE ONLY. Not for use in sales situations

While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that the speaker is not rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.

Although the speaker is employed by Principal Financial Group, none of the information necessarily represents the opinions or products of The Principal Financial Group or its subsidiaries.

No part of this presentation may be reproduced or used in any form or by any means, electronic or mechanical, including photocopying or recording, or by any information storage and retrieval system, without prior written permission from the speaker.

Disclosure

For CLE ONLY. Not for use in sales situations

Agenda

• Financial and Tax Challenges

• Exit Planning Principles– Common concerns and solutions– Resources

• Special issues and solutions for Professional and Service firms

For CLE ONLY. Not for use in sales situations

Business Transition

• Seven in 10 small business owners have thought about who would run the business in their absence

• Only 25% have formal retirement succession plans

• Only 35% have formal continuation plans in the event of their deaths.

Source: LIMRA, Small Business Owners: Full Report, 2009

For CLE ONLY. Not for use in sales situations

Financial Issues

• Cash flow, credit and receivables

• Compensation and fringe benefits

• Business valuation and continuation

• Financial Gaps and Rebuilding

For CLE ONLY. Not for use in sales situations

The Retirement Gapfilling the gap that Social Security and your qualified plan doesn’t cover

For CLE ONLY. Not for use in sales situations

The Market Gapfilling the investment gap that the recent market downturn has created

For CLE ONLY. Not for use in sales situations

The Business Value GapHelping to secure the gap between your business’s

fair market value and your book value

For CLE ONLY. Not for use in sales situations

The Government Gap filling the gap in your plan caused by reduced government benefits

For CLE ONLY. Not for use in sales situations

The Yin and Yang of Budget and Taxes

FEDERAL BUDGET• Budget Deficit: $1.65

trillion or 9% of GDP • National Debt: $14.3

trillion• Four Largest

Expenditures: Debt, Social Security, Medicare, Defense

• Medicare Solvency– With ACA: 2029 (now

2025)

– Without ACA: 2017

FEDERAL TAXES• Bush Tax Cuts remain

through 2012. Cost of extending income tax for 2 years is approx. $100 billion

• Social Security payroll tax reduction 2011 only

• Estate Tax increased $5 million exemption for 2 years, then reverts to $1 million at 55%

For CLE ONLY. Not for use in sales situations

2010 2011 2012 2013Earned Income

Top Marginal Bracket1

36.45% 36.45% 36.45% 41.95%

Unearned Income2 35% 35% 35% Up to 43.4%

Qualified Dividends3 15% 15% 15% Up to 43.4%

Capital Gains4 15% 15% 15% Up to 23.8%

2010 Tax Relief Act Cumulative Rates

For CLE ONLY. Not for use in sales situations

Special Tax and Exit Issues:Professional and Service Firms

• Employment taxes and flow through taxation• Flat tax for P.C.s• Accumulated Earnings• Fringe benefits for flow through entities• Special as to exit

– Discipline involved – “Of Counsel”– Earn outs– Non-competes

For CLE ONLY. Not for use in sales situations

For CLE ONLY. Not for use in sales situations

Step 1: Business and Personal Survival

Financial Analysis Firm Dynamics Analysis

PERSONAL•Financial Needs•Financial Gaps

•Firm/Family Issues

BUSINESS•BusinessValuation

•Benefits Review

Integrate with Overall Business Plan for the Firm

For CLE ONLY. Not for use in sales situations

Step 2: Exit Plan for Owners/Partners

Determine Objectives

• Maximize value

• Minimize taxes

• Maximize flexibility

Assess ExitTechniques

• Sale

• Capital transfer

• Gift

For CLE ONLY. Not for use in sales situations

Step 3: Funding Transfer Plan

1. Determine FundingEvents

Target Dates(retirement,

sale date, etc)

Contingent Events(Death, Disability,

Divorce)

2. Funding OpportunityReview

3. Create Funding Plan

4. Pre-Funding

5. Execute and Monitor

For CLE ONLY. Not for use in sales situations

Business Liquidity Needs when Owner is Exiting

• Costs of disruption

• Lost loyalty (revenues and receivables)

• Debt called or not extended

• Costs of fulfilling sale/transfer

• Possible estate taxes

For CLE ONLY. Not for use in sales situations

Business Liquidity Sources when Owner is Exiting

1. Funding from Cash Flow

2. Sell the Business

3. Borrow at Exit

4. Borrow from Government

5. Borrow now (recap.)

6. Capital Markets

7. ESOP

8. Life Insurance

For CLE ONLY. Not for use in sales situations

Special Considerations for Professional (and service) Firms

• Ownership – Founders vs Partners vs Associates

• Governance • Licensure • Franchise / Dealership• Multi-owner nature• Cash flow and capitalization• Valuation

For CLE ONLY. Not for use in sales situations

North American Industry Classification System (NAICS):Professional, Scientific & Technical Services

