This second article of a two-part series on pre- and post-deal planning relates primarily to helping business owners manage their post-sale wealth.
|Gary L. McGuirk is a former attorney and first vice president and private wealth advisor for Merrill Lynch Private Wealth Management in Boston.
|Paul J. McCauley is first vice president and private wealth advisor for Merrill Lynch Private Wealth Management in Boston.
|Paul D. Broude is corporate partner at Epstein Becker & Green, P.C. in Boston.
Now that you have helped your clients successfully negotiate the sale of their company, important long-term planning decisions remain before they settle into the next stage of their lives.
Assessing your clients' new financial situation is important to help them manage their wealth not only for their lifetime, but for future generations as well. There are many issues to consider in this stage, including preserving their wealth; arranging income replacement; ensuring liquidity; managing any concentrated stock position; and making sure your client is tax-efficient in setting up philanthropic vehicles.
The following are some financial and emotional considerations to review with your clients at this pivotal time.
Ensure long-term financial stability
On the financial side, sellers are sometimes not ready to transition from building to preserving wealth. For example, we find former business owners are reluctant to invest in more conservative asset classes. In addition, they have significant concerns about maintaining pre-sale lifestyle and income levels.
This is where the psychology of managing a post-sale increase in assets can come into play, and why it's important to begin with a discussion of your clients' situation.
Assess your client's position
It is important to consider your clients' position. For example, is the majority of the clients' assets liquid? Do they have a concentrated position of stock in the buyer of their business? While these issues would have been addressed during sale negotiations, now is the time to deal with the end result. In the case of a concentrated stock position, their risk profile would be increased. In this case, the remaining assets should be invested more conservatively and look very different than the concentrated equity position.
Create a balanced portfolio
Proper asset allocation is the single most important aspect of post-deal planning and critical to the success of the clients' financial plan. Often clients misjudge their ability to take on risk or underestimate the importance of asset allocation. Usually, the problem is that they aren't as diversified as they think. Windfall investors now have more diversification options to consider. For example, they now qualify for hedge funds, can invest in private equity or other non-publicly traded investments, such as collectables, real estate or small businesses, which can help dampen market volatility and level total return.
Critical issues to address at the outset include: income requirements and return expectations; time horizon; risk tolerance; and assessing portfolio volatility by measuring performance over time.
Frequently, the toughest conversations involve the clients' personal inclination to overweight securities in their former sector because that's what they know and understand. That is not always the best route, however, as it results in a less-diversified portfolio and tends to let emotion drive investment decisions.
Manage concentrated stock positions
Diversification is especially important for owners of newly acquired, substantial stock positions. We'll look now at strategies to liquidate and diversify a concentrated stock position.
If there are no restrictions on the stock, your clients are typically free to start selling shortly after the deal. As we discussed in our previous article, this is where pre-sale planning can be crucial. For example, your clients can begin implementing hedging strategies if their team of experts has made sure in advance that there is sufficient stock available to borrow against.
However, it is often the case that your client faces certain restrictions on the sale of the stock. Therefore, multiple strategies will need to be employed to help manage risk and replace income.
If your clients became employees of the acquiring company, they may be subject to trading restrictions and may only be able to sell during certain trading windows. In this case, a 10b5-1 plan can help. Rule 10b5-1 was created by the Securities and Exchange Commission in 2000, and plans established in accordance with the requirements of the rule are intended to create an affirmative defense for insiders to claims of insider trading. These plans provide for the orderly sale of stock, help with liquidity and enable your clients to build a more diversified portfolio.
Here's how a 10b5-1 plan helped one of our clients who received a large amount of stock and took a senior executive position with the buyer of his biotech company. The buyer runs clinical trials on various drugs under development and continually receives information about those trials - information not generally available to the public and considered material inside information that could affect decisions to buy and sell the buyer's stock. An "open window" for trading by insiders was virtually nonexistent. In this case, the seller set up a 10b5-1 plan to sell 10,000 shares of stock per week. The plan was established before the client had any "inside information" to protect the seller from any legal or ethical concerns about knowing information that would affect his sales. The way the 10b5-1 plan is drafted and implemented, and the time at which it is established, are all important to obtain the rule's affirmative defense, so it is important to consult with experienced professionals with respect to these plans.
