bernstein selling a business gwm ltr

8/6/2019 Bernstein Selling a Business GWM LTR

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Selling a BusinessGetting What You Need

You Can Get SatisfactionSir Michael Jagger, better known as Mick, led The Rolling Stones in proclaiming that

You cant always get what you wantbut you just might find you get what you

need. This trade-off applies to all things in life, including investments, and it has

special validity when selling a private business. Although an owners focus may be

on getting his magic number for the business up front, he may find that other

alternatives offer acceptable, or even superior, trade-offs.

We begin with the premise that business sales are typically complicated, and laden

with emotional issues. The owner is selling his means of livelihood, and morethe

configuration of his financial portfolio: Hell have to make the transition from relying

on business earnings to living off the pool of liquid investments generated by the

sale. The good news is that sellers are not in the process alone, but generally

represented by teams of advisors, usually quarterbacked by an investment banker

and including a portfolio-management professional such as Bernstein (display below).

The role of the investment manager is not to pass judgment on one or another term

sheet, but to place each in the context of the sellers overall financial objectives. This

can be done at any point in the dealbut the sooner the better.

IN THIS PAPER

Selling a private business is best

thought of as an ongoing planning

process that begins well before the

deal is consummated and ends well

afterward. But at every point along

this continuum, the owner and his

professional team are grappling

with and resolving both financial

and personal issues. Bernsteins

proprietary modeling capabilities

can quantify the likelihood that a

sale will meet an owners critical

financial objectives and help

evaluate the trade-offs across

different deal terms.Transaction Planning: A Holistic Approach

Bernstein Expertise

Long-term investment planningAsset allocationMultigenerational wealth transfer

InvestmentManager

CorporateAttorney

T&EAttorney

Client

Accountant

InvestmentBanker

Bernstein does not provide tax, legal, or accounting advice. Business sellers should discuss their individual circumstances with professionals in those areas.

Gregory D. Singer

Director of Research

Bernstein Wealth Management Group

Brian D. Wodar

Director

Bernstein Wealth Management Group


2/162 Selling a Business: Getting What You Need

A Thicket of QuestionsDisplay 2 parses some of the interconnected financial and

emotional issues that arise when selling a business. For example,

whether the owner receives enough for his business depends

on how much it generates in earnings1 and how much the market

is willing to pay for those earnings. But directly connected are

issues like whether now is a good time to sell, whether the owner

wants to retain an interest in the business for a while longer

often a negotiable pointand how the sale will impact the

owners family and employees. All of these issues affect owners

personal lives as deeply as their financial wherewithaland onboth sides of that equation professional planning can identify

opportunities and help solve problems.

Further, each of these questions leads to additional questions.

Arriving at answers is made none the easier by the blizzard of

alternatives often available, and frequently buyers and sellers find

themselves in disagreement about deal terms, legalities, and

tax-related matters. The job of the professional teamsthe

sellers and the buyersis to satisfy their respective clients,

resolve as many issues as possible before the consummation of

the deal, and monitor the transaction as it moves forward. And

there are never one-size-fits-all answers. One seller may justifiably

be anxious to consummate the deal before taxes go up in 2011;

another may be willing to pay the higher levy if he expects his

earnings to increase significantly in the near future, raising the

value of the offers hell receive. The question is whether the risk

of waiting will pay off. Well have more to say about this later.

What about the environment? Is this a good time to sell? Evidence

of an economic recovery is mounting, but financing is still tight,

and there are no assurances about what the future will bring. In

addition, the profit dynamics of every industryand, more

important, for every companyare different. That last criterion is

the one that truly counts for a business seller: Its his company and

his livelihood that are at issue. The job of his professional team is

to keep him from falling into one of two traps: rushing headlong

into selling now because the landscape looks good, or refusing

to budge because it was better several years ago and good times

may be around the corner again.

Still, owners need a touchstone for deciding whether to sell,

and one metric might be if the proceedswhether all up front

or parceled out over timeare at least enough to provide for

the owners lifetime spending needs (his so-called core-capitalSM

requirements). Ideally, hed take home even more than that and

generate excess capital (see Will You Get Enough? Core

Capital vs. Excess, facing page).

Non-Sellers RemorseDuring the boom years of the mid-2000s, many business owners

were offered and refused term sheets, hoping to do betteronly

to regret that decision when the bear market ensued. Consider

John and Jane Commander (Display 3, page 4), who decided in

early 2007 that they were ready to give up their business, which

was earning more than $7.5 million a year, and represented the

vast majority of their net worth (the rest of which was invested

in two IRAs totaling $1 million). They wanted to sell the business

for $60 million, which worked out to 8 EBITDA, a high multiple

even by 2007 standardsbut were offered $48 million. They

chose to pass. As well see, while more money is obviously better

than less, they didnt needproceeds of $60 million to meet their

financial objectives.

Indeed, three years later new offers came in, but by now, in

harder times, their earnings had declined to $6 million. Theyd

have to sell at a lower multiple, yielding $27 million cash,

leaving them with $23 million after taxes, including their IRAs.

Should they sell this time? Couldthey, and meet their objectives:

satisfying their core-spending needs ($500,000 a year, grown

Display 2

Typical Business-Owner Questions

Emotional

Do I want to stay involved inthe business?

Do I have a plan for my life afterthe sale?

What effect will the sale have onmy family and employees?

Do I have the risk tolerance toaccept contingent deal terms?

Financial

How much is my business worth?Whats the best deal structurefor me?

Will I get enough to meet myneeds?

Is all-cash-now better thanstaged/contingent payments?

Professional planning is critical

1Earnings are typically defined differently in different industries and for different purposes, but in many industries, earnings calculations for sale purposes are often before interest,taxes, depreciation, and amortization (EBITDA): in other words, the cash flow generated. Throughout this paper, earnings and EBITDA are used interchangeably.


