Business Sales and Legacy Decisions

Selling a family business is typically complicated and fraught with emotional issues for the owner. The owner is selling his means of livelihood, and more the composition of his net worth, which will migrate from business earnings to a portfolio of liquid assets generated by the sale. The good news is that owners aren't going through the process alone, but are typically represented by teams of advisors.

Selling a family business is typically complicated and fraught with emotional issues for the owner. The owner is selling his means of livelihood, and more — the composition of his net worth, which will migrate from business earnings to a portfolio of liquid assets generated by the sale. The good news is that owners aren't going through the process alone, but are typically represented by teams of advisors. The role of the investment manager isn't to pass judgment on one or another term sheet, but to place each in the context of the owner's overall financial objectives. This can be done at any point during the deal — but the sooner the better.

Owners need to consider two fundamental questions: (1) how much money they need, and (2) how much they can begin transferring to family members and charity. The touchstone for many families when deciding to sell is whether the proceeds will, at minimum, satisfy what we call the “core-capital” requirement: the amount a business owner needs to meet his lifetime spending budget, grown with inflation. Because no one wants to live with the threat of running out of money, we calculate the probability of sustaining core capital at a very high degree of confidence: typically 90 percent or better.

Any amount left over after the core-capital requirement is satisfied is the “excess,” which is used for extra spending, family legacy provisions, philanthropy or new business ventures. Because excess capital isn't a lifestyle requirement, it may be invested in a more aggressive allocation or with a lower level of confidence. For many business owners who are considering a sale, it's key to come away with at least their core-capital requirements. If the sale generates excess as well, so much the better.

In determining core and excess capital and the appropriate confidence levels that they will last through poor markets, we leverage a probabilistic planning model (our Wealth Forecasting SystemSM or WFS1). The WFS integrates the circumstances and goals of an investor with the historical and projected behavior of the various asset classes and 10,000 “what-if” scenarios specific to the investor and the markets. To bring the analysis to life, we often employ a case-study approach, which illustrates the opportunities and challenges in making the trade-offs that inevitably accompany any investment decision.

A Missed Opportunity

During the boom years of the mid-2000s, many business owners were offered and refused term sheets, hoping to do better — only to regret that decision when the bear market ensued. Consider Jim and Carol Noble, who decided in early 2007 that they were ready to give up their family business, which was earning more than $7.5 million a year and represented the vast majority of their net worth (the rest of which was invested in two individual retirement accounts totaling $1 million). They wanted to sell the business for $60 million, which worked out to 8 times earnings before interest, taxes, depreciation and amortization (EBITDA), a high multiple even by 2007 standards — but were offered $48 million. They chose to pass. As we'll see, while more money is obviously better than less, they didn't need proceeds of $60 million to meet their financial objectives.

Indeed, three years later new offers came in, but by now, in harder times, their earnings had declined to $6 million a year. They would have to sell at a 4.5 times multiple, yielding $27 million cash, leaving them with $23 million after taxes, including their IRAs. Should they sell this time? Could they sell and meet their objectives: satisfying their core-spending needs ($500,000 a year, grown with inflation), purchasing a $3 million vacation home they had their eye on for decades, establishing a substantial legacy for their two children and giving generously to charity? With so much money on the table, you wouldn't think that core capital would even be an issue, but the Nobles lived an upscale lifestyle. The couple justifiably wanted a specific core-capital number, factoring in their specific circumstances and goals, including three different deal structures they were fortunate enough to be able to consider. We projected their required core capital at $16.6 million, but that was a function of how they invested the proceeds of the deal.

Required Core Capital

Like many business owners who can no longer rely totally on earned income, the Nobles had a conservative bent when it came to investing their sale proceeds — a portfolio weighted toward bonds. The WFS evaluated the potential returns and volatility of three different stock/bond allocations. (See “Core-capital Requirements and Volatility,” this page.)

