Business Succession for Real Estate Companies

by Schwabe, Williamson & Wyatt PC
Contact

Schwabe, Williamson & Wyatt PC

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 we see many owners fail, usually because the urgency of day to day operations crowds 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.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Schwabe, Williamson & Wyatt PC | Attorney Advertising

Written by:

Schwabe, Williamson & Wyatt PC
Contact
more
less

Schwabe, Williamson & Wyatt PC on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.