Planning for Exits and Other Liquidity Events
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The following is excerpted from chapter 13 of Personal Financial Planning for Executives and Entrepreneurs, by Michael Nathanson et al. That book is available via the Amazon link on this page.
In turn, Abby now realized that her best choice might be to sell her company, leading her to have multiple consultations with attorneys and accountants (and more bills for her and David). It turns out that her now-realized vision of a digital advertising and marketing platform was quite attractive to other companies, some of which might be willing to offer considerable value for Slingshot. Unfortunately, Abby learned that planning for an eventual sale needs to begin well in advance of the sale. She learned, for example, that the after-tax value of her company was artificially lower than she expected because she had incorporated it and had failed to make an important tax election that one accountant called an “S election.” Her mistakes, coupled with the current market conditions, meant that a sale right now might not be the answer to David and Abby’s woes.
A successful entrepreneur can spend decades building and nurturing a business only to have much of its value unnecessarily evaporate because they didn’t plan appropriately for, or properly execute, an eventual liquidity event. That’s a pretty dire statement, and yet, the consequences of not planning for a liquidity event can be far-reaching, creating potential issues with meeting expenses and goals, financial independence, income and estate taxes, achieving peace of mind, and values realization. It follows that pre-liquidity-event planning, as well as eventual execution, must be thoughtful and comprehensive, incorporating each of the Five Pillars of Peace of Mind.
Before getting into the essentials of planning for liquidity events, let’s start by defining what a “liquidity event” might actually mean for an entrepreneur. Most obviously, it could mean a sale of all or a part of the business’s equity or assets in exchange for liquid consideration such as cash, equity in another private business, or marketable securities. The sale of Goliath was a liquidity event, albeit one that occurred under duress.
For a private company like Slingshot, a liquidity event could also include a public offering of its stock through which the owners are paid cash for their shares or acquire the ability to sell their shares in a public market. And it could include a sale of shares to private-equity investors, employees, or family members, with each type of transaction potentially yielding different consequences, valuations, and opportunities.
While this chapter is grounded in practical, technical advice for what to do prior to a transaction, we also want to state at the outset that it’s worth contemplating, and even “visioning,” life after the liquidity event – especially if the event represents an exit from being involved in the business.
An entrepreneur contemplating such an event should step back and ask themselves how they can plan to be as successful and fulfilled in the next stage of life as they have been running their business? How can they have the best chances of feeling a continued, strong sense of purpose, and maintain the best possible physical, mental, and relationships health, while also maximizing peace of mind and joy? These noble objectives require intentionality both before and after the big event. We advise entrepreneurs to be deliberate in the planning stage and thoughtfully consider how they will spend their time and energy once they no longer have their business on which to work. Even the most avid golfer or angler is not likely to maximize joy by engaging in these pursuits all day every day.
A life that includes a healthy dose of commitments to others, whether friends, family, charities, or alma maters, may in fact optimize peace of mind and joy more so than one that includes too much self-indulgence or isolation. Likely, a tailored and balanced combination of community focus and individualism could be ideal. We’ve come to learn that independence, the hallowed American ideal that many entrepreneurs work so hard to achieve, actually might not be as rewarding as interdependence. How to maintain a connectedness with others, after the executive team and employees are no longer part of the day-to-day routine, is worth pondering.
Timing: Planning in advance
In our experience, it’s never too early to begin planning for a future liquidity event, though, of course, the planning process will need to consider the best timing not only from the entrepreneur’s personal perspective, but also taking into account the state and direction of the industry, and the readiness and momentum of the business itself. Timing considerations should be focused on alignment of the company, industry, and owner “clocks,” to the extent possible.
As Abby learned, some planning has to happen sooner rather than later. The very decision-making behind legally organizing a business in the first place should account for the possibility of a future liquidity event. In this sense, the “choice of entity” may very well be the first act of liquidity-event planning, as, for example, C corporations often work well for future stock sales, institutional investments, tax-free reorganizations, and public offerings, while S corporations, limited liability companies, and other pass-through entities tend to work better for asset sales. Just the act of thinking about likely exit strategies when setting up a business can lead to better outcomes many years in the future when a liquidity event finally occurs.
At a minimum, effective planning for a liquidity event should begin no less than 18 months in advance of the event. Depending on the circumstances, some of the planning techniques described in this chapter may take even longer. Ideally, the planning process would start as many as five years in advance of the event, especially as it may relate to mitigating taxes and to addressing personal and family dynamics.