For the most conservative mix, 20 percent in globally diversified stocks and 80 percent in bonds, the model suggested that the portfolio would almost never generate a peak-to-trough loss as great as 20 percent. We projected that the couple's age, budget and portfolio allocation would translate into a core-capital requirement of $18.6 million (at the 90th percentile of probability) and an expected portfolio value after 30 years of spending and taxes of $30.4 million. That didn't sound at all bad — but the Nobles wondered if they could do even better.

If stocks were increased to 60 percent of the portfolio, the projected median 30-year wealth figure was $48.8 million — an increase of $18.4 million compared with the 20/80 mix. And with the extra growth of stocks, we'd expect the Nobles to need less core capital — $16.2 million. But the trade-off for stock growth is volatility. We estimated that the couple would face a one-in-three chance that at some point they'd lose as much as 20 percent. This went far beyond the limits of their risk tolerance.

The optimal solution — for this particular couple — turned out to be a bond-tilted 40/60 portfolio, which would require core capital of $16.6 million. Analysis convinced the Nobles that a 40/60 investment strategy could meet that hurdle even if markets were very poor and with a very small risk (6 percent) of ever experiencing a 20 percent portfolio correction over the next 30 years. The median 30-year wealth expectation was $39.4 million. Altogether, this was an attractive picture for the couple. The question was, would the deal net them their core capital and an additional $3 million to fund the vacation home — $19.6 million in all — plus enough extra to meet their legacy objectives?

Take the Money and Run?

The Nobles would have to work through different term sheets with their professional team, since they were considering three different types of transactions. It turned out that all three were variants of cash deals, but the cash would come to them at different times and from different sources.

  • One offer was straight cash up-front: $27 million. After paying capital gains taxes at 15 percent on the federal level and 5 percent to their state and assuming a zero cost basis in the business, the Nobles would have $23 million (including their $1 million in IRA funds). This is more than enough to meet their core needs and pay for the vacation home — and still have $3.4 million left over, even in light of investment returns far worse than they'd likely see. Why couldn't they take the offer and walk away satisfied? The fact is, they could. And while they were disappointed about not garnering $60 million, lower valuations for a business often coincide with lower valuations in the capital markets and hence higher return potential for the liquid portfolios that house business sale proceeds.

  • Another sale alternative was a leveraged recapitalization: taking on some debt in hopes of using the extra money to boost their earnings. In the deal the investment bankers laid out for the Nobles, a new partner would join them right away, taking a 20 percent ownership interest in the Nobles' shares. The couple would come away with $13.5 million up- front,2 combining proceeds from the equity sale and a substantial portion of the debt. They'd also be paid an annual salary of $400,000 for five years for continuing to play a key role in the company. Meanwhile, the Nobles would be using their company's earnings to pay down the debt and work toward a profitable exit — which, in this representative case would be five years after inception of the recap.3 True, the up-front cash would fall short of satisfying their spending needs — but the couple wouldn't consider a leveraged recap at all unless they were confident about their company's five-year earnings prospects.

  • Finally, the Nobles received a so-called “earn-out” offer: also cash with a five-year contingency, but not as dependent as a recapitalization on an earnings upswing. In this transaction, the Nobles would sell their full interest in the business in exchange for a share of the earnings, up to $2.4 million annually over five years. If post-sale earnings didn't meet agreed-upon targets, the earn-out payments would be reduced. If the couple agreed to the terms, they'd be offered $19 million immediately, plus $400,000 a year in consulting fees for five years — almost (though not quite) enough to satisfy their core needs and pay the cost of the vacation home at the 90 percent level of confidence. Unlike all-cash up-front, the final value of the earn-out would depend on how the business performed over the near term — and like a recap, the Nobles would have to be comfortable staying involved in the business.

Parsing the Trade-offs

Of course, there's no “right” alternative for every business owner, and there was no perfect answer for the Nobles. It depended on the trade-offs they were most comfortable with.

