Chapter 17
Funding the transaction

There are many options when it comes to paying for the transfer of an ownership interest. The funding of the succession plan depends on the type of transition and, in the case of a family transfer, whether you want your family to pay for it, earn it or just get it.

Any succession plan must consider first and foremost the retirement needs of the owner or of the surviving spouse in the case of the owner’s untimely death. What kind of income and assets must remain to ensure the desired quality of life? And what is the owner’s plan for life after his business? For example, if you plan to start or continue operating other businesses, you may need a certain amount of assets in your name for financing or borrowing purposes. And consider whether any assets need to be in your name to satisfy your estate plan. If you are giving the business to your son and the office building to your daughter, then this transition should be planned.

Let’s assume you plan to transfer the business to family members. Once you settle on a minimal level of income or assets you need for the rest of your life, you must tackle the question of how generous you want to be. Some owners may see the opportunity to hand over a thriving operation as a gift to a child as a moment of triumph – the final victory of a long career.

On the other hand, having worked hard to build a trucking company, many owners simply can’t just give it away to the next generation. You value your company in part because of how much work it took to build it. Would a son or daughter be as committed to the business if he or she got it for free? But money isn’t necessarily the only option. You might choose to make a transfer contingent on working in the business for a certain time while meeting certain performance goals.

Often, the result is a mixture of paying, earning and getting. Perhaps the children will be asked to pay for a large portion of the business, in part to instill a real sense of ownership and in part to ensure your retirement income. Then the remaining portion of the business is either earned or gifted. Children usually earn a portion of the business by working in the business if you want to consider this option.

There are many ways to fund the transition of a business depending on the chosen plan. Most professionals will mix and match portions of various options, including:

• Sale of business assets
• Sale or gift of stock
• Seller financing
• Life insurance
• Third-party debt
• Private and public capital markets

Business assets
Business assets are used to fund the plan most often by distributing certain unnecessary liquid assets to you thus reducing the value of the company. Your successor – usually a family member – can now afford the business. There are many considerations before just distributing assets. Depending on your entity type, you will need to consult with a tax professional to minimize tax consequences. And take care not strip the company of its necessary assets that would affect your banking relationship.

You may lease assets you personally own – often real estate or equipment – to the company. There are ways to distribute assets that can be classified as dividends, but even then there are limitations. You may want to consider deferred compensation or payment for past services. Additionally, you may want to create a liability on the balance sheet to the owner through deferred compensation thus reducing the value of the business. It may turn out that you receive a higher total payout by allowing some of your payments to be tax deductible to the business. Other ways to create a liability or agreement to make future payments are consulting agreements, covenants not to compete or rental or royalty agreements.

Seller financing
The buyer, who may be your child, does not always qualify for bank financing. In this case, you may have to provide some or all of the financing yourself. The biggest worry with seller financing is repayment. You might have some influence over a child, but don’t count on it. Family squabbles can erupt over loan issues.

Whenever you use seller financing, be sure to conduct due diligence and ensure the new business plan can repay the loan. Take a lien on the assets. Get a personal guarantee. Take out life insurance on the buyer. And have the company stock pledged as collateral. Realize, however, that if the buyer can no longer make payments on the note to you, the company may no longer be worth anything. Also, consider restricting the buyer’s ability to take out additional loans and how much he can withdraw from the company either by salary or distribution.

As a seller, you probably would prefer that the purchase price rather than the interest rate on the loan be high. The purchase price is subject to capital gains while the interest is ordinary income. Of course the buyer will want the opposite since he can expense the interest in the current year. There are specific rules on interest for which you need to consult your tax advisor. As you can imagine, Congress recognized there may be situations where the tax impact can be manipulated. Thus, for certain transactions taxpayers are required to recognize certain interest income/expense irrespective of what the seller-financing documents may provide.

One additional item to watch with seller financing is the installment sale rule. There are various tax treatments to when proceeds are received as to when taxes are due. Related party transactions may have special rules. Again, consult your tax advisor.

Life insurance
Life insurance can be a very beneficial tool in the funding of a succession plan. A common method of using life insurance is the cross-purchase. Each owner takes out a policy on the other owner. This arrangement ensures that funds will be available upon the death of a co-owner. Also, if the life insurance policy has a cash build-up then a loan can be taken from the policy and repaid by its death benefit. However, this will reduce the amount of cash available upon the death of the owner that is available to the successors/beneficiaries. The interest paid on this loan has special rules that need to be considered, but otherwise this may be a good use of funds.