• 541191 Title Abstract & Settlement Offices

• 541199 Other Legal Services• 541211 Offices of Certified

Public Accountants• 541214 Payroll Services• 541219 Other Accounting

Services• 541511 Custom Computer

Programming• Services• 541512 Computer Systems

Design Services

• 541519 Other Computer Related Services

• 541613 Marketing Consulting Services

• 541614 Process, Physical Distribution, &

• Logistics Consulting Services• 541618 Other Management

Consulting Services• 541921 Photography Studios,

Portrait• 541922 Commercial

Photography

For CLE ONLY. Not for use in sales situations

Valuation of Professional Practices

ExpertiseEducationReputation/RecommendationsSubstitutionMaintenance of ExpertiseGoodwill

For CLE ONLY. Not for use in sales situations

Rules of Thumb

• Dental Practice: 1–1.5 X annual net earnings plus fixtures, equipment, inventory

• Law Practice: 0-100% annual fee revenue, dependant on client retention

• Accounting Practice: 1-1.5X gross annual revenues

• Medical Practice: 1.5–3 X annual net earnings, plus fixtures, equip. &inventory

• Real Estate Agency: 20-50% gross annual commissions

For CLE ONLY. Not for use in sales situations

Current Business Valuation Issues

• Multiples

• Discounts– Judicial– Legislative

• Life Insurance

• Formula or Amount in Buy Sell?

For CLE ONLY. Not for use in sales situations

Buy Sell Review Principles

• When is disposition of the business? (“5 Ds”, etc)

• Correct parties to contract? (should spouse sign?)

• Valuation (Amount, Formula, Reference to life insurance)

• Does agreement work with the chosen entity type (S, C, LLC)?

• Is Life Insurance ownership compatible?

For CLE ONLY. Not for use in sales situations

Exit Planning Resources

• Business Enterprise Institute –

John Brown

• Robert Gelder - CBIZ

• John Warrilow – Built to Sell

• Christopher Meyer

• Pinnacle Equity Solutions –

John Leonetti

For CLE ONLY. Not for use in sales situations

Exit Planning Solutions

• Cross Purchase versus Entity• Multi-owner Buyout • Stay bonus• ESOP• Control: Nonvoting shares, Partnership• Select Reward Plan to fund buyout• Reduced value sale with additional

benefits

For CLE ONLY. Not for use in sales situations

BCGP How it Works

For CLE ONLY. Not for use in sales situations

GOAL: Provide the liquidity necessary to owners departing a business while protecting the viability of the business for younger owners.

Business(Remaining Owners)

Newer OwnersFinancing:

Life Insurance

Owners Near RetirementFinancing:

Sinking Fund

Agreement AgreementCommon Triggering Events

•Death•Disability•Divorce•Dissolution•Departure

Multi-Owner Buyout Strategy

For CLE ONLY. Not for use in sales situations

Cash Flow for Continuity Plan

Cash Flow Funding

Sinking Fund and Life Insurance

Multi-Owner Buyout Strategy:

Year-by-year exits: retirements, deaths, terminations, disabilities, etc

For CLE ONLY. Not for use in sales situations

Example: Litigation Law Firm

• High, but fluctuating value

• 2 founders, wanting $7.5 MM buyout

• Result: – $10 million on founder partners– $5 million on other partners– $1.2 million annual premium– Ancillary funding: Disability Income, etc

For CLE ONLY. Not for use in sales situations

Family or Internal Management SaleSelling at Lowest Defensible Cost

Results:• Payments to owner tax

deductible to the company• Lower net outlay for

purchase by children or management

• Life insurance is corporate paid and can help in living or death buyout. Can fund the deferred comp as well

• Beware: IRC 2703

Transaction:• Value sale by note at lowest

defensible valuation• For Owner

– Deferred Compensation– Consulting and non-

compete agreement

• Fund agreement with Life Insurance, etc.

For CLE ONLY. Not for use in sales situations

Selling to Family / Internal Management Selling at Lowest Defensible Cost

DeferredComp$200 K

True Value$1 MM

DefensibleValue

$800 K

High Payments

Cap Gains

Estate Tax

Lower payments

Lower Taxes

Buyer Tax Deductions

Spreads gain

For CLE ONLY. Not for use in sales situations

Stay Bonus

• Problem – non-owner key employee retention after loss of owner

• Solution – stay bonus for period of time

• Profile – family owned, special expertise, transition planning

• Implementation – side fund, life insurance (company or ILIT owned)

For CLE ONLY. Not for use in sales situations

Funding the Stay Bonus

ILIT Death Proceeds

Practice

Purchase or Loan

Additional Income

KeyE’ee

For CLE ONLY. Not for use in sales situations

• Closely held corporation funds a deferred compensation account for current executives who are potential future owners

• The account is set to vest and distribute on a Change in Control of the company

• Provides incentive/reward for key executives and retains options for current owner

Internal Sale

For CLE ONLY. Not for use in sales situations

Example:Sale of

BusinessChange of

Control Vesting

Sale to insiders

YESAccount vests and distributes to

executives and is used to execute purchase

Sale to outsiders

YESAccount vests and distributes to executives as reward for years of

service

NO NOOptional triggering event can be

retirement

Internal Sale

For CLE ONLY. Not for use in sales situations

Equity versus Ownership: Control

• Ownership: – Shares: voting, nonvoting – General and Limited Partners

• Equity– Bonuses –current and LTIP– Deferred compensation – “Non-partner” career track