But why all these complications? The Nobles could take the all-cash $27 million up-front and avoid the uncertainties. Along those lines, “Up-front Cash Offers,” p. 26, compares the up-front cash portion of each offer. The “box-and-whisker” format presents wealth values from the 5th through the 95th percentile of confidence, focusing on the 10th, the 50th and the 90th percentiles, as representative of upside, median and downside results — not guarantees, of course, but our research-based WFS forecasts.4

The all-cash-now deal was the only one that could give the couple peace of mind about meeting their needs in virtually any scenario. Success in the other two cases depended on payouts that they might — or might not — get. (With the recap, we estimated the chance of the up-front cash meeting the Nobles' core needs at only 29 percent.)

Case Closed? No

Often, business owners regard the contingency payouts as merely icing on the cake. But with the WFS, owners can systematically evaluate the sensitivity of different offers to varying earnings scenarios. The more the business earns over the contingency period, the more the owners will benefit — and the odds are generally in their favor. “Future Earnings,” p. 26, adds the potential future proceeds from the final sale of the Nobles' business in the recap case and from continuing distributions in the earn-out scenario, as well as the salary and consulting fee, respectively. For the immediate cash alternative, of course, there are no contingencies.

Using this scenario analysis, different earning outcomes were stress-tested versus the security of immediate cash. The leveraged recap and the earn-out both offered the opportunity for more upside — and the potential for greater downside, particularly so in the case of the recap. For example, we estimate that with just 5 percent earnings growth, the recap would generate a median result of almost $100 million — and an upside above $175 million (assuming the business was now valued at 5 times EBITDA rather than 4.5 times). A 10 percent earnings decline, on the other hand, would leave the Nobles with about $8 million of excess capital in downside markets — certainly no catastrophe, but the couple wouldn't want to test a recap much beyond a 10 percent earnings falloff.

An earn-out is also sensitive to profits, as its name implies — but less so. The earn-out considered by the Nobles would allow for an earnings decline as large as 20 percent and still be comparable to the all-cash offer while retaining some upside in good markets. All the alternatives — cash, recap and earn-out — were viable options that might be appropriate depending on the Nobles' priorities and risk tolerance. They might not have gotten what they wanted (that is, $60 million), but they would find that they got what they needed. And they decided to go with the simplicity and security of the all-cash up-front deal.

Discount Helps

As noted, the Nobles wished to transfer some of the excess capital from their proceeds to family beneficiaries. Addressed early enough, planning before the sale can be especially important. One effective means of transferring wealth is to gift shares. For gift tax purposes, the value of the transfer will be based on a current or recent appraisal — generally lower than the value assigned at sale because pre-sale shares are illiquid and essentially unmarketable. In addition, if the gift represents a minority interest in a private company, for gift tax purposes the value could be further discounted because the beneficiaries have no control over the illiquid shares. If the business is indeed sold for significantly more than the valuation at appraisal, the beneficiaries would end up with more than the appraised value of the gifts.

For example, if the owner uses $1 million of his lifetime applicable gift tax exclusion to transfer shares of his company that ultimately benefit from a 30 percent discount at the time of sale, he's actually transferring $1.4 million. However, to take advantage of a discount, there needs to be a sufficient time interval between the gift and the sale agreement.5


A grantor retained annuity trust (GRAT) can leverage gifting substantially. At today's low interest rates, the GRAT bogey is especially low. (As of February 2011, the Section 7520 rate was 2.8 percent.) Further, donors pay the income and capital gains taxes from outside the GRAT, enhancing the amount transferred. Because the statute of limitations on the valuation of the shares is three years (during which time GRAT distributions can be adjusted if the Internal Revenue Service disputes a claimed value), professional teams often recommend a three-year GRAT when contributing assets whose value is open to discussion.

Contributing discounted shares of a business increases the potential benefit if the company is sold within the three-year period.6 The realization of the full value of the discount helps the assets in the GRAT appreciate rapidly, making it very likely to outperform the 7520 rate. In this case, we presume that a three-year $6 million GRAT invests its proceeds from the business sale in bonds for the safety of locking in returns. Once the trust expires after three years, the proceeds intended for the children are invested for the next 27 years in an 80 percent stock/20 percent bond portfolio — suitably stock-heavy for beneficiaries with a long time horizon. “Power-up a GRAT,” this page, makes clear how the advantage of discounting builds. If the $6 million of shares in the GRAT were subject to a 30 percent discount, we'd expect the median value of the 80/20 portfolio to be $15.6 million after taxes and fully $7.8 million in very poor markets. Had the shares been discounted by 40 percent, we'd project a $24.2 million median and a $12.0 million downside case. Discounting can be a powerful tool when put to use in a GRAT.

