Creating the Win-Win-Win Strategy For

Creating a WIN-WIN-WIN Strategy

For The Seller of a

Large Family-Owned Business

And The Buyer

By Joel Koenig, Managing Member

The Koenig Group, LLC

June 2001

There has been a reduction in the number of consolidations and acquisitions by merger and acquisition firms and private equity investment banking firms.

This is in part due to a series of factors such as the slowdown of the economy, the reduction of debt capital available through commercial banks, and the fall of the technology sector company values, particularly in telecommunications, information technology and the dot com companies.

It all has had a marked effect on the number of transactions consummated, and the actual prices paid for the acquisitions.

In the recently published book “Buyout”, Thayer Capital Partners Senior Executive, Rick Rickertsen writes on ways to facilitate the completion of more business deals using the concept of the Management Buyout. Rickertsen reviews the role of Private Equity Investment Partners, Management Buyout Firms and Investment Bankers in the acquisition process.

To learn more about their current role in the acquisition & merger process, three leading Private Equity Firms were contacted: Thayer Capital Partners (Washington, DC), The Carlyle Group (Washington, DC) and GTCR, LLC (Chicago). They represent large municipalities and state government’s retirement funds, university endowments, pension funds and other institutional investors. These very large employers are able to invest a small percentage of their qualified plan assets in very high return, higher risk oriented investments such as “junk” bonds, private equity partnerships and “hedge” funds. Through private equity partnership funds, together with private capital of the management team and outside debt financing the private equity investment firms have been able to acquire and control many growing companies in the emerging growth sector and other sectors of the economy. They have also acquired a large number of family-owned, older businesses.

In discussions with principals of the three private equity firms, the author received considerable information.

The typical buyout firm provides: the expertise in finding qualified management personnel, procuring equity and debt capital to finance the acquisition and ongoing outside management assistance to acquisition targets (including successful, large family business in need of succession and exit strategies for the founders). Often, large and medium-sized family businesses are consolidated into multi-company investment partnerships with the goal of a future sale, merger or a public offering.

Typically, the investment firms receive initial fees in the (1-3 percent range), plus ongoing annual management fees, on a continuing basis. Upon the sale or IPO of the consolidated company or investment partnership, the investment firm will also realize additional large, future capital gains for itself and potentially high returns for its investors.

Over the past year, the price of certain acquisitions have fallen due to the increased risks, higher cost of debt financing and the overall compression of values due largely to the aforementioned factors.

Many aging entrepreneurs are hesitant to sell their companies during this period because of current market conditions and their perceived view that future values will increase. In many companies where a succession plan has not been implemented and the founder is also reluctant to part with his/her “child” (the company), the process often stalls. When combined with other factors, the acquisition transaction process is taking longer and can also be more costly for both the seller and the buyer.

This seller’s problem is further compounded because of the inadequate retirement benefit levels of their company’s qualified plans, particularly for the older shareholder-employee. The dynamic growth of 401 (k) plans and other defined contribution plans has exacerbated this problem.

Over the past three decades, these types of retirement plans have enabled most companies to increase corporate profits by reducing their retirement benefit costs for all employees. Highly compensated shareholder-employee owners of large family businesses have been unable to adopt meaningful qualified plans to build significant retirement benefits for themselves. This is because of the restrictions added by federal laws, including the non-discrimination rules, the top-heavy rules, ERISA, and the Affiliated Service and the Controlled Group rules, all of which increase the already high costs, for their rank and file employees.

There is another set of potential factors that further complicate the acquisition transaction process of the family-owned business. These include: the adverse income tax consequences to the seller of assets, the double taxation surrounding C Corporation sales and the large, fully taxable, restrictive covenant (non-compete) agreements forming a part of the purchase price, in practically all transactions.

Another recent complication (primarily in the medical services fields) has been the adverse impact on “acquisition” split dollar insurance as a partial funding device, used in the acquisition process. An adverse PLR, and the recent IRS announcement 2001-10, will have the dramatic effect of reducing the number of transactions using the popular “equity” split dollar concept. This strategy has been a very popular way of tax-sheltering the “services” elements portion of the sales transaction, for the seller.

For the willing buyer and willing seller, favorable transactions will continue to occur. However, when all factors are combined, future transaction prices will go down and the net available to sellers will also be reduced, particularly in the asset vs. stock sales. Further, it will be more difficult for the private equity and M&A firms to sustain large numbers of deals.

