- Angel investors typically form groups to provide equity financing to start-up companies. Angels should be considered if the new business owner(s) cannot qualify for adequate bank financing, but still require outside financing. Because angels can set their own terms, care should be taken when negotiating this financing.

- Venture capital firms (VCs) provide financing for high growth companies in exchange for significant equity. VCs are generally funded by risk-tolerant private investors who seek high returns within a short period of time. VCs typically strive for annual returns of at least 20 percent to 40 percent with investment periods ranging from three to seven years.

- Mezzanine financing may be characterized by a hybrid type of security, junior to venture capital and senior debt, often requires little to no collateral, equity conversion feature in case of default.

- At its most basic level, an LBO is a method of acquiring a company with money that is nearly all borrowed. This allows investors to make a large acquisition without committing a lot of capital. The acquirers of the target company often attempt to sell or take the target company public after five or ten years in the hopes of making sizable profits. Doing an LBO can be expensive and complex, but if successful can provide considerable returns.

- Distressed or special situations. This is a broad category referring to investments in equity or debt securities of financially stressed companies. Since this area focuses on investing in entities that are in default, under bankruptcy protection, or headed in that direction, investors must evaluate not only the ability for the entity to make a comeback, but also which class of securities might be more beneficial to hold during a restructuring process.

- Restructuring includes mergers, acquisitions, divestitures, recapitalizations, leveraged buy-outs, reorganizations, downsizings, and other types of restructuring of a corporation. During the 1980s, the value (i.e., prices paid or revenue impact) of these activities in corporate America was over $300 billion. The value of leveraged buy-outs alone was over $80 billion. In only a five-year period in the 1990s this value was equaled.

- A corporation is a unique entity that is separate and distinct from its shareholders. A corporate shareholder is only liable for corporate debts and liabilities to the extent of his or her investment in the corporation. - The corporate structure may be appropriate for businesses with the following characteristics: -Multiple owners -Multiple types of owners -Need for limited liability -Need for continuing life -Future intentions to go public -Future intentions to acquire other companies by merger -Exit strategy involving tax-free reorganization -Desire to retain taxation at the entity level.

- Many closely held corporations are eligible to elect to be taxed under Subchapter S instead of under the regular rules for taxation of corporations. If the election is made, the corporation's income, with some exceptions, is not taxed at the corporate level but is passed through and taxed to its shareholders. Thus, an electing corporation avoids double taxation of its income. Under the regular corporate income tax rules, a corporation pays a tax on its taxable income. - When considering an S corporation as a business entity, the following matters should be noted: 1. Shareholder-employees must be compensated with wages, subject to withholding. 2. Distributions, or dividends, must always be proportional to stock ownership. 3. Only one class of stock is allowed. Thus, the corporation cannot have preferred stock or any other class of stock that differs from another in any aspect other than voting rights. 4. Non-U.S. persons cannot be added as shareholders nor can a current “community property” shareholder marry a non-U.S. person. 5. Reasonable compensation must be paid to shareholder-employees.

- A limited liability company (LLC) is created by state law. As discussed previously, an LLC generally has the flexibility of a partnership with the limited liability of a corporation. An LLC member's personal liability is normally limited to the amount of his or her investment. Under most states' laws, the LLC structure is not available to licensed businesses such as law or accounting firms.

- A partnership exists for tax purposes whenever a profit-motivated business is carried on by two or more people who share in income and expenses. As previously discussed, unless the partnership is an LLC, LLP, or limited partnership, partners are “jointly and severally” liable for partnership debts.

- IRC 1202 allows individuals to exclude 50% to 100% of the gain realized from the sale of qualified small business stock held for more than 5 years.

- an agreement between the owners of a business, or among the owners of the business and the entity, to purchase and sell interests of the business at a price set under the agreement upon the occurrence of certain future events.

Planning for Closely Held Business Owners (Section IV.B) (10%, 12-13 Questions) Flashcards by Scott Murphy

Angel Investors

Angel investors typically form groups to provide equity financing to start-up companies. Angels
should be considered if the new business owner(s) cannot qualify for adequate bank financing, but still require outside financing. Because angels can set their own terms, care should be taken when
negotiating this financing.

