Selling a franchise business is more than simply waiting for investment bankers to negotiate the highest sales price. Like any business endeavor, establishing sound goals and objectives in addition to tax efficiency requires strategic planning well in advance of a business transaction. In this article, we begin by discussing various estate and tax planning strategies that may be applied prior to a business sale. Second, we discuss considerations of the transaction itself, for which investment bankers are well suited. Last, we discuss ongoing post-transaction estate and tax planning as well as investment management considerations. All tax related transactions should be reviewed with your tax accountant prior to implementation.
Pre-Transaction Estate Planning
Pre-transaction estate and tax planning is a fundamental step in preparing for the sale of a franchise business. Depending on the level of complexity surrounding the business structure, the seller’s taxable estate and their future goals and objectives, up to two years of lead time is best to engage in estate planning and wealth transfer strategies. There are a variety of strategies available that can both reduce the overall tax burden of the transaction and help shift income to the next generation. In determining which, if any, estate planning strategy is optimal, considerations including, but not limited to, the size of the seller’s taxable estate (currently the excess of estate values over $11.4 million are taxable at the Federal and potentially State levels), the desire to gift or sell company equity to family members and the inclination towards philanthropic causes should be thoroughly reviewed.
Franchise owners with estates greater than $11.4 million with a desire to bestow wealth to family members may consider a strategy like a Grantor Retained Annuity Trust (“GRAT”),. A GRAT is an estate planning strategy in which the grantor (the business owner) contributes property (in this case, shares of a closely held business) to an irrevocable trust for the benefit of his or her children. For a specified number of years, the GRAT makes an annuity payment to the grantor of principal and interest at an IRS determined interest rate. At the end of the GRAT term, whatever is left in the trust remains for the benefit of children and passes without the utilization of your federal gift and estate tax exemption of $11.4mm. The valuation of the property transferred by the Grantor is essentially “frozen” at the applicable interest rate. This strategy is perfect for a business owner in anticipation of a future sale because shares of the business can be valued at a discount in the present and the future appreciation can be recognized by the second generation at the time of the sale. It is important to note that valuation discounts can be challenged by the IRS if conducted too closely to a sale, so a best practice is to consider utilizing a GRAT more than a year in advance of your liquidity event.
Another useful wealth transfer technique can be a sale of a portion of the business to an Intentionally Defective Grantor Trust (“IDGT”). Similar to a gift to a GRAT, a sale to an IDGT is a wealth transfer technique designed to “freeze” the value of your business for estate purposes and allow the future appreciation to be recognized by your children or grandchildren. In a sale to an IDGT, the grantor establishes a trust and funds the trust with cash. The trust then purchases the asset from the grantor through a mix of cash and a promissory note. Because the grantor retains certain powers, the income tax liability of the trust can be paid annually by the grantor, also removing more assets from the taxable estate and preserving the assets in the trust that would otherwise go towards payment of taxes. Upon the sale of the business, the trust has the liquidity to pay the grantor back with the remainder to be invested for the benefit of the beneficiaries. Both the GRAT and IDGT strategies can also be useful to pass equity to family members that wish to remain in the franchise business post-sale.
A third (but not the last) strategy focuses on philanthropic causes. Despite the fact that the equity may be in a closely-held business, owners are able to donate shares to a donor advised fund, which will allow them to take an income tax deduction up to 30% of Adjusted Gross Income (“AGI”) and retain discretion as to how those donated assets are used in the years ahead. Donating shares should occur prior to the signing of a binding, definitive purchase agreement because subsequent to such event the IRS will likely view a donation as income avoidance rather than a bona fide donation. Prior to donating shares, a donor advised fund will have the closely-held business shares appraised. Applicable discounts, which would help when gifting to individual beneficiaries or trusts, will reduce the value of a charitable donation.
Pre-Transaction and Transaction Business Strategy
Investment bankers with deep franchise industry experience are critical to a successful sale. In selecting a banking group, those that understand changing industry dynamics across regions and franchise brands provide for the best potential outcomes. Furthermore, those with expertise in understanding industry leading metrics can offer strategy and solutions that will better position a franchise for sale and ultimately lead to an improved valuation. An often overlooked but equally important criteria is an investment banking group’s reputation. Those banking groups that have demonstrated an ability to close and have accumulated a history of representing quality franchise businesses will garner greater attention from potential buyers. A component of a banker’s successful history is their ability to screen buyers. While the best valuation is often viewed as the goal, the successful sale gravitates to the best offer that considers a buyer’s ability to close and their access to capital.
