- REP Management™

Retirement andExit Planning Management

1. Retirement/Phase down Timeline of Owner

2. Valuation

3. Sale to Outside or Inside 4. Tax Structure of Retirement and Exit Plan

5. Annual Payout Flexibility-Line Loss

6. Life/Disability Insurance Funding

• Value in your agency is created, maintained and transferred by your succession plan

• Value for a Rep Agnecy is different than value for your principals.

• 30 day contracts, principal mergers, controlling factors from Sysco decreasing commission rates, increased responsibilities!

• BUT……

• There is true value to your agency….CASH FLOW.

• Establishing a value is a crucial step in developing your succession plan

• Cash Flow is generated by having a Succession Plan.

- Value

What is Value in a Closely Held Business? • The technical definition for value is as follows:

•Revenue Ruling 59-60 (Valuing Closely Held Stock) defines fair market value as the price at which a property would transact between a willing buyer and seller, neither compulsed, and both reasonably informed, able and willing to trade. Fair market value is hypothetical, assuming a perfect market and:Hypothetical, not specific actual, willing buyers and sellers with identical alternatives: owning this or similar interests based on analyses of relevant factors, risks and returns.Arms-length transactions between parties with opposite interests for market-based consideration. Parties wanting artificially high / low prices fail this test. Transactions forced by agreements, bankruptcy or coercion due to regulatory / legal changes, deadlines, obsolescence, alternative investments or charity may not reflect fair market value. Neither may incomplete transactions such as unaccepted offers or unexercised options.

1. The nature and history of the business:

•Revenue Ruling 59-60 requires consideration of these factors, which we analyzed as follows:

2. The economic outlook and the condition and outlook of the industry: Long-term projections envision slow growth, low inflation, gradually rising interest rates and few major risks. The industry is stable, fragmented and consolidating. 3. Book value

4. Financial condition

5. Earning capacity: Cash flow to equity, the annual change in cash before dividends. It adjusts profits for non-cash items, capital outlays, asset purchases / sales, and changes in working capital, debt and other liabilities.

7. Whether the enterprise has goodwill or intangible value

8.Past sales of interests

9. Market prices of interests in entities engaged in the same or a similar line of business having their interests actively traded in a free and open market, either on an exchange or over-the-counter

6. Dividend-paying capacity

- Value

What is Value in a Rep Agency?......

The ability to produce and sustain consistent cash flow

Type and Situations Needed for establishing value

2. Stock Transfer to Key people

3. Key Employee Management Buyout

4. Another Rep Agency Buyout

5. ESOP

1. Buy Sell Agreements

Cash Flow/Income Approach for Rep Agencies

1. Annual Gross Commission:

• This is the base for determining the value. The starting point is 1 times annual gross commission

• The industry formula indicates that the gross commission factor is divided between two sets of agencies:

• < $3,000,000 (.8-1 times annual gross commission)• > $3,000,000 (.5-.8 times annual gross commission) 2. Line Concentration and Stability

• If your agency has 80% of its commission from 1 line than the factor would be adjusted below 1 times

- Value

3. Management Team

• Since your value is only as good as the people behind you, your management team ie succession plan factors into the value of your agency

4. Assets and Liabilities

• Most agencies are light on assets but this balance sheet item is added to the overall value.

5. Number of Payout Years

• This act almost like an interest factor

- Value

6. Reconciliation with Cash Flow

• After we have determined the value and factor than we adjust this value based upon the cash flow ability to make the annual payments.

• This cash flow reconciliation is the most important factor.• The bottom line is: if the company cannot afford to make the cash flow payments the value is undermined.• 90% of the buyout of value will occur through cash flow.

• We must also take into consideration additional cash flow requirements such as new hires to replace the owner.

- Value

6. Reconciliation with Cash Flow Cont’dExample #1:

Facts:

• The value of $3,000,000 is not sustainable because the company could not make the payments to the seller

• The reconciliation of cash flow should be around the cash flow that could make payment times 7. In this case it would be fair that the value would be around $2,250,000.

Valuation before reconciliation: $3,000,000Owners Salary and T&E: $ 300,000

Owner will completely retire

Payments Over 7 yrs: $ 428,571

Annual Gross Commission; $4,000,000

- Value

6. Reconciliation with Cash Flow Cont’d

Example #2:

Facts:

• The value of $3,000,000 is sustainable because the companycan make the payments to the seller

Annual Gross Commission: $4,000,000Valuation before reconciliation: $3,000,000Owners Salary and T&E: $ 500,000Payments Over 7 yrs: $ 428,571Owner will retire

- Value

- Tax Structure

• Many Buy Sell Agreements are structured as a sale of stock.