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To distinguish between what you wantand what you need,

weve developed a planning framework at Bernstein that

identifies so-called core capital and excess capital

(display below, left). The core amount is what you need to

meet your spending needs, grown with inflation, for the rest

of your life. Because no one wants to live with the threat

of running out of money, we calculate the probability of

sustaining core capital over an investors lifetime using ourWealth Forecasting SystemSM (see page 4) at a very high

degree of confidence: typically 90% or better.

The amount depends mostly on the investors age, spending

rate, and portfolio risk level. We estimate, for example

(display below, right), that a 65-year-old couple with a

portfolio invested 60% in stocks and 40% in bonds will

need $3.2 million of core capital for every $100,000 they

spend annually, when factoring in a range of actuarial life

expectancies. In general, the amount of required core capital

at higher spending rates varies by age and allocation. For

instance, if the couple were invested 60/40 but were 15

years younger, their longer time horizon would translate into

Will You Get Enough? Core Capital vs. Excessroughly $4.3 million of core capital. These are scalable

numbers: If the 50-year-old couple were also spending

$400,000 a year instead of $100,000, theyd need four

times as much core, or $17.2 million. For more information

on core capital and spending rates see Appendices 1 and 2

on page 12.

Any amount left over in an investors portfolio after thecore-capital requirement is satisfied is the excess: used for

extra spending, legacy provisions, philanthropy, and, in some

cases, new business ventures. The relevant issues are how

much is in the excess pool, and how the investor intends to

invest and deploy it. Because excess capital is not a lifestyle

requirement, it may be invested with more risk than an

investor may be willing to take with his core capitali.e.,

more stocks or alternative assets.

For many business sellers, its key to come away with a deal

that has the highest likelihood of meeting at least their

core-capital requirements. If the sale generates excess also,

so much the better. n

Projected Core-Capital Amounts by Age

Per $100,000 Annual Spending ($ Mil.)*

Allocation(% Stocks/% Bonds) 0/100 20/80 40/60 60/40 80/20 100/0

Age 50 $7.1 $5.6 $4.8 $4.3 $4.3 $4.3

Age 65 4.3 3.7 3.3 3.2 3.2 3.2

Age 80 2.3 2.1 2.0 2.0 2.0 2.1

*The core-capital requirements here are for couples and assume an allocation ofglobally diversified stocks and diversified intermediate-term municipal bonds in theproportions noted. Spending budgets are assumed to grow with inflation, andmaintained with a 90% degree of confidence. Based on Bernsteins estimates of therange of returns for the applicable capital markets for the periods analyzed. Data donot represent past performance and are not a promise of actual future results. SeeNotes on Wealth Forecasting System at the end of this paper. Information onlongevity and mortality-adjusted investment analysis in this study is based onmortality tables compiled in 2000. In our mortality-adjusted analyses, the life spanof an individual varies in our 10,000 trials in accordance with mortality tables.Source: Society of Actuaries RP-2000 mortality tables and AllianceBernstein

Evaluating What You Need and What You Want

Capital forNext Venture

Extra Spending

PersonalReserve

Charity

Children andGrandchildren

LifestyleSpending

Core CapitalAmount to ensure

spending needsare met

Often calculatedat 90% levelof confidence

Excess CapitalAmount for

expandedopportunities

How much doyou spend?

What is your age? What is your risk

tolerance?

How much? To whom? How quickly? How allocated? What strategies?



with inflation), purchasing a $3 million vacation home theyd

had their eye on for decades, and establishing a substantial

legacy for their two children?

With so much money on the table, you wouldnt think that core

capital would even be an issue, but the Commanders live an

upscale lifestyle, and there are subtractions from the top. Theyd

want to set aside their capital-gains tax bill in cash, for example,

and the 10% of the purchase price that would go into escrow is

never entirely safe. The couple and their team justifiably wanted

a specific core number from usan estimate of how much

theyd need to support themselves even in dreadful markets. To

answer that question, and others related to the deal, we input

the Commanders goals, assets, risk tolerance, time horizon,

and other data specific to their situation into our proprietary

Wealth Forecasting System.SM The couple were fortunate

enough to be able to consider three different deal structures, so

we studied all three term sheets, various asset allocations for

the proceeds, and several what-ifs for their business earnings

over the next five years. After subjecting these data to 10,000

simulated future returns in markets ranging from spectacular to

dismal, we generated a probability distribution of outcomes

(Display 4). We projected their required core at $16.6 million,

but that was a function of how they invested the deal proceeds.

Determining Allocation and Required Core CapitalLike many business owners who can no longer rely totally on

earned income, the Commanders had a conservative bent when

it came to investing their sale proceedsa portfolio weighted

toward bonds. We used our Wealth Forecasting System to

evaluate the potential returns and volatility of a portfolio invested

20% in globally diversified stocks and 80% in bonds ( Display 5).

While the model suggested that the portfolio would almost never

generate a peak-to-trough loss as great as 20%, that security

came at a price: Bonds have limited growth potential. We

projected that the couples age, budget, and portfolio allocation

would translate into a core-capital requirement of $18.6 million

(at the 90th percentile of probability) and an expected portfolio

value after 30 years of spending and taxes of $30.4 million. That

doesnt sound at all badbut the Commanders and their team

wondered if the couple could do even better.

The Commanders were aware that stocks tend to grow more

quickly than bonds, so they wanted to see how much more

Display 3

Case Study: John and Jane CommanderDisappointmentOr Opportunity?

In 2007

Business earning $7.5 Mil./yr.

Appraised at 6.5 earnings=$48 Mil.

Commanders passed on a sale

Their Questions:

Will we have enough to support our core needs?

Will we be able to buy a $3 million second home?Should we hold off selling again, and hope for better?

How should we evaluate alternative deal terms?