Almost every seller wants a stock sale to increase the net value received because of the lower capital gains tax rates. Conversely, the buyer prefers an asset purchase, not wanting to take on the potential liabilities inherent in the stock purchase. In many cases, the “services” elements portion of the transaction are increased to provide the buyer with higher income tax deductions and further protection. Today’s “non-compete” agreements often provide additional protection to the buyer through additional restrictions, including the non-solicitations of customers, former employees and deferred compensation. The agreements are also being extended in a large number of transactions.

This article next addresses a new WIN-WIN-WIN Strategy that will enable more transactions to be done at lower costs to buyers and at higher after-taxresults to sellers. As a by product, the strategy will also aid in increasing the ”bottom-line” of private equity firms, M&A firms and large law firms.

The strategy is called The Charlie Plan®. It is uses a very attractive defined benefit (split-funded) pension plan. This plan has been called the highest income tax deduction oriented, defined benefit pension plan available today.Its architects, Charlie Day III, EA and principal of Actuarial Business Solutions, LLC and Paula Califmade, Esq., recently appeared at the Annual Meeting of AALU (The Association for Advanced Life Underwriting) and discussed how the plan could provide older entrepreneurs, business owners and high-net worth individuals with the following advantages:

Very high current income tax deductions
Retirement income security for both the participant and spouse
Asset protection of the Qualified Plan’s assets from personal and corporate creditors
A wealth preservation planning opportunity to pass substantial assets to children and/or grandchildren without income, gift or estate taxes
An additional income security feature for the surviving spouse and children through plan owned permanent life insurance procured on a fully deductible basis, (without reducing the ultimate retirement benefit)
A very attractive estate planning benefit available at the second spouse’s death to deliver large income, Estate and GST tax-free benefits to heirs using a unique option and a qualified disclaimer.

It is possible to combine the use of the CHARLIE PLAN® with an asset purchase of a family owner’s business by using the large non-compete and restrictive covenant agreements cash flow to fund the cost of the very large defined benefit pension plan, on a fully tax-deductible basis.

The wonderful income tax reduction and wealth planning benefits realized will remove some of the impediments and complications that thwart the acquisition transaction process.

The Charlie Plan® concept can truly enable the buyer to reduce itsultimate cost of the acquisition, while actually increasing the net after-taxamounts realized by the seller and his or her family--- a WIN-WIN Transaction.

The seller’s company (with its former large number of employees) would NOT have been a suitable candidate for this plan, prior to the acquisition transaction. However, let us assume that by selling most of the corporation’s assets (including all former employees) to the buyer, and by negotiating the large non-compete, non-solicitation services contracts for the former owner’s (and spouse’s) services through a corporate serviceagreement, we could provide the selling shareholder’s corporation with 1/2 to 1/3 of the acquisition transaction’s revenues. Thereafter, the newly adopted Charlie Plan® would absorb most of these monies on a fully tax-deductible basis for the seller. The larger non-compete “services” agreements are also fully income tax-deductible to the buyer.

How would the seller make out? In a recent case, the seller was 68 years old and his wife 56. They have three children and six grandchildren. Assume a $10.0 million purchase price ($4.0 million for the “services” elements and $6.0 million for the purchase of assets) is needed to close the deal. Further, let us also assume that over the past 20 years the seller and his spouse were on the company’s payroll and earned the maximum allowable compensation for qualified plan purposes ($170,000 in 2001 and $200,000 in 2002). Assume that the seller’s old corporation will adopt The Charlie Plan® (a defined benefit split dollar pension plan) for the seller and his spouse after the purchase. Since the seller and his spouse have received large salaries in the past, they will not have to take out large salaries currently, thereby allowing the maximum available to be allocated to deductible pension plan contributions. Thereafter, the corporation will use the “services” agreement income to fund the cost of the pension plan.

Unlike the standard non-compete, restrictive covenant which becomes fully taxable to the selling shareholder, our transaction offers the seller (through his retention of the “shell” corporation) the ability to adopt a very high level defined benefit pension plan (The Charlie Plan®) and absorb the taxable restrictive covenant payments through bona-fide qualified plan deductible contributions which become non-taxable to the seller..

There are several other features of the plan that are truly unique. Unlike almost every other qualified plan for family business corporations, there is no lump sum benefit option at retirement or the participant’s death, in this plan. Thus, there are no assets to be included in either the participant’s (or spouse’s) estates. Further, the normal form of retirement is a 100% fully funded joint & survivor benefit. These two features allow for substantially increased costs of funding to the corporate sponsor, thereby also increasing the maximum allowable corporate income tax deductions.