An alternative to a GRAT is an installment sale to an intentionally defective grantor trust (IDGT). With this strategy, an outright (potentially taxable) gift of 10 percent of the overall transfer of the shares is made to the trust (a general rule under prevailing practice: No tax or legal authority expressly sanctions 10 percent as a necessary or sufficient amount). The remainder of the assets is sold to the trust in exchange for an interest-bearing note. The growth of those assets can pass to the beneficiaries free of additional transfer tax if they appreciate faster than the applicable federal rate (AFR) hurdle — lower than the Section 7520 rate for any loan of nine years or shorter. As of February 2011, the mid-term AFR (operative for greater than three years but no more than nine) was 2.33 percent, annual compounding. There are, of course, advantages and disadvantages of both GRATs and installment sales to IDGTs. For example, if the GRAT donor dies during the term of the trust, part or all of the trust assets revert to the donor's estate and might not be gifted to a beneficiary free of transfer taxes. Advice from the business owner's professional team is critical in putting trust vehicles to best use.

Quantifying the Advantages

Assembling a legacy plan yields notable benefits. Returning to the Noble case study, let's assume the couple sold the business for $27 million in cash and did no planning prior to or after that point. Recall that on Day 1, they'd have $3.4 million to set aside for legacy. In the absence of any estate-planning techniques, we project that even in dismal markets the legacy would grow to $13.2 million — the amount left over at the 90th percentile of probability before any estate taxes (refer back to “Future Earnings,” p. 26.) But in the median case (see “Reducing Tax Impact on Legacy,” p. 30), we projected that — again, making use of no planning tools — they'd leave a hefty amount to their heirs after 30 years: $39.4 million, netting $18.8 million to their children after estate tax.

Suppose, though, that the couple's legacy strategy was, pre-sale, to fund a three-year GRAT with $6 million in company shares, 30 percent discounted, investing the proceeds in a liquid portfolio over the 27 years following the GRAT's term. The models suggest that their heirs could expect the GRAT combined with the rest of the Nobles' assets after estate taxes to produce $29.8 million — $11 million in additional wealth.7 Through the single action of funding a trust before the sale with discounted shares — and then investing the proceeds appropriately — the couple would be able to increase the legacy to their children by more than 50 percent.

Setting Up a Private Foundation

Recall that the Nobles also had philanthropic goals. A variety of vehicles were at their disposal to meet them, including direct gifts, charitable remainder unitrusts, charitable lead annuity trusts and their strategy of choice: establishing a private foundation (PF). What attracted them to a PF was its pure charitable intent, its typically long life (many are set up to last in perpetuity, though that goal is difficult to meet) and its familial aspect: Many PFs are managed by successive generations, which was the Nobles' hope. In addition, the Nobles would retain full control over the PF's assets and the grants it distributed — not always the case with, say, direct gifts to charity.

Like certain other charitable vehicles, PFs carry a large up-front tax deduction (albeit more restrictive than direct gifting to a public charity)8 and allow the assets to grow in a tax-advantaged environment. In exchange for the tax benefit, the PF will have to distribute at least 5 percent of its assets annually. The Nobles are eager to establish a multigenerational philanthropic legacy, though their professional team has made them aware that administrative costs can be high and reporting requirements time consuming. Like all wealth strategies, PFs entail trade-offs; for the Nobles, they were acceptable.

Sizable Charitable Distributions

“Charitable Giving,” this page, presents the wealth picture we'd expect from a PF after 30 years if the Nobles initially contributed $4 million in cash from the deal proceeds — funded from their excess assets — allocated 65 percent to global stocks, 25 percent to bonds and 10 percent to real estate investment trusts. In the median case we'd expect the PF to be able to distribute a total of $9 million over the three decades, leaving another $10 million in the PF to continue the Nobles' philanthropic legacy. Thus, their charity would receive a total of $19 million in funding while preserving a comfortable cushion for the Nobles' retirement objectives and still leaving a substantial $11.6 million legacy for their children. (See “Philanthropic Goals Achieved,” this page.)