Will we leave a sizable estate?

In 2010 (65 years old)

Earnings down to $6 Mil.

Appraised at 4.5 earnings=$27 Mil.

Net proceeds after taxes: $23 Mil.*

*Includes $1 million in IRAs

Display 4

Quantifying the Possibilities: The Wealth Forecasting System

Family Profile Data Scenarios Bernstein Wealth Forecasting Model Probability DistributionDistribution of 10,000 Outcomes

10,000 Simulated

Observations Based on

Bernsteins Proprietary

Capital-Markets Research

10%

50%Median Outcome

90%

5%Top 5% of Outcomes

95%Bottom 5% of Outcomes

Financial Goals

Assets

Income Requirements

Risk Tolerance

Tax Rates

Time Horizon

DealTerms

AssetAllocation

See Notes on Wealth Forecasting System at the end of this paper.Source: AllianceBernstein


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wealth they might accumulate over 30 years if they invested at

a higher risk level. If we pushed stocks to 60% of the portfolio,

we projected the 30-year wealth figure at $48.8 million$18.4

million more than a 20/80 mix. And with the extra growth of

stocks, wed expect the Commanders to need less core

capital$16.2 million. But the trade-off for stock growth is

volatility. We estimated that the Commanders would face a

one-in-three chance that at some point theyd lose as much as

20%. This went far beyond the limits of their risk tolerance.

The optimal solutionfor this particular coupleturned out to

be a bond-tilted 40/60 portfolio, which would require core

capital of $16.6 million. Our analysis convinced the Command-

ers and their team that a 40/60 investment strategy could meet

that hurdle even if markets were very poor, and with a very

small risk (6%) of ever experiencing a 20% portfolio correction

over the next 30 years. Our median 30-year wealth expectation

was $39.4 million. Altogether, this was an attractive picture for

the couple, one they could readily embrace as the centerpiece

of their financial planning. The question is, would the deal net

them their core capital, and an additional $3 million to fund

the vacation home$19.6 million in all, plus enough extra to

support a legacy for their kids?

Take the Money and Runor Wait Awhile?And so the Commanders would have to work through different

term sheets with their professional team, since they were

considering three different types of transactions. It turned out

that all were variants of cash deals, but the cash would come to

them at different times and from different sources.

n One offer was straight cash up front: $27 million. After paying

capital-gains taxes at 15% on the federal level and 5% to

their state, and assuming a zero cost basis in the business,

the Commanders would have $23 million (counting their $1

million in IRA funds). It wasnt the $60 million they were

looking for in 2007, but it was substantially more than their

spending plans required. They could easily satisfy their core

needs, buy the vacation home, and have $3.4 million left over

for legacy purposes on Day 1even in very poor markets

and before any multigenerational planning. Why couldnt

they take the offer and walk away satisfied? The fact is, they

couldif they were willing to leave behind their disappoint-

ment about not garnering $60 million. In business sales, the

financial and the emotional issues are inextricably tied to one

another. Theres another angle to consider about accepting a

lower offer than the peak the couple had hoped for: Lower

valuations for a business often coincide with lower valuations

in the capital marketsand hence higher return potential for

the liquid portfolios that house business-sale proceeds. For theCommanders this could even translate into more wealth in the

out years than if they sold at the higher 2007 offer.

n Another sale alternative was a leveraged recapitalization.

What if the company took on some debt in hopes of using

the extra money to improve their operations, and hence their

earnings? They might find a prospective buyer interested

in the growing potential of the business. In the deal the

investment bankers laid out for the Commanders, a new

partner would enter the business right away, with a 20%

ownership interest in the Commanders shares. Under this

structure, combining proceeds from the sale of equity and a

substantial portion of the debt assumed by the business, the

Commanders would come away with $13.5 million.2 Theyd

also be paid an annual salary of $400,000 for five years

for continuing to participate in the companys operations.

Meanwhile, the couple would be using their companys

earnings to pay down the debt and work toward a profitable

exitin this representative case, five years after inception of

Display 5

Core-Capital Requirements and Volatility:Three Representative Asset Mixes*

% Stock/Bond Allocation 20/80 40/60 60/40

Core Capital Required $18.6 Mil. $16.6 Mil. $16.2 Mil .

Probability of 20%Peak-to-Trough Loss, 30 Yrs.

2% 6% 33%

Median Wealth, 30 Yrs. $30.4 Mil. $39.4 Mil. $48.8 Mil .

*Core-capital assumptions are based on lifestyle spending needs of $500,000 per year,growing with inflation, and not including the $3 million vacation home or any legacy

plans. Based on Bernsteins estimates of the range of returns for the applicable capitalmarkets over the next 30 years. Data do not represent any past performance and are nota promise of actual future results. See Notes on Wealth Forecasting System at the end ofthis paper.Source: AllianceBernstein

2The debt on the balance sheet is a double-edged sword. On the one hand, it would presumably be used to improve the business; on the other, much of the earnings would have to beused to pay down the debtwhich is why recaps tend to be so contingent on earnings. However, the Commanders would not be liable for any of the debt personally, which is anobligation of the business.



the recap.3 True, the up-front cash would fall short of

satisfying their spending needsbut the couple wouldnt

consider a leveraged recap in the first place unless they were

confident about their companys five-year earnings prospects.

In a worst (and unlikely) case, if earnings plummeted enough,

a deal would probably be worked out through negotiations

between the would-be buyer and seller, albeit probably at a

price that both sides would see as a compromise.

n Finally, the Commanders received a so-called earn-out offer:

also cash with a five-year contingency, but not as dependent asa recapitalization on an earnings upswing. In this transaction,

the Commanders would give up their entire interest in the

business in exchange for a share of the earnings: as much

as $2.4 million annually over a five-year period. If post-sale

earnings were to fall short of agreed-upon targets, the

earn-out payments would be reduced proportionately. If the

Commanders agreed to the terms, the couple would be

offered $19 million on Day 1, plus $400,000 a year in consult-

ing fees for five yearsnot quite enough to meet their core

needs and the cost of the vacation home at the critical 90%

level of confidence, though close. But unlike all-cash up front,

the final value of the earn-out would be dependent on howthe business performed over the near termand like a recap,

the Commanders would have to be interested in staying

involved in business operations.