This is not to say that it’s ever too late to plan for a liquidity event – until it actually occurs of course! The important message here is more about utility and effectiveness: Planning will be more useful and effective if it happens well in advance of the liquidity event.
The deal team: Assembling a great advisory team
Now it’s time for a hard truth: Planning for liquidity events is usually a complex matter. The next few pages are going to be full of some common-sense concepts but also a number of complex and technical ones. Making matters more challenging, some of these concepts will be financial, and some will be legal. Some will address taxes, and some will involve estate planning and wealth transfer techniques. Some will be only about business, and some will focus on family and personal emotions.
Due to the requirement for interdisciplinary planning, after first having addressed timing, we should address the need to build a team of select advisors with expertise and experience specific to liquidity events. This professional team should be led and coordinated by a trusted advisor designated by the entrepreneur and charged with coordinating and overseeing the efforts of the team. The lead advisor should be chosen, at least in part, for their ability to view the liquidity event with a broad, objective perspective as to how it fits within the life and financial plans of the entrepreneur.
In some cases, the lead can be the entrepreneur’s financial advisor, who may be in a good position to see the liquidity event in the context of the entrepreneur’s broader goals, but the financial advisor often plays a supporting role instead. Other critical team members are the entrepreneur’s lawyers and accountants. In each case, however, these professionals must have great familiarity with the type of liquidity event being considered. A common mistake is to rely exclusively on the trusted lawyers and accountants that have regularly served the entrepreneur in the past, even though they may not have the expertise and experience necessary to guide the entrepreneur through a liquidity event. Planning for liquidity events requires specialization in certain practice areas. Therefore, it may be necessary to supplement the expertise of the entrepreneur’s current advisors with the insights, observations, and recommendations of others with deep expertise on a very specific subject, such as mergers and acquisitions.
On the business side, it is often advisable to engage an investment banker or valuation company to assist with matters of valuation and deal structure. These professionals may also be able to explore the universe of alternative buyers or investors and other liquidity options for the entrepreneur, possibly creating competition among potential suitors.
Other business-related advisors might include someone who can help consider the impact of a liquidity event on the underlying business itself. This person could be a third-party consultant, or it could be another trusted advisor such as an accountant who simply knows the business well. In either case, it is prudent to separately evaluate the potential impact of the liquidity event on the underlying business, removing the entrepreneur’s personal interests from consideration.
Finally, it might be helpful to include a family member or other personal advisor on the team. This person, often a financial advisor, accountant, or corporate attorney, can help with some of the personal elements, and even emotions, that a liquidity event can expose. Selling a business, for example, can trigger feelings that are best addressed by someone close to the entrepreneur – someone who can help the entrepreneur understand those feelings and make rational decisions in the right frame of mind.
The exact composition of the entrepreneur’s team should be personal to the entrepreneur, the business, and their circumstances. It should also reflect a sense of pragmatism, as advisors can be quite expensive. Their fees must be justified by their ability to provide valuable advice and by the magnitude of the transaction. That being said, reasonable fees should not be a barrier to assembling the right team. A well-structured, coordinated advisory team is essential for optimizing any substantial liquidity event.
A good team can help the entrepreneur get more and keep more, thereby leading to greater peace of mind and with it, greater joy and fulfillment. As an added bonus, much of the advice provided by the team may ultimately prove beneficial in improving the underlying business, even if a transaction never occurs.
Maximizing the rewards: Wealth building through liquidity events
As discussed at the beginning of this book, the rewards of being an executive or entrepreneur include the opportunity to receive substantial cash flow, benefits, and profits attributable to:
1. Performing services as an employee of their company; and
2. Equity ownership in the company.
But a liquidity event usually changes this dynamic – dramatically. When an entrepreneur sells some or all of their business, for example, they are typically selling a right to future cash flow in exchange for cash or other consideration, some of which is usually paid up front and some over time. While the entrepreneur may ultimately be better off economically after the sale, they often fail to plan for the impact on their current cash flow and benefits.
To illustrate this point, let’s go back to Abby and Slingshot. Slingshot’s technology platform ended up having substantial value, allowing Abby to sell Slingshot to a strategic buyer at an impressive price and at a time of great family need. Putting aside for now the tax and other issues associated with that sale, let’s assume that Abby successfully negotiated to sell Slingshot for millions of dollars, even though it was actually a break-even operation after paying Abby every year. Why would a buyer be willing to pay a high price for what was seemingly a break-even operation?
