By Michael Oleksak
This article was originally published in Financial Executive.

Over the next several decades, millions of U.S. businesses will be sold, merged, recapitalized, gifted, closed, or liquidated. In any of these events, both the owner and the company’s value will benefit from advance exit planning. Financial executives, whether internal or external, play a key role in educating company owners on the basics of exit planning.

If you are the lead financial officer of a privately-held business, such as CFO or VP Finance, part of your fiduciary duty is to protect the company from the risk of an unplanned change of ownership, through sudden death, of both the shares and the operation of the business. You also play an important role in increasing the company’s value by strengthening it for the possibility of a future transition or transaction.

Whether you are an internal or external financial advisor, you should make the business owner aware of three things every owner must have: a will, a succession plan, and an exit strategy.

The will protects the ownership of the firm in case a tragedy or sudden death affects the owner. With a will, the shares will stay out of probate court and land in the hands of the person or people chosen by the owner, thereby ensuring some sense of business continuity.

The succession plan will help with the orderly transition of the operation of the business if the owner is suddenly incapacitated. The exercise of preparing a succession plan will also help establish whether internal management is strong enough to handle running the company without the owner.

The exit strategy will be the catalyst to determine whether the company is ready for some other entity to assume ownership. Are the books and records, processes and systems, management and employees, business model, brand, public image and reputation desirable enough for someone else to pay to acquire it? If the answer is yes, the next question is would the acquirer be external or internal?

Exit Options

The owner’s external exit options are sale to a strategic buyer or sale to a private equity group. Internal transfer options include a management buy-out, a sale of shares through the Employee Stock Option Plan (ESOP), or gifting of shares, usually to the next generation of the owner’s family. Each of these five exit options has a different valuation range, with external transfers generally having higher values. The owner will also relinquish control of the firm after the external transaction, giving up the ability to subsidize his or her lifestyle through internal expenses. The external exit option also eliminates the owner’s control over his or her legacy, so the owner must determine his or her financial and emotional readiness to exit the business.

If the owner is emotionally ready to leave the business, but needs the highest financial return, as the financial advisor you can recommend that a sale to a third-party strategic or third-party financial buyer should be considered. Under these arrangements, it’s important to calculate investment banking and legal fees, as well as taxes, because all will be subtracted from the amount of the check the owner will cash at the end of the day. Due diligence by the third party buyer will be thorough. If there are family members working in the business, their employment may be at risk if the current owner is not calling the shots. The owner may be required to bridge any financing or value gap with seller notes or earnouts over time.

A management buyout (MBO) creates a different risk to analyze: is the management team capable of continuing to generate enough cash to pay out the owner over time? Some industries lend themselves to MBO’s better than others, such as construction. Such a deal will require outside financing from a bank or another source, and management may be required to pledge personal assets to support a bank loan. Seller notes will also likely be part of the financing. After the buyout, the owner may still be involved and may retain some financial expense benefits under the deal. The further in advance this option is considered, the better the owner can prepare the team for the execution [?transition?].

An ESOP is a tax-advantaged, though administratively complex, way for the owner to take some money off the table by selling shares to employees and management. Under a buyout or transfer through an ESOP, the owner will likely remain in control if less than 50% is sold, and will continue to have some personal expenses paid by the company.

Gifting is also a tax-advantaged way to transfer ownership, usually to (hopefully capable) family members. The owner can stay in control and have expenses paid for by the firm. This option will cause complications in relationships, especially as you get deeper into the second and third generations of the family. Capable outside consultants with experience in family business issues should be considered to help smooth out issues.

All the options that financial executives can suggest for exit strategies carry different valuation ranges, with external transfers having higher valuation ranges (and higher tax impacts). However, a clear awareness of each will help the owner and the company mitigate risk and prepare for the future.

Michael Oleksak is a principal at Trek Consulting LLC, which helps business owners focus on the dual challenges of building and realizing the maximum value of their life’s work. For more information, visit www.trekconsulting.com.

By Vernon W. Holleman, III
This article was previously published in The National Underwriter

In light of the financial meltdown, it is a good time to talk to the (still) wealthy about using life insurance as a financial tool for giving to charity.