Working Through the Trade-OffsOf course, theres no right alternative for every business

owner. Some owners feel both emotionally and financially

secure staying tied to their business for a longer period. Other

owners are eager to take the cash immediately, if they can get

it, and go on to the next phase of their lives (which may not be

retirement but another business venture). Similarly, there was

no perfect alternative for the Commanders. It depended on the

trade-offs they were most comfortable withwhich is where

we and their other professional advisors came in. We knew,

though, that working together, wed enable the Commandersto identify the strategy best tailored to meet their goals.

Display 6 lays out the issues in schematic form.

But why all these complications? As we said, the Commanders

could take the all-cash $27 million up front and avoid the

uncertainties, a strategy that many business owners embrace.

Along those lines, we compare the up-front cash portion of each

offer in Display 7. The all-cash-now deal was the only one that

virtually ensured the couple would meet their needs in any

plausible scenario; in the other two cases, a significant portion of

the transaction involved contingent payouts. (With the recap, we

estimated the chance of the up-front cash meeting the Com-

manders core needs at only 29%.) Deferring completion to a later

date would mean exposure to a whole host of issues outside the

scope of this paper, including future market conditions and buyer

insolvency. Extreme cases, as we re-learned in 2008, do occur.

Display 6

Three Representative Commander Sale Alternatives

All Cash Now Leveraged Recap Earn-Out

$13.5 MillionUp Front

Salary:$400K/Year

80% RetainedEquity

$19 MillionUp Front

Consulting Fee:$400K/Year

Up to $12 Mil.in Earn-Outs

over 5 Years

Exit from Business Expected After Five Years Transaction Complete

$27 Million Up Front

3The ultimate buyer could be the 20% owner, but the final transaction is more commonly an outright sale of 100% of the business interests to a third party.


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The Icing on the Cake?But the case isnt closed. Often, business owners regard the

contingency payouts as merely icing on the cake. But with our

Wealth Forecasting System, we can help sellers systematically

evaluate the sensitivity of different offers to varying earnings

scenarios. The more the business earns over the contingency

period, the more the sellers will benefitand the odds are

generally in their favor. Display 8 adds the potential future proceeds

from the final sale of the Commander business in the recap case

and from continuing distributions in the earn-out scenario, as well

as the salary and consulting fee, respectively. For the immediate-

cash alternative, of course, there are no contingencies.

Using this scenario analysis, we were able to help them

stress-test different earnings outcomes versus the security of

immediate cash. The leveraged recap and the earn-out both

offered the opportunity for more upsideand the potential

for greater downside as well. But because of its reliance on

leverage, the recap was far more sensitive to earnings changes

on both sides. So, for example, we estimated that just 5%

earnings growth would be enough to deliver a median result

of almost $100 millionand an upside above $175 million.4

A 10% earnings decline, on the other hand, would leave

the Commanders with about $8 million of excess capital in

downside marketsnot a dismal outcome by any means, but

the Commanders wouldnt want to test a recap much beyond a

10% earnings falloff. As weve said, they wouldnt want to take

the risk of a recap unless they were quite sanguine about the

future of their business.

An earn-out is also sensitive to profits, as its name impliesbut

less so. The earn-out considered by the Commanders would

Display 8

Adding In Future Earnings:

Cash vs. Leveraged Recap vs. Earn-Out

Commander Nominal Wealth Values, Year 30

After Taxes, Spending, and $3 Million Home Purchase

40% Stocks/60% Bonds*

05%

Decline20%

Decline5%

Growth10%

Decline

Earnings:Leveraged Recap

Earnings:Earn-Out

ImmediateCash

5%

10%

50%

90%95%

Level

of

Confidence

85.2

39.4

13.2

66.4

30.4

8.2

178.0

94.8

50.0

104.8

51.4

22.0

78.4

36.011.4

>98%96%>98%95%97%

Probability of Meeting Spending Needs

$Millions

*See second footnote to Display 7. Leveraged recapitalization examples assume fiveyears of annual pretax salary income at $400,000, annual rates of growth or declinein EBITDA as noted, and pretax sale proceeds at Year 5 of $12,484,000 and$34,030,000, respectively. Earn-out examples assume five years of annual pretaxconsulting income at $400,000 and annual rates of decline in pretax payments relatedto the earn-out schedule. All sale proceeds are assumed to be taxed at the capital-gainsrates in effect upon distribution. See Notes on Wealth Forecasting System at the end ofthis paper.Source: AllianceBernstein

Display 7

Up-Front Cash:* All-Cash vs. Leveraged Recap and Earn-Out

Commander Nominal Wealth Values, Year 30


40% Stocks/60% Bonds

85.2

39.4

13.2 9.80.0

41.8

14.2

0.0

82%29%97%

$M

illions

Level

of

Confidence

0.0

Probability of Meeting Spending Needs

5%

10%

50%

90%95%

Immediate Cash Leveraged Recap Earn-Out

Level

of

Confidence

0

*Cash includes $1 million total in John and Janes IRAs.Basis in business assumed to be zero. Spending assumed to grow with inflation eachyear. Based on Bernsteins estimates of the range of returns for the applicable capitalmarkets over the next 30 years. Data do not represent any past performance and are nota promise of actual future results. See Notes on Wealth Forecasting System at the end ofthis paper.Source: AllianceBernstein

4Assuming that the business was now valued at 5 EBITDA rather than 4.5, reflecting the improved earnings



Taxes Slated to Increase

Top Marginal Tax Rates

15

15

35

35

%Capital Gains

Dividends

Taxable Interest

Earned Income

2010

20.0

39.6

39.6

39.6

%

2011

23.8

43.4

43.4

40.5

%

2013

59

189

24

16

%

% Change

(2013/Current)

Based on recent healthcare legislation; assumes joint filers with annual incomeabove $250K or single filer with income above $200K.