Business owners may be accustomed to significant salaries and post-sale, may have reduced or nominal compensation and substantially reduced company-paid benefits. Replacing pre-sale annual income levels without depleting principal is a vital aspect of post-sale planning. Boosting income can be handled in a number of ways, through proper asset allocation that shifts investments to income-producing classes such as bonds, and through various strategies for managing single stock positions. In addition, financing strategies can be discussed if clients need cash before they are allowed to sell restricted stock.
A client, who needs some immediate liquidity but wants to defer some of the tax consequences of the sale, may want to consider a pre-paid forward. With this strategy, the client agrees to sell shares at a future date, but at a discounted price, say 80 percent of current market value, with payment received now from the buyer of the shares. When the agreed-upon sale date arrives, the actual transaction takes place and the client pays taxes on the sale, presumably at capital gains rates. The downside of this strategy is that it caps upside potential. In addition, there are high minimum net worth requirements. As with most hedging strategies, tax straddle rules apply, so it is important to work with your clients' tax advisors.
Sometimes a client wishes to keep a portion of the stock received in the transaction - either because of emotional ties to the company or a bullish outlook. In this case, a strategy to consider is a cashless collar. At maturity, the client is protected from depreciation below a certain amount (the put strike price) and participates in any appreciation up to a certain amount (the call strike price).
If the stock is undervalued or expected to increase in value, a strategy that provides income is a customized covered call program contract. Here, the client continues to own the underlying stock and sells a call to a buyer who is bullish on the stock. The strike price (or point of sale) will be higher than the stock's current price. The benefit of this strategy is that the stock-owner receives income from the call premium. The downside is that the upside potential is capped at the strike price and the stock-owner is not protected from a severe drop in the stock price. Clients should note since these are private offerings and not exchange traded investments, liquidity may be limited should the client wish to close out the position prior to maturity.
Another way to generate income, for a client who is philanthropically inclined, is to use the appreciated stock to fund a charitable remainder trust (CRT). A CRT provides a way to increase income while reducing capital gains, income and estate taxes. Your client receives a current income tax deduction and a payment stream for life, a strategy that can help close the gap in income that may result from a sale or merger. Also, once the appreciated stock is in the CRT, the trustee can sell that stock and reallocate into a diversified portfolio with virtually no tax implication. Ultimately, upon the death of the client or surviving spouse the CRT will go to one or more charities specified by your client.
Deal with short- and long-term emotional stability
Business owners often face a variety of emotional considerations in the post-sale period. Based on our experience, the biggest emotional consideration is your clients' reluctance to diversify a concentrated stock position for a variety of reasons. Helping clients through this process is essential so that they are willing to look at the stock they have received as something to be sold.
In addition, because they still want a measure of control over the business they spent years developing, they may sign employment contracts that include a non-compete agreement. We find there is usually a post-sale honeymoon period of about a year and then sellers may want to move on to pursue other business ventures.
If your clients are through with the daily grind of the business world, be sure to talk to them about philanthropic endeavors. It's up to the individual, but we often find the best way for former business owners to maintain a sense of importance once they no longer have an office to go to is to volunteer their time. Contributing financially is important and a valuable tax saving strategy, but sometimes brainpower is the most valuable asset. Massachusetts is full of inspirational causes that would benefit from experienced leadership and the can-do, entrepreneurial spirit your clients would bring.
If your clients don't have time to volunteer, ask them to consider a family foundation. Family foundations provide important tax advantages and offer donors control over which charities receive distributions from the foundation and over how foundation funds are invested. Using a foundation can also be a useful tool for managing a concentrated stock position that offers significant financial and emotional benefits to clients.
Foundations also provide a way to pass on values and involve clients' family members in supporting important causes. They can help turn your clients' success into "significance," and help teach future generations the importance of charitable giving and family unity. One of our clients who set up a family foundation had five children. The children took turns sitting on the foundation board and sharing in decisions about how funds should be distributed, which proved to be a wonderful family experience.
Continue to take a team approach
As with pre-sale planning, taking a team approach to the post-sale planning phase will serve your clients best in managing their increased wealth. Most of the strategies we've discussed require bringing together a client's legal, tax and financial advisors. This team approach helps sellers make smart decisions, with the impact of each action evaluated and coordinated from these important perspectives.