The answer to that question is that, while the past performance of Slingshot was relevant to projecting its future performance, the buyer assumed that it could improve Slingshot’s revenue and reduce its expenses. One such assumption involved Abby’s salary and benefits. Abby would be asked to stay on for one year to help with the post-sale transition at a relatively low salary level – far less than her current compensation – to serve in a part-time capacity. After one year, she would leave the company altogether, and thereafter, the company would be run by personnel already in place at the acquiring company. Before assessing the potential impact of the sale on Abby and David’s current cash flow, we also need to make some assumptions about the composition and timing of the sale proceeds. Let’s assume that half of the sale proceeds are being paid at closing, with some being paid in cash and some being paid in stock of the acquiring company. The remaining half will be paid as an “earn-out” over the next four years, provided that certain levels of revenue are achieved in each year.
This structure, which is not atypical, presents several basic cash-flow challenges for Abby and David. First, the deal proceeds will be taxable, as discussed in greater detail below. The couple, therefore, will need to set aside sufficient funds to pay the associated taxes when due. Second, because the value of the stock of the acquiring company will be included in the taxable amount, the after-tax cash proceeds will be disproportionately depleted to pay the taxes on the stock, as well as the cash, assuming that the stock cannot be liquidated immediately to pay the taxes. Third, because some of the proceeds will be paid on a contingent basis in the future, Abby and David will need to account for the fact that the receipt of those proceeds is not guaranteed. If Slingshot underperforms or the buyer runs into financial difficulties, they are unlikely to receive any additional proceeds. Remember that contingent payments promised by a buyer are nothing more than an unfunded debt obligation, assuming a lack of security or an escrow structure.
In turn, Abby and David will need a plan to make up for the cash that Abby was, but no longer will be, taking out of Slingshot by:
1. Reducing their expenses further (which is impractical, given their circumstances);
2. Drawing down the after-tax value of the cash proceeds; and/or
3. Living off the investment returns generated by the after-tax deal proceeds.
This type of exercise is integral to the general planning process for a liquidity event. In effect, it first comes down to projecting the value of the after-tax deal proceeds, the time of their receipt, and the likelihood of their receipt. It then involves an assessment of how the after-tax proceeds can be used to replace any current cash-flow lost through the transaction.
Making matters more complicated, if the entrepreneur is not going to remain a long-term employee of the company, as is the case with Abby, then an assessment must be undertaken to understand the potential loss of employee benefits and other reimbursable expenses such as automobile, boat, plane, and home-office expenses. This assessment must include a determination of how and whether they can be replaced efficiently from a pricing and tax perspective, which is often not the case.
Finally, the entrepreneur must assess the emotional and non-financial aspects not only of engaging in the sale but also of potentially changing or losing their job and, for some, even their standing within their family or community. Many entrepreneurs have worked for so long to build their company that they begin to tie their identities to their company and to their position. Effective planning for a liquidity event should consider these non-financial aspects of a potential transaction along with the financial aspects. Consider the case of Abby. She founded Slingshot, and her job leading it is the only position she’s ever had. Selling Slingshot under duress is emotional enough for her and David, but the personal impact of surrendering her job along with the sale should not be underestimated.
Achieving financial independence
Continuing the above discussion, we must now think not only about Abby and David’s annual cash flow but also about the long-term implications of selling Slingshot on their financial plan. This analysis is related but different. It involves a comparison of how, prior to the sale, Slingshot fit into the couple’s plans for achieving financial independence – our second pillar – and how, after the sale, the proceeds received from selling Slingshot will affect that analysis.
Conducting this exercise requires more than thinking about the annual cash-flow needs of Abby and David. In this exercise, we must assume that any expected drawdowns on the deal proceeds to pay taxes and support current living expenses will deplete the couple’s future savings and stress their ability to achieve financial independence. The exercise must also involve an analysis of the likelihood of receiving any contingent consideration and the future tax impact of the deal. In the case of Abby’s sale of Slingshot, it must even involve an analysis of the acquiring company’s stock, including its potential for future price appreciation, ability to produce dividends, and liquidity.
Of course, Abby will now be freed up to work again after she leaves Slingshot, and that, too, must be considered in an analysis of how the sale fits into the couple’s financial-independence plans. Note, however, that most sales by entrepreneurs involve substantial restrictive covenants on founders like Abby. These covenants can preclude competition for several years, making it difficult to replicate the pre-sale earnings of the entrepreneur until they expire, at least within the same line of business.