Increase in Medicare tax of 0.9%; currently, Medicare tax is 1.45%, so the newMedicare tax would total 2.35%. Including ordinary income tax and Medicaretax, the effective tax rate in 2010 is 35% + 1.45% = 36.45%; in 2013, thetop rate would be 39.6% + 2.35% = 41.95%, and the change would thereforebe 15%. Figures exclude Social Security tax and state income tax.Source: AllianceBernstein

*For a detailed study of the investment implications of the coming shift in the Tax Code, see our April 2010 white paper, Investment Opportunity amid Tax Uncertainty?**Aside from the analysis in this box, we have not accounted for the Medicare surtaxes in this paper. Further, in all analyses, we assume a 5% state capital-gains tax, and weassume ordinary-income tax on dividends starting in 2011. In the 20%, 23.8%, and 28% scenarios for capital-gains tax, we assume that the tax rate is in effect the year thesale is consummated and remains constant thereafter.

The Impact of Taxes: Growth in Assets

Commander Business Sold for $27 Million

Nominal Wealth Values, Year 30


40% Stocks/60% Bonds

85.2

39.4

13.2

74.8

33.2

51.6

21.4

0.6

63.8

27.6

4.9

Federal Capital-Gains Tax Rate

$Millions

8.80

15% 20% 28%23.8%

5%

10%

50%

90%95%

Levelof

Confidence

Basis in business assumed to be zero. Spending assumed to grow with inflation eachyear. In 15% tax case, federal capital-gains tax on the transaction and the liquid

portfolio is 15% in Year 1 and 20% thereafter, consistent with current tax law. In the20%, 23.8%, and 28% tax cases, federal capital-gains tax on the transaction and theliquid portfolio is at those rates in Year 1 and in each year thereafter. Based on

Bernsteins estimates of the range of returns for the applicable capital markets over thenext 30 years. Data do not represent any past performance and are not a promise ofactual future results. See Notes on Wealth Forecasting System at the end of this paper.Source: AllianceBernstein

The Tax Code has already built in large increases in an array

of taxes for 2011, with an incremental hike in 2013 to

support healthcare reform (display below). The maximum

federal capital-gains ratethe key tax for business sellersis

scheduled to climb from 15% today to 20% in 2011 and to

23.8% two years later. Altogether, the levy is scheduled to

increase by more than half over the three-year period.*

So suppose the Commanders waited a year or more to allow

their business to grow. And what if it didnt? The display to

the right illustrates the 30-year wealth consequences for

four different capital-gains rates: 1) 15% in Year 1 and 20%

thereafter; 2) 20% each year; 3) 23.8% each year, reflecting

the surcharge for high-bracket taxpayers to help defray the

cost of healthcare reform; and 4) 28% each year; to our

knowledge, no proposal for a 28% gains tax is on the table,

but weve seen that rate historically.**

Two conclusions emerge from the display. First, taxes have a

significant impact on wealth accumulationno surprise there.

For a business sold at $27 million with liquid proceeds invested

in a 40/60 construction, the difference in median wealth

between a 15% gains tax in the first year and a 20% levy would

amount to $6.2 million after three decades: a 16% gap. Still, in

each of these tax scenarios, the Commanders would meet their

spending needs at the 90th percentile of probabilityalbeit withlittle to spare if gains taxes were as high as 28%.

How Much Taxes Count


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allow for an earnings decline as large as 20% and still be

comparable to the all-cash offer while retaining some upside

in good markets. Allthe alternativescash, recap, and earn-

outwere viable options that might be appropriate depending

on the Commanders priorities and risk tolerance. They might

not have gotten what they wanted (i.e., $60 million), but they

would find that they got what they needed.

Setting the Table for the FamilyAs weve said, the Commanders wished to transfer some of

the excess capital from their proceeds to family beneficiaries.Addressed early enough, planning before the sale can be

especially important. One effective means of transferring wealth

is to gift shares. For gift-tax purposes, the value of the transfer

will be based on a current or recent appraisalgenerally lower

than the value assigned at sale because pre-sale shares are

illiquid and essentially unmarketable. In addition, if the gift

represents a minority interest in a private company, for gift-tax

purposes the value could be further discounted because the

beneficiaries have no control over the illiquid shares. If the

business is indeed sold for significantly more than the valuation

at appraisal, the beneficiaries would end up with more than the

appraised value of the gifts.

For example, if the owner uses his $1 million lifetime applicable

gift-tax exclusion amount to transfer shares of his company

that ultimately benefit from a 30% discount at the time of sale,

hes actually transferring $1.4 million. However, to take

advantage of a discount, there needs to be a sufficient time

interval between the gift and the sale agreement.5

Adding the Power of GRATsA grantor-retained annuity trust, or GRAT, can leverage gifting

substantially. Heres how it works: The owner contributes shares

of his business to the trust and receives annuity payments back

that equal his gift plus an amount of interest determined by the

IRS Section 7520 rate. If the assets in the GRAT appreciate at a

rate faster than the 7520 hurdle, the GRAT succeeds and all

extra appreciation passes to the beneficiaries free of transfer

tax. At todays low interest rates, the GRAT bogey is especially

low. (As of June 2010, the Section 7520 rate was 3.2%.)

Further, donors pay the income and capital-gains taxes from

5Consult a valuation specialist to determine the appropriate discount in your situation.