A franchise business’s core brand, geography and profit margins, among many factors, are material components in developing a sale valuation. Veteran investment bankers with broad experience and a myriad of closed deals can identify shortfalls in a business’s metrics that can be rectified prior to the go-to-market launch. Once engaged, bankers will provide valuation services and, importantly, provide worse case, base case and best case valuation scenarios with weighted probabilities. In doing so, sellers and bankers have a framework from which to evaluate competing offers and the probability of higher upside.
A successful transaction should have a relatively short duration with a target closing time frame of six months. Franchise businesses are cyclical and transaction timing can have a material impact on valuations should market dynamics deteriorate prior to close. It is therefore important to involve legal advisors that are experienced in the nuances of franchise businesses and understand what constitutes standard practices as it relates to purchase and sale agreements. Here too, investment bankers can provide value as to the risks associated with various negotiation issues. In addition, bankers can help you interact with Parent Brands that have approval authority over any transaction.
As part of the sale process, capital gains taxes and depreciation recapture should be given serious consideration. Investment bankers will work with your accounting advisors to determine purchase price allocations and deprecation recapture determinants. While it follows that capital gains create a payable tax, there exist tax strategies for real property that may defer the timing of the payment and in some cases reduce the actual amount payable. Both a Section 721 Structured Exchange and a Section 1031 Exchange are such strategies . The former allows owners to contribute real property to a real estate operating company. Key benefits of a 721 Exchange are that the selling owner does not have to identify an investment property (as is the case for a 1031 Exchange), the owner gains immediate real estate diversification and the payment of taxes is only due when shares of the new real estate operating company are sold. Importantly, should the owner of the real estate operating company shares pass-away, the cost basis of those shares are stepped-up to fair market value, effectively eliminating the capital gains tax payable for heirs.
In a 1031 Exchange, a real estate investment property must be identified, which provides less diversification but greater managerial control. An advantage of a 1031 Exchange is the ability to use leverage in addition to the sales proceeds from the real estate portion of a franchise sale. For example, $10 million of sales proceeds could be combined with $30 million of debt to purchase a portfolio of assets. Over the ensuing years, cash flow from the assets is used to paydown debt and increase equity. Capital liquidity in future years may be accessed through a dividend recapitalization funded through a debt refinancing, which allows the owner to enjoy his/her capital without the payment of taxes as the recap is deemed a return of capital.
Other tax savvy post-sale investments could include Opportunity Zone Funds, created through recently enacted tax legislation. These funds are important as they allow investors to utilize capital gains from any source for qualifying investments. Subject to certain Opportunity Zone Fund parameters, capital gains are invested in the Opportunity Zone and the taxes on those gains (that are usually payable at the next filing date) are deferred and potentially reduced. Furthermore, capital gains taxes on the Opportunity Zone investment may be completely waived subject to holding periods and other requirements. Again, each strategy has its own merits depending on the selling business owner’s objectives.
Post-Transaction Estate Planning and Investment Management
Subsequent to the sale of a closely-held business, an owner has effectively transitioned from a “concentrated” investment strategy (the closely-held business) to a diversified investment portfolio. The key to success is replacing income generated from the closely-held business with income derived from the investment portfolio. Though beyond the scope of this article, it is suffice to state that an enormous variety of income and capital gains-focused strategies are available with varying levels of risk and liquidity. Given the current level of interest rates, owners should consider a portfolio’s total return, which incorporates both income and capital gains. Harvesting capital gains can serve the same cash flow purpose as receiving bond income, but at a lower tax rate depending on holding period and other factors. In determining what investment allocation is appropriate, thoughtful consideration should focus on a variety of issues including ongoing cash flow needs, significant one-time expenditures, tolerance for portfolio drawdowns and desired liquidity levels.
Identifying and working with an experienced holistic financial advisor will provide options and considerations for pre- and post- transaction planning. Pre- and post-transaction planning should include a thorough review of your current estate plan along with an analysis of your financial needs and goals. A sound financial plan can also help in the process of transitioning from a lifestyle in which a significant portion of your net worth is held within a business or real estate to a lifestyle in which you are reliant on a liquid portfolio of cash and securities. Pre-transaction planning can be complex and strategies will depend on individual circumstances and intent. It is important to consider the benefits and drawbacks of all strategies prior to the sale of a business and to execute the strategy most aligned with your intentions. A good financial advisor will work with your accountant and attorney to review all tax strategies in advance of implementation.
The selection of investment banker is incredibly important and should consider the group’s industry-specific tenure, industry reputation, pre-marketing input to financials and optimization strategies, percentage closing rate, and average time to close. The investment banker should provide a range of potential, probability weighted valuations to guide sellers during the bidding process. Often times the highest valuation is not the best offer and the investment banker is there to insure the best choice is made.