Business Succession for Real Estate Companies
Planning for a business succession – sale or transition of a business to new owners – is as important as planning for business formation or business operations. In our experience, however, planning for business succession is often haphazard or non-existent. This article suggests some concrete steps to help owners of real estate businesses plan for succession and highlights particular troublesome.
Real estate businesses such as developers, contractors, and brokerages often have a small number of owners or are owned by a family. Typically, such a business is structured as a pass-through entity like a limited liability company or an S-corporation. The usual exit scenarios for such companies are: (1) transition of ownership to children or other family members; (2) transition of ownership to key employees; or (3) outright sale to a third party.
Here is an outline of steps to take in pulling together a succession plan:
- No matter what the exit scenario, every business should know what it is worth and why. It is critical to get an unbiased, accurate value, which generally requires a professional evaluation. Knowing the factors that impact the value of the business is important, like the value associated with the business owner’s contributions, which often comes up in the real estate and construction industry where personal relationships and reputation are so important. Factors like this could limit a business’ value in a sale, but knowing this gives the business owners a chance to address the issue.
- The current owners need to identify the successors, whether that be one or more family members, key employees, or third parties such as a competitor or a private equity fund.
- If the successors are family members or key employees, are they aware of the plan? Concrete steps to prepare them for future ownership are almost always required, but often delayed or overlooked.
- Tax considerations are a key element of all succession plans. Owners should consider federal, state, and local taxes in a variety of scenarios, with the assistance of a tax attorney or CPA with experience in succession planning.
Execution of the plan is where many owners fail, usually because the urgency of day-to-day operations crowd out the important task of executing a succession plan.
An outside advisor, such as a business owner who has successfully executed an exit or a professional consultant, can make all the difference in executing a transition plan. For example, a well thought-out plan for transition of a closely-held business in the real estate industry from current owners to key employees might include the following elements:
- a mechanism such as a right of first refusal to limit current owners from selling their ownership interests to third parties;
- an annual valuation of the business;
- a mechanism whereby key employees are bonused enough money to purchase ownership interests in increments from the company;
- an option by the company to redeem, and the other owners to purchase, ownership interests of an owner who ceases employment for any reason;
- key man insurance to provide liquidity for a buyout of an owner who suffers incapacity or death;
- an obligation to redeem ownership interests of retiring owners and a financing mechanism to pay for the redemption;
- for contractors and brokers, ensuring continuity of the necessary licenses; and
- non-competition and confidentiality covenants to make it harder for owners to leave the company with key customers.
The real estate industry is highly cyclical, participants often take on significant debt and trailing risks are significant and persistent once projects are completed. An exiting owner who times his or her exit cleverly (or just gets lucky) can burden the remaining owners with paying an inflated price. Typically, valuations take into consideration three or more years of past performance. We have also seen language that attempts to reduce compensation to the exiting owner based on future (post-closing) performance. This is not practical unless the company or the remaining owners are paying for the ownership interests in installments, for example under a promissory note.
We often recommend that transfers to key employees occur incrementally over many years, which spreads the burden of financing the redemption of the exiting owners out over time, and gives the key employees time to transition into leadership roles.
The devil is in the details and key legal and tax issues arising from such a scenario would include the following:
- How the employees will hold their ownership interests may negatively impact the business itself. For example, holding S-corporation stock in a trust could result in an inadvertent termination of the election unless the trusts meet certain requirements for holding S-corporation stock.
- If the company owns real estate, consider how the contemplated transfers will occur without triggering Washington real estate excise tax.
- Issuances of stock to employees will generally trigger a requirement to comply with federal and state securities laws, including, in Washington, a filing with the State Department of Financial Institutions.
- Distributions such as dividends and redemptions to exiting shareholders cannot legally be made if they render the company insolvent.
Real estate companies often are highly leveraged, and the owners may personally guaranty significant obligations. When the owners transfer ownership to their successors, thought should be given to whether the beneficiary of the guaranty will release the guarantors. For companies that rely on bonding companies to act as surety for their contractual obligations, the companies may be subject to capital retention agreements. Obviously a payout to an exiting owner redeeming his or her shares will impact the company’s net worth, so the expectations of the exiting owner should be consistent with the reality of the company’s net worth obligations. Similarly, lenders will generally demand the company comply with financial covenants in their loan agreements, which could be breached by a payout to an exiting shareholder.
For business owners, succession planning will impact and need to be coordinated with their estate planning – and vice versa. This includes determining how much income or value the owner needs from the business to provide for themselves and their family and ensuring the succession planning takes this into account, what methods for transferring ownership are available and most tax efficient, and providing for beneficiaries who are not involved in the business.
Transitioning ownership of any company, particularly real estate companies, has many moving parts, and a smooth transition requires thoughtful planning and effective execution. Both planning and execution stages can benefit from advice and discipline of experienced counselors.