Comparisons based on taxes are revealing. To realize the

same after-tax proceeds on a $27 million sale in 2010, a

business would need to sell for $28.9 million in 2011 and

$30 million two years later. If earnings are used as the metric,

EBITDA would have to increase by a cumulative 11.7% for

an owner selling in 2013 to break even after taxes versus

consummating the deal for $27 million pretax in 2010

(display below). Even if he waited only until 2011 to sell, hisearnings would have to jump substantially. Alternatively,

earnings multiples would need to accelerate by the same

amounts, or a combination of earnings and multiples would

have to achieve that rate of growth. Its no revelation for

business owners or their professional teams, but tax planning

can make millions of dollars of difference.

And so, all else equal, an owner would be well-advised to

sell in 2010 rather than later. But in fact, all else is rarely

equal, and each sale needs to be evaluated in its own

rightincluding the prevailing tax rate, among many

criteria. We would emphasize, though, that selling a

business and investing the proceeds in a liquid portfolio is a

risk-reducing diversification strategy, decreasing dependence

on one source of wealth. In that light, selling earlier rather

than later tends to make more sense, especially when taxes

are scheduled to rise imminently. n

Commander Earnings Required to Sell for

$27 Million Pretax

$6.7 Mil.2013

$6.4 Mil.2011

$6.0 Mil.2010

Assuming capital-gains tax rates of 15% in 2010, 20% in 2011, and 23.8%in 2013Source: AllianceBernstein



outside the GRAT, enhancing the amount transferred. Because

the statute of limitations on the valuation of the shares is three

years (during which time GRAT distributions can be adjusted

if the IRS disputes a claimed value), professional teams often

recommend a three-year GRAT when contributing assets whose

value is questionable.6

Contributing discounted shares of a business, depicted in

Display 9, increases the potential benefit if the company is sold

within the three-year period.7 The realization of the full value

of the discount helps the assets in the GRAT appreciate rapidly,

making it very likely to outperform the 7520 rate. In this case,

we presume that a three-year $6 million GRAT invests its

proceeds from the business sale in bonds for the safety of

locking in returns. Once the trust expires after three years,

the proceeds intended for the children are invested for the

next 27 years in an 80% stock/20% bond portfoliosuitably

stock-heavy if you assume that the beneficiaries have a long

time horizon. The display makes clear how the advantage of

discounting builds. If the $6 million of shares in the GRAT were

subject to a 30% discount, wed expect the median value of the

80/20 portfolio to be $15.6 million after taxes and fully $7.8

million in very poor markets. Had the shares been discounted by

40%, wed project a $24.2 million median and a $12.0 milliondownside case. Discounting can be a powerful tool when put to

use in a GRAT.

Quantifying the Advantages of PlanningAssembling a legacy plan yields notable benefits. Returning to

the Commander case study, lets assume the couple sold the

business for $27 million in cash and did no planning prior to or

after that point. Recall that on Day 1, theyd have $3.4 million

to set aside for legacy. In the absence of any estate-planning

techniques, wed project that even in dismal markets the legacy

would grow to $13.2 millionthe amount left over at the 90th

percentile of probability before any estate taxes (refer back

to Display 8, page 7). But in the median case (Display 10,

left side) we projected thatagain, making use of no planning

toolstheyd leave a hefty amount to their heirs at the end of

30 years: $18.8 million afterestate taxes. But theyd cede even

more to the government.

Suppose, though, that the couples legacy strategy was, pre-sale,

to fund a three-year GRAT with $6 million in company shares,

30% discounted (Display 10, right side). Assume the Command-

ers invested the proceeds in a liquid portfolio over the 27 years

following the GRATs term. Our models suggest that their heirs

could expect the GRAT combined with the rest of the Com-

manders assets after estate taxes to produce $11 million in

6As of this writing, Congress is considering GRATs and may require that all such trusts have terms no shorter than 10 years. In that event, a business owner may opt for a 10-yearGRAT or use another strategy. The most likely candidate is an installment sale to an Intentionally Defective Grantor Trust (IDGT). With this strategy, an outright (potentiallytaxable) gift of 10% of the overall transfer of the shares is made to the trust (a general rule under prevailing practice: No tax or legal authority expressly sanctions 10% as a necessaryor sufficient amount). The remainder of the assets is sold to the trust in exchange for an interest-bearing note. The growth of those assets can pass to the beneficiaries free of additionaltransfer tax if they appreciate at a rate higher than a hurdle interest rate. (The Applicable Federal Rate [AFR] is lower than the Section 7520 rate for any loan of nine years orshorter. As of this writing, the mid-term AFR for June 2010 is 2.72%.) There are, of course, advantages and disadvantages of both GRATs and installment sales to IDGTs. Forexample, if the GRAT donor dies during the term of the trust, part or all of the trust assets revert to the donors estate and might not be gifted to a beneficiary free of transfer taxes.

Advice from the business owners professional team is critical in putting trust vehicles to best use. Our May 2010 white paper, Transfer Opportunities in Advance of LegislativeChange: An Interim Approach to Planning with GRATs, evaluates gifting alternatives in light of the possibility that the minimum GRAT term will be extended to 10 years.7Assuming that the GRAT was funded long enough before the sale to take full advantage of the discounted shares (see above and page 9).