For those with a private foundation, help them think about using life insurance as “asset replenishment” after the recent market storm. The idea is simple: to replenish asset losses of the foundation using life insurance on the donor’s life, thereby creating dollars not there today for real leverage tomorrow.

Life insurance potentially avails donors of new opportunities to make gifts. Today, most donors are simply thinking of how to complete gifts already made and are making few new commitments. You can help them ensure that assets that have been lost are recovered or guarantee a nice return.

Charities love planned gifts. And today they are looking for good planned giving stories to tell. Help them by exciting your clients about the power of giving life insurance. After many exotic and hyped investments failed or proved fraudulent, demonstrating the tax-free growth and returns of life insurance, a known commodity, is cool again.

Life insurance lets donors have a real impact on, for example, their alma mater. The school would apply for, say, a $1 million life insurance policy of which the school would be both owner and beneficiary. The donor would make annual gifts of the premium to the school and take charitable deductions for doing so.

In a recent example of this strategy, my firm helped a 55-year-old man create a gift using life insurance because making a current cash gift was not an option. We suggested he determine his insurability in a preliminary underwriting test. After collecting medical records, the underwriter at our chosen carrier deemed him to be in “preferred” health. Result: He could accomplish his goal of a $1 million policy with his budget.

After full underwriting, it turned out he was “super preferred”–all the better. This created a roughly $9,500 annual premium for the policy. He examined several funding alternatives, including “pay forever” and abbreviated scenarios, and determined the pay forever was the best bet because it provided the best return on his investment.

He also wanted the policy to last until age 100 with cash value in the contract, but he did not want to fund the policy to have it endow (wherein the cash value equals the death benefit at age 100). The internal rate of return (IRR) of the contract if the donor lives to be 100 will be no less than 7%, a handsome long-term net return. Both the donor and the school were pleased—the proverbial win-win.

Issues to consider

Insurable interest is the first planning aspect that must be confirmed. In my example, the donor had not only graduated from the school; he had two children who had gone there and served on the school’s board. Most importantly, he had a long track record of giving, both annually and during campaigns. The Truth is, the school would suffer a financial loss at his death.

It is very important that you understand the relationship of your client (the donor) with the charity so you can justify the insurable interest to the underwriter(s) at the carrier(s). Do this first–don’t just assume anyone with a charitable intent can acquire life insurance because they want to; insurable interest laws were established for a good reason. Also, you don’t want to excite clients by the idea of gifting, only to find they just started working with a charity or there is not enough history to justify insuring them.

It would be easy to assume that your client can take a full tax deduction for a planned gift of life insurance, but don’t assume. Confirm it with a tax professional, so there are no surprises.

In addition to insurability, the client’s specific rating classification makes a real difference in charitable planning. Today, most carriers have as many as five standard or better ratings. Each improvement in the underwriting class means savings for the donor and/or a greater gift to the charitable organization.

Thus shopping for multiple carriers is key, as those with standard and preferred “plus” ratings can create significant savings over a carrier offering only standard and preferred rating classes. However, this theory must be tested, as costs will differ. A market analysis is the only way to find the best product choice for the client.

You must also help clients budget for a policy acquisition, both for the short and long term. Don’t assume that because individuals of means are making a planned charitable gift that they will want to pay the premium forever, or that they won’t ever have cash-flow issues. Therefore, be wary of no-lapse guarantee universal life products that offer little premium flexibility if a donor ceases payments. Also, remember the charity will own the policy and may need to cash the policy in before it matures. So building up cash value is key.

Whole life, as an alternative to UL, may not give enough flexibility either; and a variable life product that sees down markets may affect the expectations of the donor and the charity too much. We’ve achieved the greatest success using life insurance for charitable purposes with a traditional universal life product that offers good cash accumulation until late in life, but that also (to keep the premium reasonable) does not require funding until the policy endows.

This policy type strikes a reasonable balance between keeping the premium low while building a cash value cushion that may be needed to meet temporary needs, maintain the policy in the event of missed premium payments or accommodate a decision by the charitable institution to cash out early. Talk through these issues with the donor and the charity so proper planning can be implemented.

Vernon W. Holleman, III, is president of The Holleman Companies, an insurance advisory firm based in Chevy Chase, Md. He can be reached at Vernon@hollemanco.com.