Personal Wealth Law News

Here is a guest article on valuation from Chuck Bertsch, a well-known valuation expert who has helped many of our clients:

RE: VALUATIONS IN HARD TIMES

We often use the capitalized earnings method to arrive at the value of a business. This consists of selecting an earnings level representative of future expectations for a company and, then, capitalizing these earnings with a rate which reflects investor return requirements and long-term growth expectations [A capitalization rate is the same as a price to earnings ratio expressed as a decimal; e.g., a P/E ratio of 6 is equal to a capitalization rate of .167].

The capitalization rate is the company’s weighted average cost of capital (“WACC”). If a business is appropriately capitalized with all equity the capitalization rate, or WACC, is determined by reference to Ibbotson (now Morningstar) long-term equity returns, plus an allowance for specific risk. Alternative approaches exist.

Some companies, of course, can be financed with a mix of debt and equity. In these cases, a judgment is made as to the appropriate mix of capital inputs. A WACC which reflects the returns demanded by suppliers of both types of capital is then computed.

Suppose, for example, we have a company with $15 million of equity capital, no debt, and $3 million of net income. Using the Ibbotson procedure, we might come up with an equity return requirement of 20%. The $3 million of net income, capitalized with a rate of .20, yields $15 million as the value of the company.

If, however, we were to judge the company could be financed 40% with debt yielding 7% the calculation would be different. In this case we would compute a WACC of .148 (60% equity at a rate of .20, plus 40% debt at a rate of .07). The $3 million of net income, capitalized with a rate of .148, yields $20.3 million as the value of the company, a 35% increase from the all equity case.

Two years ago, or perhaps only six months ago, an assumption of 40% debt financing in a company’s capital structure might have been unremarkable. Today this is far less likely to be true. As we read on a daily basis, credit markets are closed to many borrowers or prohibitive in terms of cost (junk bonds have been priced to yield 18% to 20% in recent months). If we conclude that the company in our example can best be financed with only 20% debt (at rates higher than 7%), or no debt, the effect on WACC and value is obvious.

In the second paragraph above, we mentioned “specific risk.” In our view, specific risk premiums have escalated significantly over the last six months. This is partly because historical long-term rates of return do not reflect requirements in today’s exceedingly risk-averse environment; it also is because the vast majority of businesses confront much greater volatility in their earnings prospects (and, hence, more risk) than has been the case in past times.

The impact of these two factors, changes in WACC’s and specific risk premiums, mean that over the last six months most companies have suffered material declines in value even in cases where earnings have resisted the general downtrend.

Frederick C. “Chuck” Bertsch III, MBA, ASA

F.C. Bertsch & Co., Inc.

416 Roundhill

St. Davids, PA 19087

610-964-1800
610-964-1801 (fax)

fcb@fcbertsch.com

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F.C. Bertsch & Co.’s valuation practice focuses on ownership interests in closely-held businesses, partnerships, and limited liability companies. Chuck Bertsch has been valuing business interests for 30 years. He belongs to the American Society of Appraisers (where he is an Accredited Senior Appraiser) and the Philadelphia, Delaware County and Chester County Estate Planning Councils. He has served as CFO of two companies (one NYSE listed) and is a graduate of Wharton (MBA in Finance) and Wesleyan University

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In the midst of disturbing news about the economy, there are opportunities now available that make succession planning for businesses work well. There are two reasons: lower values for businesses and historically low IRS interest rates used in planning for wealth transfers.

It’s no secret that the economic downturn has reduced the value of many businesses. For those businesses that are well-run, it’s likely that this will be only a temporary drop, and that as the economy recovers, values should increase again. That means that this is a good time to transfer assets at the lowest gift tax cost.

In addition, the interest rates used by the IRS in determining the value of split-interest and deferred gifts is now at its lowest point ever, 2.0% for gifts made in February 2009. If a gift is made in the form of a grantor retained annuity trust, which allows a business owner to transfer ownership but defer the date when the transfer is completed, more can be transferred when the IRS rates are lower.

Succession planning is a complicated process, but the benefits of doing it correctly and at the right time are great. Now is the time to think about that kind of planning.

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Dagwood Bumstead, featured in the long-running comic strip Blondie, has worked for more than 70 years for J. C. Dithers, the model for many a law firm senior partner. But that was not the way he started out comic strip life. His saga tells an interesting story about family business succession.

Dagwood began as the heir to an industrial empire, the Bumstead Locomotive Works. He fell in love with Blondie Boopadoop, whom his family considered beneath him socially. When he insisted on marrying Blondie anyway, his father disinherited him. Thus ended his future of becoming an executive in a large industrial concern, and he turned instead to more than 70 years of wage slavery, carpools, running into the mailman, etc. He seems to have become stuck as the equivalent of a third year associate. Meanwhile, Blondie started her own business, and the Bumstead Locomotive Works has disappeared. Perhaps Dagwood could have saved the company and redirected its business to defense contracting or microchips.

