Financing a transition

By Mark Rosenbaum The Daily Record Newswire Senior partners want to retire. Emerging leaders want a greater stake in their companies and a say in their direction. Everybody wants some assurance of financial stability now and in the future. In good times, funding retirement and leadership transition is complex. In lean times, when there's less to go around, a firm often can find itself in a difficult situation. But several key considerations can help finance a successful transition. Understand the real value of stock ownership The obvious and most common vehicle for ownership transition is stock. But shareholders in professional services firms shouldn't look to company stock as their primary source of retirement income. The stock value in most professional service firms is created by: 1, the goodwill and reputation of the firm; 2, accounts receivable; and 3, depreciated office equipment. There is not much held in retained earnings, real estate or other appreciating assets. Firms try to value their stock based on a number of formulas, but stock in a professional services firm is worth only what someone else is willing to pay for it. When the economy is tough, the perceived value in stock can diminish rapidly. When cash is scarce, who is going to buy out a company and where will the money come from? If there are multiple partners, whose stock gets repurchased first? Will the remaining partners end up paying a premium to the first partner retiring, and what assurances will exist that cash will be available for their repurchase of stock? Even if the money was present to buy out the stock, it may not be enough to meet the departing partner's expectations. Don't make the company pay for retirement Closely held firms should be proactive about funding retirement. Partners and firms should set money aside as revenue is generated rather than relying primarily on a potential sale of their stock. Establishing a cash reserve to repurchase stock can be expensive, and the income tax impact is significant. The corporation usually has better uses for retained earnings. Forcing future leaders or the company into debt in order to fund a retirement hardly leaves the firm on solid financial footing going forward. Qualified pension or profit-sharing plans that allow pre-tax savings are excellent vehicles. Under the correct circumstances, these plans can provide higher profit-sharing percentage allocations for key shareholders. They can create nice retirement accounts within the 401(k) plan. Many owners invest earnings back into the company. Understandably, this creates the corporate growth that the owners want; however, it leaves them at the mercy of the market come retirement time. Some diversification in retirement income sources can be helpful and allow for flexibility in terms of any future sale. With the right qualified retirement plan contributions and consulting contract/deferred compensation agreements post-retirement, the stock can serve as a secondary source of revenue. Just don't count on cashing stocks as a primary source of retirement income. Creatively encourage retention There are other ways to reward and retain people besides giving them stock. In some cases, it is the perfect retention vehicle; in other cases, it's not. Some key employees are great contributors, but not particularly good managers. Should poor managers run the business? A phantom stock plan is a type of contract that offers key employees the growth inherent to actual stock ownership without them holding the shares. This approach will require the corporation to establish reserve accounts to fund this liability; however, it does not infringe on plans for ownership transition. Another approach is a deferred compensation plan in which a company contributes a certain amount of money, based on performance, to a fund that will be available only in the future -- say in five or 10 years or at retirement. If the employees stay, they receive the money; if they leave prior to the "trigger date," they forfeit the balance. Loyalty and performance are rewarded. Oftentimes, the deferred compensation or supplemental retirement income plans are used by key shareholders as well. This lets the company pay an income in the future in exchange for services provided today. This future promise creates a liability on the books of the corporation, which reduces the value of company shares. This reduction in value can work to the advantage of a future purchaser -- reducing the share price, but with an obligation to pay the seller an income for years into the future. The combination of a qualified retirement plan, stock repurchase and deferred compensation can offer an excellent retirement plan scenario. Plan for tomorrow today When firms begin to understand their options and the ramifications of transition planning, it's clear that early planning is better. Only legal counsel can draft the appropriate documents to implement these plans, and they must be reviewed by an accounting specialist to make certain the tax and accounting ramifications are well understood. It's important to look at all options and design a plan that is customized to the people within the firm. Who should be owners and managers in the future? What type of compensation will retain them and meet their objectives? How do owners begin to think about their companies in perpetuity, using multiple strategies for management succession and evolution? A company can address key issues today to be prepared for the future. ---------- Mark Rosenbaum is a partner in the Succession Consulting Group and managing partner of Rosenbaum Financial, a Portland firm that provides estate, business succession and wealth management strategies. Contact him at mark@rosenbaumfinancial.com. Published: Thu, Dec 29, 2011