• When an owner retires, becomes disabled or is acquired in a stock sale the annual payments are non-deductible.

• We will use an example of $4,000,000 of value.

• The total cost to fund the disability buyout or retirement of $4,000,000 would be $8,100,000 or $810,000/yr. In other words the company would have to generate $810,000 of income pay taxes on it and have the $543,000 needed to make the payment..

• What would happen if the owner would become disabled or retired? The company would have to purchase his stock over 10 yrs at 6%.

• The Exiting owner would pay capital gains tax on the stock portion and income tax on the interest. He will net just over $4,000,000.

2. REP Buy Sell (Retirement and Exit Plan Buy Sell)

• Over 95% of buy sell agreements are stock sales. At death, disability or retirement the stock of the company will either be redeemed by the company or purchased by the other owner(s). • This is extremely tax inefficient. Example:

$1,000,000 value paid over 10 yrs at 6% interest at death, disability,

Retirement. Every dollar of stock sale is non-deductible to company.

Agency has to earn grossed up amount of commission pay taxes on it

and than have the after tax amount.

• All of $1,000,000 of principal is non-deductible in S Corp at 40% the true cost of principal alone is $1,666,666 and seller nets $800,000 after tax (15% federal 5% state).

• The goal of the REP Buy Sell is to net the seller the same $800,000 but reduce the cost to agency by converting a portion of the buyout to be deductible.

- Convert Taxable Income

2. REP Buy Sell (Retirement and Exit Plan Buy Sell)

• Book value stock sale and deferred compensation plan.

$100,000 book value stock sale and $1,200,000 deferred compensation plan. Example:

Total cost of the plan would be $1,366,000 ($100,000 non-deductible and

$1,200,000 deductible). Seller would net same $800,000 but agency would save

$300,000 or 18%!• In the case example of $4,000,000, the plan to convert the stock sale to deferred compensation will save the company $2,000,000.

• Book Value stock allows you to transition sweat equity stock at little or no tax cost.• Typical Objections from accountants.

- REP Buy Sell²

• Combination of Rep Buy Sell (Book value and deferred compensation plan and cash balance defined benefit plan.

• Company has to buy owner in 5 yrs for $1,000,000. Company has 4 owners and around $200,000 of k-1 at end of year total or $50,000 each. Each owner would net around $30,000 after taxes. Current plan will cost company $1,666,666 to pay for stock in 5 yrs at today’s price.

• REP Buy Sell to make stock sale into Book Value and Deferred Compensation will save around $666,000.

• Shelter the $200,000 of k-1 from taxes and save them $80,000/yr in taxes. We put $200,000 into cash balance defined benefit plan and exiting owner receives around $180,000 of total deposit tax deferred next 5 yrs. That is an increase of $150,000per year over existing plan. We credit that $150,000against deferred compensation. That means that$750,000 of DC will be pre-paid and we used tax savings of $400,000 to help pay for it. $250,000 left tobe paid. Saves $1,066,000 total on buyout.

- Convert Taxable Income

Personal Goodwill Sale

• The benefit to an asset sale which is technically corporate goodwill is that the buyer can amortize over 15 yrs. The seller will be taxed at ordinary not capital gains rates.

• The personal goodwill concept is taken from the “Martin Ice Cream” Case. The case argued that the asset/goodwill the owner was selling was not attributable to corporate goodwill but personal goodwill. • Personal goodwill allows the seller to pay capital gains tax and the buyer to amortize over 15 yrs.

RetentionIncentive andSuccession ofKey Person Management

- RISK Management

• REP management planning applies when you have successors in place or are being bought out.

• RISK management planning applies when you do not have key successors in place but have key people who you need to retain. Your value of your agency is only as good as the key people behind you.

• RISK management is key because future buyouts will occur through cash flow and without key people you can’t produce cash flow. If another agency wants to buy you than they need to know the key people will stay.

Steps in Planning

- RISK Management

1. Identify Key Personnel to retain.

2. Interview them to establish their goals and objectives.

3. Establish Incentive Award dollars/stock Compensation in addition to regular compensation.

Guaranteed amountGuaranteed Base plus Incentive based upon gross sales/commission

4. Incentive Award to be all bonused, half deferred or all deferred.

5. Establish vesting schedule (retention) on the deferred amount.

6. Determine how to fund. Mutual Funds or Life Ins.

Stock

Stock Options

Phantom Stock

Non-Qualified Informally Funded PlansSection 83 PlanSection 79 Plan

Please consult your tax advisor before implementing any of the discussed strategies.