Display 9

What a Difference a Discount Makes: A Short-Term Trust

Nominal $6 Million Three-Yr. GRAT Remainder Values After Taxes

Year 30, 100% Bonds Post-Transaction in GRAT

80% Stocks/20% Bonds Thereafter*

32.2

15.67.8

49.8

24.2

74.8

36.4

18.0

50%40%30%

Discount

$

Millions

12.0

0

5%

10%

50%

90%

95%

Level

of

Confidence

*Basis in business assumed to be zero. Assumes GRAT remainder is transferred to anirrevocable trust that pays its own taxes (i.e., a non-grantor trust). Bonds are 100%intermediate-term diversified municipals for the first three years. Thereafter, theallocation is 80% globally diversified stocks and 20% intermediate-term diversifiedmunicipal bonds. Based on Bernsteins estimates of the range of returns for the applicablecapital markets over the next 30 years. Data do not represent any past performance andare not a promise of actual future results. See Notes on Wealth Forecasting System atthe end of this paper.Source: AllianceBernstein


11/1611

additional wealth.8 Through the single action of funding a trust

before the sale with discounted sharesand then investing the

proceeds appropriatelythe couple would be able to increase

the legacy to their children by more than 50%and reduce their

estate-tax liability by nearly $6 million. The benefit derives from

removing appreciating assets from the Commanders estate,

decreasing their estate taxes, and setting that 80/20 risk level for

the childrens portfolio rather than their own more conservative

40/60. If the couple were uneasy about leaving their children

so much money, or wanted to do even more planning, pre- or

post-sale, for any reason, there would be a variety of multigener-ational and philanthropic strategies at their disposal.

Such strategiesusing vehicles including direct gifts, private

foundations, charitable remainder unitrusts (CRUTs), and

charitable lead annuity trusts (CLATs)could be used for

philanthropic purposes alone or for wealth transfer to both the

family and charity. Each such strategy would absorb some of the

Commanders gifting capacity and reduce their estate-tax bill.

These techniques lie beyond the scope of this study, but the same

basic principles applyrelying on professional counsel, consider-

ing various trust vehicles, and carefully timing all strategies. Even

when a deal is complete, its not too late to plan for legacy-build-

ing; its doing nothing with excess capital that can incur a large

opportunity cost.

ConclusionWe conclude with these thoughts about the intricacies of selling

a closely held business:

n Planning for personal as well as financial issues in a business

sale can help the owner feel secure about completing a deal.

Emotions count for a lot, whether theyre centered around

the effects of the sale on family and staff, the owners desire

(or lack of it) to close out a phase of his life, or any otherissue not directly related to the proceeds.

n Rigorous scenario analysis is critical in understanding the impact

that uncertain future earnings, valuations, and tax rates have

on different deal structures that owners may be considering.

n Owners are well-advised to revisit their plans continuously

throughout the sale process (before, during, and afterward).

As for the Commanders, they were strongly considering the

leveraged transaction to recapture the level of upside they had in

2007. But ultimately they opted for an all-cash up-front deal and

they decided to initiate a pre-transaction GRAT, a combination

that provided them with peace of mind and virtual certainty of

leaving a significant legacy for their children. They and their

professional team knew they were trading off some good things

for others they rated even better. Sir Michael would approve.

The authors would like to acknowledge Cory Dowell, a Director

of Bernsteins Wealth Management Group, and Matthew J.

Teich, an Investment Planning Analyst in the Group, for their

invaluable insights and quantitative research.

Display 10

Reducing Tax Impact on Legacy

$27 Million Sale: Distribution of Family Wealth, Year 30

After Spending and Taxes in Typical Markets*

To Govt

Left for

Heirs

No Planning( to Government)

$6 Mil. Pre-Sale GRAT, 30% Discount(More Wealth, to Govt)

$20.6

Million

$18.8

Million

To Govt

Left for

Heirs

$14.9

Million$29.8

Million

$44.7 Mil.$39.4 Mil.

3

*Median results. See footnote 6 on page 10. Assumes that the spouses die in same year,and that $1 million per person is exempt from estate taxes. The remaining estate istaxed at a 55% rate. In the GRAT case, term of trust is assumed to be three years.Median senior-generation wealth before estate taxes is $29.1 million, and medianremaining trust assets are $15.6 million.The analysis on the left assumes that with nolifetime wealth transfer the remaining assets after estate taxes pass to the children. Basedon Bernsteins estimates of the range of returns for the applicable capital markets over thenext 30 years. Data do not represent any past performance and are not a promise ofactual future results. See Notes on Wealth Forecasting System at the end of this paper.Source: AllianceBernstein

8Assuming that the GRAT proceeds were invested in an 80/20 stock/bond mix, and that the Commanders portfolio was allocated 40/60 for the full 30 years.



Appendix 2: Core-Capital Requirement by Allocation, Investor Age, and Annual Spending Budget ($ Millions)

AnnualSpendingBudget $100,000 $250,000 $500,000 $750,000 $1,000,000 $100,000 $250,000 $500,000 $750,000 $1,000,000

0% Stocks/100% Bonds 20% Stocks/80% Bonds

Age Age

50 $7.1 $17.9 $35.7 $53.6 $71.4 50 $5.6 $13.9 $27.8 $41.7 $55.6

65 4.3 10.9 21.7 32.6 43.5 65 3.7 9.3 18.5 27.8 37.0

80 2.3 5.7 11.4 17.0 22.7 80 2.1 5.2 10.4 15.6 20.8


Age Age

50 $4.8 $11.9 $23.8 $35.7 $47.6 50 $4.3 $10.9 $21.7 $32.6 $43.5

65 3.3 8.3 16.7 25.0 33.3 65 3.2 8.1 16.1 24.2 32.3

80 2.0 5.0 10.0 15.0 20.0 80 2.0 5.0 10.0 15.0 20.0


Age Age

50 $4.3 $10.9 $21.7 $32.6 $43.5 50 $4.3 $10.9 $21.7 $32.6 $43.5

65 3.2 8.1 16.1 24.2 32.3 65 3.2 8.1 16.1 24.2 32.3

80 2.0 5.1 10.2 15.3 20.4 80 2.1 5.2 10.4 15.6 20.8

*Spending is grown with inflation; spending rates assume maintaining spending with a 90% level of confidence.Based on Bernsteins estimates of the range of returns for the applicable capital markets over the periods analyzed at the 90% level of confidence. Data do not represent any past

performance and are not a promise of actual future results. See Notes on Wealth Forecasting System at the end of this paper.Source: Society of Actuaries RP-2000 mortality tables and AllianceBernstein