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Venture Capital

Venture capital firms (VCs) provide financing for high growth companies in exchange for significant equity. VCs are generally funded by risk-tolerant private investors who seek high returns within a
short period of time. VCs typically strive for annual returns of at least 20 percent to 40 percent with investment periods ranging from three to seven years.

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Mezzanine Financing

Mezzanine financing may be characterized by a hybrid type of security, junior to venture capital and senior debt, often requires little to no collateral, equity conversion feature in case of default.

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Leveraged Buyouts

At its most basic level, an LBO is a method of acquiring a company with money that is nearly all borrowed. This allows
investors to make a large acquisition without committing a lot of capital. The acquirers of the target company often attempt to sell or take the target company public after five or ten years in the hopes of making sizable profits.
Doing an LBO can be expensive and complex, but if successful can provide considerable returns.

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Distressed Debt

Distressed or special situations. This is a broad category referring to
investments in equity or debt securities of financially stressed companies. Since this area focuses on investing in entities that are in default, under
bankruptcy protection, or headed in that direction, investors must evaluate not only the ability for the entity to make a comeback, but also
which class of securities might be more beneficial to hold during a restructuring process.

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Restructuring

Restructuring includes mergers, acquisitions, divestitures, recapitalizations, leveraged buy-outs, reorganizations, downsizings, and other types of restructuring of a corporation. During the 1980s, the value (i.e., prices paid or revenue impact) of these
activities in corporate America was over $300 billion. The value of leveraged buy-outs alone was over $80 billion. In only a five-year period in the 1990s this value was
equaled.

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C-Corporations

A corporation is a unique entity that is separate and distinct from its shareholders. A corporate shareholder is only liable for corporate debts and liabilities to the extent of his or her investment in
the corporation.
The corporate structure may be appropriate for businesses with the following characteristics:
-Multiple owners
-Multiple types of owners
-Need for limited liability
-Need for continuing life
-Future intentions to go public
-Future intentions to acquire other companies by merger
-Exit strategy involving tax-free reorganization
-Desire to retain taxation at the entity level.

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S-Corp

Many closely held corporations are eligible to elect to be taxed under Subchapter S instead of under the regular rules for taxation of corporations. If the election is made, the corporation’s income, with some exceptions, is not taxed at the corporate level but is passed through and taxed to its shareholders. Thus, an electing corporation avoids double taxation of its income.
Under the regular corporate income tax rules, a corporation pays a tax on its taxable income.
When considering an S corporation as a business entity, the following matters should be noted:
1. Shareholder-employees must be compensated with wages, subject to withholding.
2. Distributions, or dividends, must always be proportional to stock ownership.
3. Only one class of stock is allowed. Thus, the corporation cannot have preferred stock or any other
class of stock that differs from another in any aspect other than voting rights.
4. Non-U.S. persons cannot be added as shareholders nor can a current “community property”
shareholder marry a non-U.S. person.
5. Reasonable compensation must be paid to shareholder-employees.

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LLC

A limited liability company (LLC) is created by state law. As discussed previously, an LLC generally has the flexibility of a partnership with the limited liability of a corporation. An LLC member’s personal liability is normally limited to the amount of his or her investment. Under most states’ laws, the LLC structure is not available to licensed businesses such as law or accounting firms.

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Partnerships

A partnership exists for tax purposes whenever a profit-motivated business is carried on by two or more people who share in income and expenses. As previously discussed, unless the partnership is an LLC, LLP, or limited partnership, partners are “jointly and severally” liable for partnership debts.

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Section 1202 Stock

IRC 1202 allows individuals to exclude 50% to 100% of the
gain realized from the sale of qualified small business stock
held for more than 5 years.

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Family Holding Companies (FHC)

Also sometimes called an asset holding company. It is a method of recapitalization.
FHC is authorized to issue both voting preferred stock and non-voting common stock and is set up to manage the assets of another entity or entities.

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Buy-Sell Agreement

an agreement between the
owners of a business, or among the owners of the business and the entity, to purchase and sell interests of the business at a price set under the agreement upon the occurrence of certain future events.

