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Preferred Stock Recapitalization

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Preferred Stock Recapitalization VOL. 1, ISSUE NO. 3 FEBRUARY 2000 Recapitalizing the Closely Held Business for Estate Planning by George B. Hawkins, ASA, CFA, Managing Director By exchanging a portion of one’s common stock holdings of Banister Financial, Inc. in Charlotte, North Carolina. for a newly created class of preferred stock, and then gifting the remaining common stock to offspring, the owner can fix “My company’s value is increasing faster than I can afford the value (with some exceptions noted later) held for future to gift to my children. What can I do to prevent a huge estate tax purposes. The children bear the benefit in the fu- estate tax liability?” Many professionals who consult ture growth of value of the common shares along with any closely held businesses frequently hear this concern. One individual future estate tax liability. Moreover, the preferred technique that can successfully address this dilemma is a stock might (in certain circumstances) possess voting rights. recapitalization, which was defined by the Supreme Court Thus, the older generation may still hold voting influence or as a “reshuffling of a capital structure within the frame- even control. This is obviously important if the next genera- work of an existing corporation.”1 Recapitalization is an tion is not sufficiently groomed to lead the company. important strategy for the estate-planning attorney, accoun- tant or business appraiser who advises clients on business Valuing Preferred Stock succession and estate planning. Although technically equity, nonconvertible preferred stock is really more like debt or a bond from a valuation standpoint. One specific type of recapitalization, the preferred stock However, it comes behind debt-holders in preference in a liq- recapitalization, is discussed here with special focus on the uidation. Preferred stock is valued similar to a bond or other resulting benefits, drawbacks and valuation issues. It is im- debt instruments. That is, the value is fundamentally the portant to note that a single misstep can spell tax disaster, present value of the future stream of payments (dividends in thwart the original goals and imperil the financial condi- the case of preferred stock, plus any redemption or liquida- tion of the company. Only the knowledgeable professional tion proceeds) to be received, with dividends discounted back can provide effective advice and use the technique to suc- to their current worth at a discount rate which reflects risk of cessfully accomplish the tax, financial and family succes- nonpayment and the time value of money. sion goals of clients. Valuing preferred stock can be quite complex. First, is the A client may faithfully follow professional advice and use the preferred stock cumulative or noncumulative (if the company personal exemption, along with continuing annual exclusion misses a dividend the holder does not recapture the lost ben- gifts to pass ownership to the next generation. Still, the busi- efit)? Does it have a liquidation preference, and if so, in what ness value can keep growing at a rate faster than it can be effec- amount? Does the issue have protections or triggers in the tively given away. The situation is critical if the client has lim- event the company takes actions, financial or otherwise, which ited personal liquidity to pay large gift taxes required on the could endanger the ability of the enterprise to meet continu- sizable gifts needed to outpace the growth in value. ing dividend payments, now or in the future? All of these factors affect risk and, therefore, the yield (dividends as a The “Preferred Stock Shuffle” percentage of the face value of the preferred issue) required. A preferred stock recapitalization, or “freeze,” can resolve the problem of increasing estate tax liability and shift future Fundamental Credit and Risk appreciation in company common equity value to heirs. Analysis Essential Straight preferred stock (not convertible into common stock), while legally representing equity in a company, is really much Other risks must be carefully and fully examined to arrive at like debt in that it does not benefit directly from continued the appropriate dividend yield necessary to value preferred stock. growth in company value. Most basic is an analysis of the financial condition of the com- Reproduced with permission from CCH Business Valuation Alert, published and copyrighted by CCH INCORPORATED, 2700 Lake Cook Road, Riverwoods, Illinois 60015. pany and its ability to meet existing debt service requirements fair market value. If the owner gets less in equivalent value and operating needs, along with the preferred dividend from its than he or she gives up, the IRS could construe the difference current and anticipated future cash resources. This involves a to be a gift. Also, excellent legal advice is required since the full credit analysis. Such analysis includes an examination of use of certain credit protection features, and other bells and liquidity (ability to meet current liabilities from liquid and near whistles to lower the required yield on the preferred could liquid assets), working capital, leverage (reliance on debt) and run afoul of IRS regulations on estate-planning freezes. asset utilization. Trends in earnings, cash flows and forecasted future results must also be examined. Also, the nature, terms If the recapitalization results in the owner still retaining and loan covenants of the debts in place must be reviewed. common shares which constitute a minority interest, it is How do they increase risk and affect cash flows? What secures possible that these shares might be valued for estate tax these obligations? If there is a default, what is the collateral purposes with discounts for both minority interest and lack coverage (at liquidation value of the assets) available to pay off of marketability. However, the applicability of these dis- creditors and still cover the preferred stock liquidation prefer- counts will depend on an examination of the entire trans- ence? Or, will there be a shortfall? action, the degree to which the preferred shares have vot- ing rights, if any, the resulting distribution of ownership, Beyond the numbers are a whole host of other risk factors both the impacts of the bylaws and shareholders’ agreements internal and external to the company that must be examined. Inter- and a host of other factors. nal risks might include key person issues, reliance on one or sev- eral key customers or suppliers, and access to credit, to name just Ideal Climate to Issue a few. External variables include an almost limitless array ranging Preferred Stock from the economy and the outlook for the industry, to government regulations, competitive threats and new technologies. In order to Since preferred stocks are valued much like debt, their value is value preferred stock the business valuator must undertake a full highly interest sensitive. That is why an environment of low examination of these and many other risk factors. interest rates is ideal for undertaking a recapitalization. The dividend yield set on the new issue might be lower than in other Recapitalization offers a potential reduction in personal economic periods since it is correlated to a significant degree risk. An advantage for the older owner is that by exchang- with interest rates, lowering the annual impact of the annual ing common for preferred, the individual may be able to cash flow needs of the company to meet the obligation. lower the risk of the high proportion of net worth they have tied up in the company. This may occur since the preferred “Fixed Value”—Or Is It? shares typically have a liquidation preference and will come It is not exactly true to say that the preferred stock has a fixed ahead of the company common shareholders in the event value that is immovable. Changes in three key factors—credit of a problem. Of course, this is not always true and will quality, the general level of interest rates, and trends in pre- depend on the degree of asset protection backing the liqui- ferred dividend yields—can change the value of the preferred dation preference, the post-recapitalization impact of the shares over time from that at the time of the recapitalization. dividend requirement on the financial condition of the busi- If credit quality improves, thus lowering risk, this may lower ness, the terms of the preferred stock issue, and a host of the yield a fair market value investor requires on such an is- other factors. sue, raising the value of the preferred stock with its already stated and fixed dividend rate. Conversely, a deterioration in Why Does Risk Affect the Value of company finances, the industry outlook, or negative changes Preferred Shares? in the management team, to name just a few, may have the opposite effect. Similarly, changes in the general levels of The higher the risk, the higher the yield an investor would interest rates and market returns also change the value, much require to buy the preferred shares of a company. Risk di- as they impact the value of bonds. rectly impacts value since the higher the yield required for risk, the lower the present value (in today’s dollars) of the Downside of a Recapitalization respective future income (dividends) streams to the buyer. If The first, and most obvious, disadvantage is giving up the the stated dividend rate on the issue is below a market rate, chance to share in the potential future growth in company the preferred stock will have a market value below its face value. Second, the company faces a continuing dividend amount. Conversely, if the rate is higher than the market, it requirement that may drain precious cash flows at a time will have a market value that is at a premium to its stated face when the company has more critical needs, such as a new amount.
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