Planning for and minimizing taxes
Planning for and minimizing taxes is always important, and, as we have seen from our story, the consequences of not doing so can be dire. In the context of liquidity events, where large sums of money are often involved, a failure of tax planning can be catastrophic.
Making wise choices of entity
As we said at the beginning of this chapter, planning for liquidity associated with a company should start at the very beginning – when the company is first established. Most business entities are organized as a C corporation, an S corporation, a limited liability company, or a partnership. The choice – often referred to as “choice of entity” – can have important, long-term consequences from a tax and business perspective.
From a tax perspective, a C corporation is a corporate structure in which the entity is taxed separately from its owners (a.k.a. “shareholders”). Net income generated by a C corporation is taxed at the entity level at the prevail- ing corporate tax rate each year. A C corporation may distribute some or all of its after-tax net income to shareholders in the form of a dividend. To the extent that dividends are paid by a C corporation, shareholders are then taxed on the amount received. In this sense, C corporations are called “double-tax” vehicles because the income they earn is taxed at the entity level and then again when it is distributed to shareholders.
S corporations are corporations that have elected to have their income taxed only once, at the shareholder level, with a few potential exceptions. They are therefore referred to as pass-through entities because, from a tax perspective, their income is treated as passing through the entity to be taxed at the shareholder level. Importantly, there are restrictions on the types of corporations that can make an “S election.”
Limited liability companies and partnerships can usually elect to be taxed like C corporations, but they otherwise are taxed as pass-through entities, similar to the way S corporations are taxed. In some respects, however, they remain different from S corporations for tax purposes even when they are pass-through entities (unless they elect to be treated as an S corporation).
So why does any of this matter in terms of planning for a liquidity event?
For many reasons!
Many acquisitions are structured as asset purchases, where the buyer acquires the seller’s assets in exchange for cash and other consideration. Buyers often prefer to buy assets, and not the stock or other equity of a company, because they do not want to acquire the liabilities, including potential liabilities, that could come with buying the company’s ownership interests.
If a seller of assets is a C corporation, then the proceeds generally will be taxed twice – first when received by the company and then when they are distributed to shareholders as dividends. There are techniques available to mitigate this result, but the C corporation structure generally presents challenges to a company seeking to sell its assets.
In contrast, S corporations and limited liability companies that are taxed as pass-through entities are likely to offer more tax efficiency in the event of a future sale. Better yet, they usually can be converted into C corporations in the future if necessary, whereas converting an existing C corporation into a pass-through entity is generally expensive and inefficient.
Now, C corporations aren’t always a bad choice for companies expecting to be sold in the future. They can offer advantages too, but typically only when it’s reasonable to expect a stock sale and not an asset sale. In fact, as discussed in our chapter on income taxes, if a C corporation is a “qualified small business,” it may even be possible to sell the stock free of federal income taxes!
Indeed, it might even have been possible for Abby to set up two businesses – one for her consulting business and one for her technology platform. The consulting business could have been an S corporation, and the technology business could have been a C corporation that might have been eligible to be a qualified small business. (Consulting businesses generally cannot be qualified small businesses, but technology companies can be.) A little planning really would have helped.
We could write an entire book about the choice of entity, but the point here is that it’s an important part of liquidity planning, and it needs attention as soon as possible. Consider Abby’s potential sale of Slingshot. Because she failed to make an S election, she would likely be forced to pay taxes twice on an asset sale – once at the corporate level and once when the after-tax proceeds were distributed to her.
Managing equity incentives
As the founder of Slingshot, Abby didn’t have to worry about the intricacies of managing stock options or restricted stock in advance of potentially selling Slingshot. Yet, let’s shift our attention now to an executive like David who has been granted equity incentives but who, unlike David, might be carefully planning for a potential sale of shares or IPO.
Corporate executives can do some simple but highly effective planning for liquidity events by properly managing their equity incentives to convert as much ordinary income as possible into capital gain. By exercising options in advance of a liquidity event and while the value of the underlying shares is lower, there is an opportunity to convert future appreciation into capital gain. As previously discussed, in the case of non-qualified stock options, the executive will recognize ordinary compensation income on the difference between the value at the time of exercise and the option price. If the executive can then hold the shares for more than one year after exercise, all of the future appreciation will be eligible for capital gain treatment upon sale.
With incentive stock options, the opportunity is even more interesting. While the exercise of ISOs does trigger potential AMT exposure, there is otherwise no income tax liability at the time of exercise. Better yet, if the shares received upon exercise are held for at least two years from the grant date and one year from the exercise date before selling them, then all of the gain will be taxable as capital gain.