Life insurance policies can also be used to help make up the difference between children’s inheritance and round off the edges in a purchase agreement. There are times when you can, under special rules, use life insurance and tax rules to your advantage.

We have already discussed a Welfare Benefit Trust, but there are numerous other plans such as a traditional Variable Universal Life policy that build cash value or a 412i plan. Split-dollar plans have been very popular, but recently there have been some major changes to the way companies and employees handle these type of plans. In general, a split-dollar plan is not a life insurance policy but a method of funding the premium. It is a way of providing an economic benefit to the employee.
There are many ways that life insurance can be used creatively and kept out of your estate if you seek the advice of an insurance professional and tax advisor.

Third-party debt
Sometimes, an old-fashioned bank is the best financing option. Plus, the traditional method is good yardstick on the fundamentals of the deal. With the amount of regulation on banks and their conservative nature, you can get a good feel for your succession plan. If a banker does not want to touch your deal, then you, too, should pause and reconsider. On the other hand, just because a banker will fund your plan does not mean traditional financing is your best source of funds.

Once you identify a potential lender, the next step in obtaining necessary financing is to prepare a formal loan proposal (commonly referred to as a “loan package”). The objective of the loan package is to provide the potential lender with the information needed in order to render a lending decision. Outlined below is a summary of the basic information generally included in most loan proposals.

Purpose of the loan. The purpose of the loan should be described in specific terms, rather than simply stating that the company needs “to buy dad out.” The discussion of the loan’s purpose may also include a general statement of the expected benefits if the loan is granted and the expected impact on the company if it is denied.

In addition, keep in mind that the reasons funds are needed tend to influence the financing terms to be sought. As a general rule, the life of the asset to be purchased should at least equal the term of the financing used to acquire it. In other words, short-term financing may be used for acquiring additional working capital; medium-term financing may be used to purchase equipment or machinery; and, long-term financing should be used to acquire buildings, building improvements and other forms of real estate to be used within the business.

Generally, the asset is the company itself and most bankers want to see a plan to repay the loan during the five- to 10-year period. This will most likely mean that the buyer will have to discipline his cash management during such period to the point that such cash management may severely limit his take home pay during this period.

The stated purpose of the loan will also affect the other information included in the proposal. For example, the banker will want to know if you plan to seller-finance a portion of the loan or if you will strip out certain assets. Other information that could bolster the loan request would be the quality of the underlying assets, including the current age of the company’s accounts receivable and the accounts receivable turnover ratio. This information will help show the banker that your buyer will have some immediate working capital and provide assurance that the quality of the assets purchased can be relied upon to provide the sources of cash necessary to repay the loan.

Amount of the loan. Request the amount you need. Some loan applicants request more than they need, believing the loan approved will be less than requested. Others ask for less than they need, believing that a smaller loan is more easily approved. Either alternative can lead to trouble. If the lender is familiar with the company already or has experience within the company’s industry and suspects that the company has not adequately considered its value, the credibility of the company and its management may be damaged.

If a larger-than-needed loan is sought and approved, the result may be unnecessarily high interest costs. Conversely, a loan that’s too small may result in inadequate funding. The company may need to change plans or go through the financing request process a second time – albeit at a time when the company is least able to repay a new loan. You don’t want to have to go back to the banker for different terms or options.

Repayment of the loan. The plan for repayment is critical for the lender. This section should describe how cash flow will cover the loan for repayment. A variety of historical and projected financial statements can be provided to the lender to corroborate the company’s stated ability and intention to repay the loan timely.

Lenders may want a second repayment source in case cash flow is less than anticipated or unexpected events and circumstances arise. The second source generally is not directly connected with operations. For example, it may be a lien on other assets or a personal guarantee by the owner. The second source may be described in this section of the financing proposal or in a separate section on collateral.

Collateral. A small business should expect lenders to require adequate collateral for a loan. This may include a lien on trucks and trailers or other equipment and buildings; accounts receivable; or life insurance policies on the owners and/or key employees. This section of the proposal should present your plans for offering collateral, and it might include a list of all your trucks and trailers in use at the company and identification of any items that are unencumbered, encumbered and leased. The list should include the equipment cost and the estimated market or replacement value.