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Triggering Event of a Buy-Sell

The events triggering a purchase may include the
death, retirement or disability of an owner, an attempted sale to a third party, and the termination of employment of an owner for reasons other than death, retirement or disability. Also divorce, bankruptcy or insolvency of an owner may also trigger an option or obligation to purchase.

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Cross Purchase Buy-Sell

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CHB Valuation & Tax Form Sale of the Business Summary

The value of a business is equal to the present value of future cash flows to the owner. Estimating such value is done in a variety of ways, but the
conceptual objective is the same regardless of valuation methodology.
The “terminal value” is typically a significant component of a business’s value and is often estimated by capitalizing a future period’s expected cash flow, earnings or EBITDA (or some other similar financial metric).

Capitalized Earnings (Know how to calculate)

Formula: Valuation = earnings / (discount rate - growth rate)

Example: An investment property is expected to generate $5m in annual income. The discount rate is 15% and expected growth rate is 3.5%. What is the value of this property?
Valuation = $5m / (15%-3.5%)
Valuation = $5m/ (11.5%)
Valuation = $43,478,261

Control Premium

The additional amount an investor is willing to pay for a controlling stake in a company.

Minority Interest Discount

The reduction in value of a minority ownership stake in a company compared to the pro-rata share of the entire company’s value.

Lack of Marketability Discount

The reduction in the value of an asset, often shares of a privately held company, due to their limited ability to e easily sold or traded on the open market.

Tools for Business Transfer

Employee Stock Option Plans (ESOPs)

A retirement plan that allows employees of a company to become partial owners by acquiring shares of the company’s stock. The company contributes either cash or shares of its stock to the ESOP, which holds the shares on behalf of the employee.
It has the follow tax benefits:
- The company can effectively deduct purchase payments.
- The owners can defer tax on the sale.
Effective in the following ways: Tax bene’s / Leveraging opportunity / Tax-advantaged means of compensating employees / motivating employees.

Self-Canceling Installment Note (SCIN)

The SCIN involves the sale of property in exchange
for an installment note calling for a specified number
of fixed payments at a specified interest rate over a
set period of time, but also provides that the note
payments terminate upon the death of the seller
– Since death terminates the seller’s right to receive
payments, there is nothing of value to include in the
seller-decedent’s estate
The gift tax issue is avoided by reflecting the self-canceling
feature as part of the bargained-for consideration for the sale, by either placing a premium on the price to be paid for the business interest or by stating an interest rate for the note substantially
above the market rate
Since the note, by its terms, is canceled by the noteholder’s
death, the value of the note is excluded from the decedent’s
estate.

Private Annuity

The business owner (transferor) transfers ownership of the business to the family member (transferee) in exchange for the transferee’s
promise (which must be unsecured) to make payments to the transferor for life
If the private annuity is structured successfully, there is no gift tax cost, and the value of the annuity is not included in the annuitant’s estate.

"Asset" Sales

- Buyers prefer to buy assets, not stock.

"Stock" Sales

- Sellers prefer to sell stock, not assets.

IRS Section 338 Election

- Allows acquiring corporation to buy stock of the target company for "legal purposes", but allows this purchase to be considered a purchase of assets for "Tax Purposes". - Only allowed on C-Corp and S-Corps - Purchase must be considered at "qualified stock purchase" - Intended result is tax benefit to acquiring company due to immediate benefit through step up in basis in the assets it is purchasing.

Code Section 6166 Installment Payments

- Is available only if the decedent was a U.S. citizen or resident at the time of death and the value of the decedent's interest in a closely held business exceeds 35% of the value of the decedent's adjusted gross estate. - Elect to defer completely for five years payment of the portion of the estate taxes attributable to the closely held business interest and thereafter pay the deferred portion of the estate taes in up to 10 annual installments.

IRC Section 303

- For qualified transactions, distributions in redemption of a deceased shareholders stock may be treated as a capital hain and not as dividends taxable at ordinary income tax rates. -Value of stock must be > 35% of the adjusted gross estate. - estate is generally liable for taxes and expenses.. - redemption must be made no later than 3 years and 90 days from due date of IRS form 706, or 60 days after court decision if contested, or no later than allowed installment payments of estate tax due.