Planning Helps Meet Multiple Goals

The Nobles can comfortably execute a $6 million pre-transaction GRAT or fund a $4 million post-transaction PF or some blend of the two strategies that get their wealth where they want it to go. Or they might consider other strategies. There are no panaceas in selling a family business or in any other wealth-building event. But we're convinced that careful quantitative planning using a team of experts can help demystify family business sales and help any owner achieve his multiple financial and personal goals. The alternative, to let the situation simply play itself out without taking control, is almost surely a suboptimal strategy.

Bernstein Global Wealth Management, a unit of AllianceBernstein L.P., does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.


  1. The Bernstein Wealth Forecasting System (WFS) uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model doesn't draw randomly from a set of historical returns to produce estimates for the future. Instead, our forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.
  2. The debt on the balance sheet is a double-edged sword. On the one hand, it will presumably be used to improve the business; on the other, much of the earnings will have to be used to pay down the debt — which is why recaps tend to be so contingent on earnings. However, the Nobles won't be liable for any of the debt personally, which is an obligation of the business.
  3. The ultimate buyer could be the 20 percent owner, but the final transaction is more commonly an outright sale of 100 percent of the business interests to a third party.
  4. The wealth calculations in this article were performed prior to the Dec. 17, 2010 tax legislation; therefore, we assumed modestly higher rates for 2011 and 2012 than currently in the Internal Revenue Code. In analyses over long time horizons, this discrepancy has minimal impact on results.
  5. Consult a valuation specialist to determine the appropriate discount in your situation.
  6. Assuming that the grantor retained annuity trust (GRAT) was funded long enough before the sale to take full advantage of the discounted shares.
  7. Assuming that the GRAT proceeds were invested in an 80/20 stock/bond mix and that the Nobles' portfolio was allocated 40/60 for the full 30 years.
  8. The maximum deduction that can be used in any one tax year on cash gifts to a private foundation is 30 percent of adjusted gross income versus 50 percent for cash gifts to a public charity; for gifts of publicly marketable stock, 20 percent and 30 percent, respectively, determined by market value; for gifts of closely held stock and real estate, 20 percent (determined by cost basis) and 30 percent (market value), respectively. Tax deductions that can't be used in a given year can be carried forward for an additional five years before expiring.

Gregory D. Singer, far left, is the director of research for Bernstein's Wealth Management Group, based in New York. Brian D. Wodar is a director of the Group, based in Chicago

Core-capital Requirements and Volatility

The optimal solution in our example is a bond-tilted 40/60 portfolio

% Stock/Bond Allocation 20/80 40/60 60/40
Core capital required $18.6 million $16.6 million $16.2 million
Probability of ≥ 20%
peak-to-trough loss, 30 years
2% 6% 33%
Median wealth, 30 years $30.4 million $39.4 million $48.8 million

Note: Core-capital assumptions are based on lifestyle spending needs of $500,000 per year, growing with inflation and not including the $3 million vacation home or any legacy plans. Based on Bernstein's estimates of the range of returns for the applicable capital markets over the next 30 years. Data don't represent any past performance and aren't a promise of actual future results. See Wealth Forecasting System, endnote 1 in this article.


Family Tree

This Maxfield Parrish oil on board illustration, “At Close of Day,” (15 in. by 13 in.) from 1941, sold for $215,100 at Heritage Auctions Signature Illustration Art auction on Feb. 11, 2011 in Beverly Hills, Calif. Known for his landscape paintings, Parrish publicly announced his emancipation from “the figure” and devotion to pure landscape paintings. Originally titled “Plainfield, New Hampshire Village Church at Dusk,” the illustration is one of the earliest winter scenes he produced. Parrish's use of cobalt blue has been said to be the “protagonist of his landscape paintings.”