Restricted stock also offers opportunities for liquidity-event planning. By making a Section 83(b) election within 30 days of grant, ordinary compensation income is immediately recognized equal to the value of the stock less any purchase price paid, but all future appreciation on the shares is eligible for capital gain treatment.
Sounds good, right? Of course it does, but just remember that liquidity events don’t always happen as planned, and stock prices sometimes go down rather than up. This was the lesson that David learned when he made his Section 83(b) election. What this means is simply that managing equity incentives to maximize the after-tax value of a liquidity event requires strategy, foresight, and, in some cases, a measured approach.
Accelerating charitable contributions and perpetuating family values through philanthropy
For entrepreneurs and corporate shareholders, a liquidity event can offer a unique opportunity to “pre-fund” a long-term charitable giving objective while simultaneously creating a valuable income tax deduction. If so inclined, an owner could donate long-term, highly appreciated shares before there is a binding commitment to effect the liquidity event. When this technique works, it not only generates an income tax deduction equal to the fair market value of the stock on the date of contribution but also avoids any need to pay capital gain taxes on the appreciation in the shares.
Donor-advised funds or foundations work well if the donor is looking to accumulate a pool of dedicated funds in order to fund charitable gifts over a multiyear period. As discussed elsewhere in this book, donor-advised funds are organized as charities, so, subject to the limitations discussed in our chapters on taxation and philanthropy, the full value of the contribution may be claimed as a tax deduction in the year of contribution, which, presumably, is also the year of the liquidity event. Certain charitable trusts, discussed in our chapter on estate planning, may also be an option. If the charitable objective is paramount and if immediacy is critical, it might also be possible to donate shares directly to charitable entities in the year of the liquidity event.
There is, however, one major caveat to this technique. If the shares are donated after there is a legally binding requirement to execute the liquidity event, then the IRS can take the position that the appreciation in the shares is taxable to the donor. In taking this position, the IRS would rely on the well-established tax doctrine that taxpayers cannot “assign” their taxable income to others, including charities.
Keep in mind that, of course, philanthropy is about much more than obtaining tax benefits. Most importantly, it’s about supporting important causes and, by doing so, also perpetuating the donor’s personal mission and values. In this sense, a liquidity event offers a great opportunity to unite a family while also making meaningful contributions to others.
Mitigating state and local taxes
We don’t recommend making life decisions based solely on tax strategy. With that important disclaimer out of the way, there are many states and localities that do not impose taxes on capital gain and other income. Entrepreneurs and executives who are living in higher-tax jurisdictions and who are willing to move to no-tax or lower-tax states may be able to do so sufficiently in advance of a liquidity event to escape taxation by their original states of residence. Just remember, however, that state departments of revenue and taxation can and often do audit former resident taxpayers who move out of state, especially if they continue to maintain some level of presence in-state. Many states have a presumption that someone is a resident of the state if they are there for a majority of the year. Also, many states have specific income-sourcing rules that can effectively “claw-back” income for tax purposes even if the taxpayer legitimately moved to another state years earlier. These rules are particularly important for executives who receive equity incentive awards that are subject to multiyear vesting schedules. Finally, just because an entrepreneur or executive moves to a different state, it doesn’t necessarily follow that the business moves as well. Depending upon the nature of the business, a liquidity event could very well trigger taxation in multiple non-resident states.
Mitigating estate and gift taxes
We already have described a wide variety of techniques to transfer value to family members and charities in a manner designed to reduce estate and gift taxes. In planning for liquidity events, these techniques often take center stage given expectations for greater and more liquid wealth. Among the long list of available techniques are the following:
- Gifting shares at discounted, pre-liquidity values to family members either directly or through entities such as family limited liability companies or limited partnerships
- Gifting shares to grantor trusts at pre-liquidity values
- Selling shares to grantor trusts at pre-liquidity values for an installment note
- Transferring shares to GRATs at pre-liquidity values
- Transferring shares to long-term “dynasty” trusts at pre-liquidity values
- Transferring shares to charitable trusts or foundations
Planning for Others
Along with all of the financially-focused planning around liquidity events, entrepreneurs must also think about the potential impact of a liquidity event on three important constituencies: their family, their employees (some of whom may also be family members), and their communities. While the preceding section focuses primarily on minimizing taxes, many of the techniques it describes assume some desire on the part of the entrepreneur to share their newfound liquidity with family members or charitable organizations. And they can be quite effective in accomplishing this result.