The plan also uses a traditional insured death benefit (100 times the monthly retirement benefit). This feature not only increases the ultimate death benefits under the plan to the surviving spouse or their heirs, but also increases the allowable income tax deductions of the plan without causing any reduction in retirement benefits. It transforms a normally non-deductible corporate or personal insurance premium expenses into fully tax-deductible retirement plan contributions.

Because the acquisition absorbed all of the company’s former employees, the former restrictions (non-discrimination and top-heavy rules, control group or affiliated service group problems) no longer exist. The $4.0 million of predictable corporate “services” income over the next eight years can be used to fund a very meaningful program for the seller and his spouse. Thus, we now have an “ideal” prospect.

When we overlay the goals and objectives of the seller with the overall advantages of The Charlie Plan®, we reinforce the WIN-WIN Transaction.

As a firm specializing in Qualified and Non-Qualified Plans and Family Wealth Planning for over 30 years, it is a very rare occasion to be able to bring such added value to the acquisition, merger and wealth planning processes.

When comparing the Charlie Plan® for the buyer, seller and the seller’s heirs with the conventional sale of a business, there will also be a reinvestment of some of the after-tax proceeds into non-deductible, taxable alternative investments. We have also assumed that the seller can afford to reinvest normally fully taxable Restrictive Covenant and “services” payments in the Charlie Plan of $500,000 a year pre-tax to provide income security, asset protection and family wealth preservation. The other after-tax dollars received from the sale proceeds can be reinvested in tax-sheltered vehicles such as Nimcrut Charitable Remainder Trusts and Charitable Lead Trusts thereby leveraging many millions of sale proceeds into income tax planning and wealth planning strategies.

The Charlie Plan® delivers substantially more retirement income over the joint lifetimes of the seller and spouse with less investment risk. The plan also enjoys income tax deferral on the plan’s assets investment returns and is exempt from personal and corporate creditors in every State.

The plan further provides an income tax-free insured death benefit maximum of $1,300,000 per plan participant. In order to maintain the income tax-free nature of the death benefits, the participant must annually impute current income under the current IRS taxable table for qualified plans. If the estate tax is fully repealed before or after 2010, the death benefit would be received both income and estate tax free by the surviving spouse, increasing further the high levels of lifetime retirement income. If the estate tax comes back under the “sunset” provisions of The Economic Growth and Tax Relief Reconciliation Act of 2001, the surviving spouse may wish to disclaim the plan’s death benefit proceeds under a qualified disclaimer. This allows the death benefit proceeds to pass income and estate tax free to their heirs under a unique planning option.

These features further highlight the WIN-WIN Transaction for the Seller.

Conclusion

The Charlie Plan® offers unique tax and wealth planning opportunities for the very high income, older family business owner or entrepreneur. Regretfully, the complexity of the Non-Discrimination Rules, the top-heavy rules and the affiliated service and control group rules make it difficult for many large family businesses to be able to adopt it. However, as this article demonstrates, certain merger and acquisition target companies become “ideal” candidates for this WIN-WIN strategy, creating lower income tax costs, more formidable tax and economic benefits, greater income security for the founder and spouse, and larger net distributions to heirs. When combined with the large income tax benefits and liability protections to the buyer, this transaction in the hands of the private equity investment company, the management buyout or merger and acquisition firm truly becomes the WIN-WIN-WIN arrangement!!

As this technique is better understood and promoted by the investment community, more attractive transactions will be executed with “ideal” target candidates and private equity and management buyout acquisition groups using The Charlie Plan®.

About the Author

Joel Koenig, principal of The Koenig Group, LLC has specialized in qualified and non-qualified executive benefits and wealth planning for business owners, senior executives, entrepreneurs and high net worth individuals for the past 35 years. Joel graduated from the University of Michigan and attended NYU Graduate School of Business. He was an original partner of M Financial Corporation and a director of The Management Compensation Group, Inc. (MCG), The Todd Organization, Inc. and National Philanthropic Affiliates. He has served on the editorial board of Trusts & Estates (Insurance) and the advisory board of directors of the $25 Million International Forum. Joel has lectured extensively at Estate Planning Councils, The Association for Advanced Life Underwriting (AALU), CLU Seminars and numerous industry meetings. He also has been a contributing author for the American College's Advanced Pension Planning course and The AALU Handbook on Split Dollar. He has also been published in The CLU Journal, Keeping Current,Life Association News and Trusts & Estates.

He can be reached at (301) 652-4545 or , or on his firm’s Website at.