A growing role for CFOs in ownership transitions. Originally published in Accounting Today

As record numbers of boomers reach retirement age, more private companies than ever must wrestle with transition challenges. 

Seven out of 10 business owners aged 50-plus will transition out of their businesses within the next decade, according to data from the Exit Planning Institute. Meanwhile, the U.S. Small Business Administration estimates that 10 million boomer-owned businesses will change hands between 2019 and 2029. This "Silver Tsunami" means private companies are grappling like never before with the complexities of ensuring continuity in leadership and operations. Against this backdrop, chief financial officers will assume a pivotal role in orchestrating strategies that safeguard the future viability and prosperity of their organizations. 

Transition planning is inherently multidisciplinary. Private company CFOs must navigate complex financial structures, assess risk factors and collaborate with legal and HR teams to ensure a seamless transition process. That's more easily said than done. CFOs must have a blend of financial acumen and interpersonal skills to navigate the intricacies of an ownership transfer smoothly. 

For private company CFOs, controllers and senior managers, their plate is full these days. But, without having a clear roadmap for ownership transfer, they could face a succession crisis, leadership gaps and potential legal disputes. Moreover, the lack of a structured transition plan can erode stakeholder trust, diminish employee morale and jeopardize customer relationships. Ultimately, failing to plan for an ownership transition can result in irreparable damage to their company's reputation and financial standing.

Getting started on the path to transition planning

The first crucial step in business transition planning is to identify key stakeholders and to clarify long-term objectives. Stakeholders may include owners, family members, employees, investors and external advisors. Understanding and communicating their perspectives, concerns and aspirations is essential for crafting a transition plan that aligns with the company's goals and values. 

A thorough assessment of the current business structure and ownership structure is imperative for effective transition planning. At a minimum, CFOs should evaluate legal entities, ownership percentages, governance structures and operational frameworks. Identifying potential challenges, such as complex ownership arrangements or outdated governance practices, enables a company's senior financial leaders to devise strategies to streamline the transition process. Additionally, assessing the company's financial health and market position provides valuable insights for shaping the transition plan.

Setting clear and measurable goals, along with realistic timelines, is essential for driving the transition planning process forward. These goals may include succession objectives, financial targets, operational milestones and strategic initiatives. Establishing achievable timelines helps ensure accountability and progress throughout the transition journey. By breaking down the transition plan into actionable steps with defined deadlines, CFOs can maintain momentum and mitigate delays or setbacks.

Four transition options

Exploring ownership transfer options is a critical aspect of business transition planning. Here are four viable options for private companies to consider:

1. Family succession: Family succession involves transferring ownership and leadership of the business to family members, typically to the next generation. This option preserves the legacy of the company while keeping it within the family's control. However, family succession can present challenges related to family dynamics, succession readiness and inequitable distribution of company ownership among family members. 

2. Management buyout: An MBO allows the existing management team or group of managers to purchase an ownership stake in the company. This option provides continuity in leadership and allows experienced managers to take ownership and responsibility for your company's future. MBOs can be attractive for companies that have capable management teams seeking to retain control and continuity while providing liquidity for exiting owners. 

3. Employee stock ownership plan: An ESOP involves the establishment of a trust to purchase company shares on behalf of employees. Through ESOPs, employees gradually acquire ownership stakes in the firm, aligning their interests with the company's long-term success. ESOPs can enhance employee engagement, retention and productivity while providing a tax-efficient mechanism for ownership transition. 

4. Selling to a third party: Selling the business to a third party, such as a strategic buyer, private equity firm or other outside investor, is a common ownership transfer option for private companies. This option offers liquidity for owners and may provide opportunities for business expansion, access to new markets or strategic partnerships. However, a third-party sale can greatly alter company culture, operations and strategic direction so it requires careful consideration of your company's values and goals.

No matter which transition option CFOs choose, they must pay close attention to the business valuation and tax implications of the transaction.

Valuation and tax implications 

Conducting a comprehensive valuation of the business is essential for determining its fair market value and for facilitating informed decision-making during an ownership transition. Valuation methods may include asset-based approaches, income-based approaches or market-based approaches. As a senior member of a company's financial team, CFOs have a thorough understanding of the organization's financial performance, assets and liabilities. But do they know how to incorporate those metrics and proper market data to do a fair market value analysis? This is where engaging an independent business valuation professional can help them get an objective, independent assessment of your company's true worth. 

Valuation is a highly subjective field and requires three key attributes: 1. Sound methodology and logic;2. Data, data and more data;3. Ability to utilize multiple methodologies. Each of the attributes above involves accounting, financial, economic and legal considerations. While most senior leaders possess some of this expertise, very few can translate that knowledge into an accurate appraisal. Common mistakes include conflating enterprise value and equity value, or using an overly simple methodology that doesn't accurately reflect the company's worth. Another common misstep is using outdated or irrelevant market multiples (often from a previous transaction in which they were tangentially involved). Further, most private company financial leaders are unaware of how certain factors affect the value of partial equity interests (i.e. less than 100%). 

Without having a qualified appraiser to guide your team, the company and its owners could be exposed to the following risks:

1. Receiving more (or less) than fair market value;
2. Understating or overstating taxable income for the entity or its owners;
3. Not meeting adequate disclosure requirements for a gift tax return and creating a permanent audit risk;
4. Creating cash flow issues for the entity or its owners.

An independent valuation professional should be able to analyze the subject company, make comparisons to industry benchmarks, incorporate economic or industry factors and provide multiple valuation methods rooted in real-time market data. They should also address interest-specific issues such as differences in distribution preferences and discounts for lack of control and marketability, and document all of their work in a detailed report that meets professional standards and reporting requirements. 

Example

One company we work with has an aging CEO/owner who is ready to turn over the reins to his capable adult son. They put together a transition plan with their former CPA and attorney which included elevated pay and salary continuation for dad as part of his buyout. As we started to review the plan, several red flags jumped out at us:

1. No actual equity got moved, so no transition was accomplished.
2. Dad got taxed at ordinary rates rather than at lower cap gain rates (and didn't use the basis in his shares to reduce the gain).
3. We couldn't unwind the old transaction and 409A deductions were taken — something the IRS frowns upon.

While the faulty transition plan could not be completely rectified, we were able to salvage it by gifting the equity to match what should have been part of the original deal in a stock purchase agreement. However, the company suffered in three important ways:

1. It lost the ability to use that basis and a higher tax rate for dad.
2. The gift tax could not be avoided on the gift.
3. It incurred significant additional legal, consulting and compliance expenses.

Tax planning plays a crucial role in minimizing tax liabilities associated with ownership transition and maximizing after-tax proceeds for all parties involved. The finance team should collaborate with tax advisors to devise tax-efficient strategies tailored to the specific circumstances of the transition. This may include structuring the transaction to leverage tax benefits, utilizing available exemptions or credits, and implementing estate planning techniques to optimize tax outcomes for owners and stakeholders. Doing homework on the valuation side can save lots of time and money on the tax-planning side down the road.  

Anthony Venette, CPA/ABV is a Senior Manager, Business Valuation & Advisory, DeJoy & Co., CPAs & Advisors in Rochester, New York. He provides business valuation and advisory services to corporate and individual clients of DeJoy.