There are few things more life-changing than a liquidity event. It takes extensive preparation – financially and emotionally – to ensure the successful transition of wealth so that it can be preserved and used in the pursuit of new ambitions.
For entrepreneurs, concentrated stockholders and top executives, the decisions made over the 24 months preceding a liquidity event may be the most important decisions of their career. However, in the all-consuming push to get the company to the finish line, many critical planning issues are often neglected, resulting in a more limited range of opportunities to capitalize on their success.
While liquidity events can suddenly magnify wealth, they can also produce unforeseen financial, tax and legal challenges that can catch all but the most sophisticated business owners and advisors off guard. Among the myriad planning issues that arise before a liquidity event, here are three that are commonly neglected.
Transitioning Wealth from the Business to a Personal Investment Strategy
The sale of a business represents a critical juncture where business owners need to be able to transition their wealth from their business to a personal investment strategy to ensure its continued growth and preservation. This is particularly important for planning for cash flow needs and accounting for potential tax ramifications of the liquidity event.
Oftentimes the outcome of this planning will shape the deal structure itself because business owners will better understand how a potential transaction will impact their personal finances. For that reason, it is vital to conduct pre-liquidity cash flow and tax planning as early as possible. By putting everything into context early on, a range of potential outcomes can be generated providing the opportunity to resolve any issues before the liquidity event occurs. If you wait until after the transaction to do the planning, it’s difficult to make any changes, your choices will be limited, and tax ramifications are largely locked in place.
Magnifying Charitable Giving and Tax Benefits
For the philanthropically inclined, there are several gifting strategies that may be available prior to a liquidity event that will not be available later. Entrepreneurs or stockholders who take the time to plan ahead are better positioned to take advantage of the leverage these strategies create to maximize both the charitable gift and the tax benefits. This is possible when your clients take action before their assets increase significantly in value – in other words, prior to a sale or IPO.
For example, these strategies may involve valuation discounts on stock transfer to a Grantor Retained Annuity Trust (GRAT), which generates an annual payment to the donor for a fixed period of time after which any of the remaining trust value is passed on to a beneficiary as a gift. Or, they may involve transferring stock into a Charitable Remainder Trust to generate income for a beneficiary while deferring taxation and generating a potential tax deduction for a remainder charitable interest. It could involve the early exercise of Incentive Stock Options to qualify for long-term capital gains treatment.
Other charitable gifting strategies should be implemented pre-liquidity, so they are able to receive the inflow immediately after the sale is finalized. For example, by setting up a private 501(c)(3) foundation, you can direct gifts to multiple charitable organizations while reducing your taxable income. For smaller donations, clients could contribute to donor-advised funds, which are managed by a public charity on their behalf. They can advise the sponsoring charity where you want the money to go while receiving the maximum tax deduction. With donor-advised funds, clients avoid the excise taxes and other restrictions imposed on a private foundation.
Your clients may be in a position to benefit from a combination of these strategies, but the key is to do the necessary pre-liquidity planning to determine which strategy will generate the maximum benefits for them and their charities.
Preparing for the Onslaught of Attention from Family, Friends and Advisors
For the most part, business owners and concentrated stockholders enjoy a high degree of privacy regarding their financial holdings. However, once a transaction is announced or an IPO S-1 filing is flipped from confidential to public, the dam of privacy breaks, bringing an onslaught of mostly unwanted attention on them and their families. Suddenly, the value of their holdings becomes gossip fodder for nosy, extended family members, neighbors and friends at the club and financial advisors appear to emerge from the woodwork.
Family members are often involved in the push to prepare the business for sale, but few families are prepared for the realities of life following it. In many cases, simply understanding the issues and making them aware of the consequences of this new visibility of family wealth can help them deal with the attention.
Taking a more proactive approach, some families hire a family business expert to guide them in the process of establishing family governance policies as a way to educate family members and bring them together under a unifying mission or purpose. This can be especially effective for helping younger family members cope with their new status.
As for financial advisors, having a well-conceived investment philosophy and strategy leading up to the liquidity event is not only essential, it’s the best way to ward off advancing advisors who have a sudden interest in your wealth. It can also help alleviate the impulse many entrepreneurs have to reinvest their new wealth in another business venture simply because “it’s what they know.” In reality, that is one of the quickest ways to destroy wealth.
Investing for life after a business sale typically requires an entirely different mindset based on new objectives and ambitions. Having a strategy in place well before the sale also helps business owners to prepare emotionally for their exit.