Personal guarantees. Many banks require the business owner to personally guarantee the business loan. If you anticipate this requirement identify any potential guarantors and describe their relationship to the business. The proposal should also provide financial information about the guarantor, such as the last three years’ personal income tax returns of the guarantor as well as the guarantor’s personal financial statements. You may also be required to sign a personal guarantee if a family member is taking over the business.

Other information. The loan proposal should discuss any other information specific to the company and the loan requested. For example, lenders often consider the background and experience of the owners and key management in deciding whether to make a loan. Therefore, the loan package should include the names, functional responsibilities and resumes of the owners and key members of company management. Organizational charts are useful in this process too. The objective is to provide relevant information about the education, training, experience and accomplishments that indicate the competence and capabilities of those who run the company.

Examples of other information the company might want to include (or the lender might request) include the following:

• Company history
• Business plan
• Copies of significant contracts with shippers or agreements to buy more trucks
• Sample driver retention programs and advertisements
• Copies of insurance policies.
• Articles of incorporation or partnership agreements
• Industry data and comparable company data

Historical financial statements. As mentioned previously, lenders need certain financial information in order to determine the ability of the company to repay its loan. Generally, lenders want to see at least three years of historical financial statements and may request current interim statements if the latest annual statements are more than three to six months old. The lender will expect to see basic financial statements – balance sheets; income statements; statements of retained earnings or changes in stockholder’s equity; statements of cash flows; and notes to the financial statements – prepared in accordance with generally accepted accounting principles.

It may be appropriate to present additional explanations or details of items in the basic financial statements, such as:

• An explanation of any losses or unusual operating results
• Aged accounts receivable and accounts payable summaries with explanations of past-due accounts or accounts with special payment terms
• A detailed truck and trailer list with current market values and planned turnover or other age information
• Details of off-balance-sheet or highly depreciated assets. This would include leased trucks and trailers
• Revenues by customer and revenue per mile
• Details of selling, general, and administrative expenses
• A summary of insurance coverage, including liability, cargo, key-person, umbrella, etc
• Details of your past compensation and planned compensation of the buyer

Notes to the financial statements or supplemental information should include detailed information about your existing debt, including date and original amount of debt, interest rate, payment terms, current balance and collateral pledged. You should also disclose details of any lease obligations, loans from you or other related-party debt, and loss contingencies.

Prospective financial information. Lenders may be as interested in prospective financial information as in historical financial statements. Prospective results of operations and financial position help the lender assess how the loan will affect the company. Lenders are especially interested in prospective cash flow, since that provides the means of repaying the loan.

Generally, the lender requests prospective information for at least the first year after the financing is received and may request prospective information for the entire period of the loan. Usually, prospective information you should present monthly for the first projected year and quarterly for each year after. If the company has previously prepared budgets for the past or the current period, it may be appropriate to present the budgeted amounts alongside the historical actual amounts and show the variation from budget.

An insignificant or favorable variation might give the lender more confidence in prospective presentations for the future period. It also helps to present cash flow projections using both likely and conservative scenarios. Doing so presents a possible range of financing needs and shows the company has at least considered a conservative range of assumptions. The format of prospective financial information should be consistent with that used for historical financial statements.

The prospective presentation should represent company management’s estimates of the conditions it expects will exist and the actions it will take if the loan is obtained. Lenders will often use management’s projections to set loan covenants and conditions, so be realistic in your prospective information.

Professional assistance in the preparation of the loan package is recommended. A CPA experienced in preparing loan proposals often knows what specific information a particular financial institution – or even a particular loan officer -- will require and will be able to guide you in compiling the necessary information and in preparing the actual proposal document.

Other sources
The Small Business Administration may be a source of funds. More accurately, the SBA doesn’t provide financing. Rather, it guarantees loans for the bank. A bank will provide the funds, and the government will back you – usually at 75 percent. These are used if traditional bank credit cannot be obtained.

Finally, going public or using a private placement is a succession plan and funding source all in one. Refer to Chapter 8 on the merits of each type of funding.

Each of the above ways is only a sampling of options you can evaluate while deciding how to fund your succession plan. Remember, there are many options, but they must meet your needs. Expand your traditional advisor circle and make sure you use specialists when completing a succession plan. Not all advisors are aware of each funding source.