What’s the lesson for those thinking about family business succession, which is one of the most difficult goals to achieve but one of the most satisfying when it is achieved? It’s a better course of action for the family members to discuss each of their goals and plans. Bumstead Senior should have realized the consequences of leaving no one to follow him in the business. Dagwood could have suggested that he come into the business on a lower level so that he could prove himself. Senior’s lawyer could have explained how disinheriting his son would probably put an end to the plans to have the business remain in the family and successful. But I suppose that wouldn’t make for a good comic strip; better to feature big sandwiches and funny bowties.

Here are two sources of learning on the process of business succession, very different but both helpful. One is a book titled “Estate & Business Succession Planning,” by Russell J. Fishkind and Robert C. Kautz. The second is a series of programs on succession planning that feature a theatrical performance of vignettes in the story of family businesses. These programs have been arranged by a psychologist, Dr. Scott Budge, who has spoken for PBI on business succession planning. They are presented in Philadelphia from time to time.

Republished with permission of The Legal Intelligencer.

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Megatrends is a name given to important changes in the economy or in the behavior of many people. People write books and articles about megatrends, hoping to identify them before others do and to benefit in some way (usually by selling more books). There are several megatrends that have a definite impact on trusts and estates work, and that will be discussed in future blogs:

• People are becoming wealthier, even with the current stock market setbacks. This is a worldwide phenomenon and contributes to the international flavor of much estate planning.
• A large number of people (the always demanding baby boom generation) are getting close to retirement and to a “final” disposition of their assets.
• There is a strong interest in business succession planning, particularly in this part of the country, where there are so many family-owned businesses. To deal with these issues, trusts and estates lawyers often have to act like psychologists, or at least hire them.
• People want to protect their assets against litigation and divorce, among other threats.
• There is and will continue to be a need for increased tax revenues, which leads inevitably to more complex tax laws and the need to plan for them. When Congress talks about tax simplification, tax lawyers go car shopping.

The combination of these megatrends demonstrates the growing importance of the broad practice area of trusts and estates, often referred to by more general names such as personal wealth, private client or wealth transmission, and ensures that this will be an area of growing importance for lawyers, one that focuses not on death but on the enjoyment of life.

In the next blog, we’ll review the campaign to repeal the federal estate tax and the likely future of the tax and the exemption from tax, as well as efforts to repeal the Pa. inheritance tax.

Republished with permission of The Legal Intelligencer.

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One of the greatest impediments to retirement by an older generation of a family business is concern about maintaining an adequate income stream in retirement. The owner/managers of a business generally rely upon the business to provide a comfortable income and to cover many expenses. There might be a reluctance to give that up, which could lead to a postponement of retirement beyond what would otherwise be an appropriate time.

We have worked with a number of business owners on this problem, and one helpful solution could be the use of a retirement plan. If there is another, assured source of income, the business owner might be more willing to give up the reins of ownership and management a little sooner. This takes some careful planning, and there are different types of plans that might be appropriate in particular cases. One type of plan that permits the buildup of a large retirement benefit in a short period of time is the defined benefit pension plan. In contrast to the standard 401(k) plan, a defined benefit plan often permits large contributions, which can create a substantial retirement benefit in as little as 5-8 years. There are rules you need to comply with in setting up such plans, but when the situation is right, retirement plans can be an important element of a business succession plan.

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This post was written by The Beringer Group:

In the US, the family business has, since the end of WWII, been one of the great producers of both jobs and wealth.  And yet, if one reads the literature, one knows that most family businesses don’t last beyond two generations.  This can be due to many causes, but one of the most prevalent is the lack of planning to tax-effectively pass the business from one generation to another.

As the senior generation business owner ages, and the next generation prepares to enter the business or, having entered, to assume more responsibility, it is typical for all of the equity and control to be and remain in the hands of the senior generation.  The owner who really wants to keep the business in the family needs to begin thinking about whether equity is an asset or a liability and about whether all that he/she really needs (or wants) is control until such time as the younger generation is ready to assume company leadership. continue reading

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I think there are two reasons why there is now so much interest in planning for the future in family-owned businesses:

• the baby boom generation, a significant percentage of the population, is heading toward retirement age, and bringing with it many businesses that were started 10, 20 and 30 years ago.
• we’ve had 40 or more years of fairly good times in the US- some recessions and economic downturns, but no event like the Great Depression to wipe out people’s hard work.

What is involved in family business planning? Well, this is what it isn’t: it isn’t a package of documents run off a computer, to be signed by family members to transfer ownership of a business. What is it? It’s a process of learning what people want and don’t want; of helping them to understand how they can achieve what they want, and when they can’t achieve it; of helping families to remain close despite different financial situations and opportunities.

More than anything else, it’s a process of listening to what people think and hope to achieve. Most owners of family businesses are very intelligent, but not trained or experienced in how and when to pass on ownership or control of the business. The assistance we can provide is to be good listeners and then to apply our own experience in finding ways, through various planning techniques, to help families achive their goals. At that point, we might become involved in preparing estate plans and business transition plans, and in guiding owners through legal concepts in transferring ownership.

There are many pieces to the puzzle of successful family businesses. In future entries, we’ll review some of those pieces to see how they can help in making family transition successful.

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