Appendix 1: Sustainable Annual Spending Rate* by Allocation and Investor Age

Allocation(% Stocks/% Bonds) 0/100 20/80 40/60 60/40 80/20 100/0

Age

50 1.4% 1.8% 2.1% 2.3% 2.3% 2.3%

65 2.3 2.7 3.0 3.1 3.1 3.1

80 4.4 4.8 5.0 5.0 4.9 4.8


13/1613

Notes on Wealth Forecasting SystemThe Bernstein Wealth Forecasting SystemSM (WFS) is designed to

assist investors in making a range of key decisions, including

setting their long-term allocation of financial assets. The WFS

consists of a four-step process: (1) Client Profile Input: the

clients asset allocation, income, expenses, cash withdrawals, tax

rate, risk-tolerance goals, and other factors; (2) Client Scenarios:

in effect, questions the client would like our guidance on,

which may touch on issues such as which vehicles are best for

intergenerational and philanthropic giving, what his/her

cash-flow stream is likely to be, whether his/her portfolio canbeat inflation long term, when to retire, and how different asset

allocations might impact his/her long-term security; (3) The

Capital Markets Engine: our proprietary model that uses our

research and historical data to create a vast range of market

returns, taking into account the linkages within and among

the capital markets (not Bernstein portfolios), as well as their

unpredictability; and (4) A Probability Distribution of Outcomes:

based on the assets invested pursuant to the stated asset

allocation, 90% of the estimated returns and asset values the

client could expect to experience, represented within a range

established by the 5th and 95th percentiles of probability.

However, outcomes outside this range are expected to occur

10% of the time; thus, the range does not establish the

boundaries for all outcomes. Further, we often focus on the

10th, 50th, and 90th percentiles to represent the upside,

median, and downside cases. Asset-class projections used in

this paper are derived from the following: US value stocks are

represented by the S&P/Barra Value Index, with an assumed

50-year compounding rate of 8.9%, based on simulations with

initial market conditions as of December 31, 2009; US growth

stocks by the S&P/Barra Growth Index (compounding rate of

8.5%); developed international stocks by the Morgan Stanley

Capital International (MSCI) EAFE Index of major markets in

Europe, Australasia, and the Far East, with countries weighted

by market capitalization and currency positions unhedged

(compounding rate of 9.2%); emerging markets stocks by the

MSCI Emerging Markets Index (compounding rate of 7.2%);

municipal bonds by diversified AA-rated securities with seven-

year maturities (compounding rate of 3.9%); taxable bonds by

diversified securities with seven-year maturities (compounding

rate of 5.4%); and inflation by the Consumer Price Index(compounding rate of 3.0%). Expected market returns on

bonds are derived taking into account yield and other criteria.

An important assumption is that stocks will, over time, outper-

form long-term bonds by a reasonable amount, although this is

by no means a certainty. Moreover, actual future results may not

be consonant with Bernsteins estimates of the range of market

returns, as these returns are subject to a variety of economic,

market, and other variables. Accordingly, this analysis should

not be construed as a promise of actual future results, the

actual range of future results, or the actual probability that

these results will be realized.

Mortality Assumptions: Mortality is modeled using our proprie-

tary simulation model, which creates a range of death ages for

a given age. The outcomes of the mortality simulation model

are then combined with the outcomes of the Capital Markets

Engine on a trial-by-trial basis to produce summarized mortality-

adjusted results. Mortality simulations are based on the Society

of Actuaries Retirement Plans Experience Committee Mortality

Tables RP-2000. n


14/16


15/1614 Publication Title

Global Wealth Management

Client-Centered Wealth Management Solutions

At Bernstein, we are dedicated to providing our clients with wealth management

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16/16

Note to All Readers: The information contained herein reflects, as of the date hereof, the views of AllianceBernstein L.P. (or its applicable affiliate providing this publication)(AllianceBernstein) and sources believed by AllianceBernstein to be reliable. No representation or warranty is made concerning the accuracy of any data compiled herein.

In addition, there can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is neither indicative of, nor a guaranteeof, future results. The views expressed herein may change at any time subsequent to the date of issue hereof. These materials are provided for informational purposes only,and under no circumstances may any information contained herein be construed as investment advice. AllianceBernstein does not provide tax, legal, or accounting advice.The information contained herein does not take into account your particular investment objectives, financial situation, or needs, and you should, in considering this material,discuss your individual circumstances with professionals in those areas before making any decisions. Any information contained herein may not be construed as any salesor marketing materials in respect of, or an offer or solicitation for the purchase or sale of, any financial instrument, product, or service sponsored or provided byAllianceBernstein L.P. or any affiliate or agent thereof. References to specific securities are presented solely in the context of industry analysis and are not to be consideredrecommendations by AllianceBernstein. AllianceBernstein and its affiliates may have positions in, and may effect transactions in, the markets, industry sectors, and companiesdescribed herein.

Bernstein Global Wealth Management is a unit of AllianceBernstein L.P.

Note to UK Readers: AllianceBernstein Global Wealth Management is a unit of AllianceBernstein Limited. AllianceBernstein Limited (FRN147956) is authorised andregulated in the United Kingdom by the Financial Services Authority. Issued by AllianceBernstein Limited, Devonshire House, 1 Mayfair Place, London W1J 8AJ.

Bernstein Global Wealth Management and AllianceBernstein Global Wealth Management do not offer tax, legal, or accounting advice. In considering thismaterial, you should discuss your individual circumstances with professionals in those areas before making any decisions.

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