But what about employees? Planning for a liquidity event may require planning for them too. Some buyers and investors will want to improve profitability by reducing headcount. In turn, entrepreneurs must consider whether they want to take steps to protect employees, potentially at their expense. Many buyers and investors will be receptive to such steps, particularly if they come with economic concessions from the entrepreneur.
Planning for employees can also include a consideration of employees as potential participants in the liquidity event itself. Substantial events may lead some entrepreneurs to consider special bonuses for employees who helped them build the company over time. These bonuses should be specifically structured to be tax deductible, preferably for the benefit of the entrepreneur if possible. Granting equity or equity-like interests to employees in advance of a liquidity event is another effective tool for sharing the wealth with valued employees, though, to be most effective, these grants should occur well in advance of the transaction.
Involving employees can also take the form of them being considered as buyers or investors in the company. In many cases, this is not a practical exercise, as they lack the means to be buyers or investors. Nevertheless, it sometimes is possible for employees to line up financing. It may also be possible to utilize structures such as employee stock ownership plans (“ESOPs”) to offer liquidity to the entrepreneur. ESOPs enable private companies to make contributions into tax-deferred stock ownership plans for their employees. They can be used to purchase shares from existing owners, sometimes in a tax- advantaged manner, and can even borrow funds to do so. They offer substantial, albeit different, tax advantages with respect to C corporations and S corporations, but they are regulated as retirement plans under ERISA and are subject to many legal requirements, including broad employee participation subject to vesting.
Managing risk – the fifth pillar – is also part of planning for a liquidity event. In most cases, it largely involves revisiting the entrepreneur’s financial plan and adjusting it accordingly to account for the projected increase in liquidity within the entrepreneur’s holdings.
Of course, while that may sound simple, it often isn’t. At a minimum, it likely requires a comprehensive insurance review given the dramatic change of circumstances. With greater liquidity, for example, life, disability, and long- term-care insurance policies should be reviewed and reevaluated to determine whether they remain appropriate. Business insurance may ultimately become obsolete if the business is sold, but tail-risk insurance, described below, may now become necessary. Property and casualty insurance, including excess liability or umbrella policies, should be revisited, as should health, dental, and other insurance coverages that may no longer be provided as an employee benefit.
Yet, beyond the obvious, there are several more obscure considerations that arise specifically around certain types of liquidity events. Many such transactions, including sales and third-party investments, typically require the company and its shareholders to make legal representations and warranties to the buyers or investors and, in some cases, indemnify the buyers or investors for any material breaches. In these cases, entrepreneurs who are experiencing liquidity events obviously need to be careful that they are not in breach of their representations or warranties (e.g., their financials are accurate). Less obviously, they need to be mindful of reserving some of their proceeds in conservative, liquid investments in the event that they are called upon to return any of the purchase price.
Some advisors might suggest a different line of thinking – that the entrepreneurs should consider stashing away their deal proceeds so that damaged buyers or investors cannot reach them in the event of a breach. We are not proponents of that kind of thinking, as we believe it raises ethical concerns, but we are proponents of considering techniques to protect newfound liquid wealth from unscrupulous claimants, estranged family members, and others who may see this wealth as a potential target. Elsewhere in this book, we have discussed in detail the use of insurance, trusts, and other structures for this purpose, which are worth reconsidering in the context of a planned liquidity event.
Another way to mitigate the risk of buyers or sellers coming back to an entrepreneur to recover consideration for breaches of representations and warranties is to ensure that the company’s insurance coverage for potentially damaging claims and events is adequate and continuous. Buyers and investors have less to complain about when something goes wrong but is covered by a good insurance policy. In the event that a company policy is not continued after the event and cannot be relied upon retroactively, then it may be necessary for a careful entrepreneur to seek a “tail-risk” policy, which effectively extends the coverage period for an older policy.
Putting it all together
Planning for a liquidity event or exit is a multifaceted endeavor that is ideally performed over a multiyear period. It can even be quite enjoyable and rewarding. If exiting, the entrepreneur can be well-served by planning ahead to be as successful in the next stage of life as they have been while running the business. Assembling the right deal team can result in a better outcome. Cash-flow planning considerations, both nearand long-term, are paramount, and there exist a multitude of tax-mitigation opportunities, especially if one plans in advance. Liquidity events also present opportunities to unite families through philanthropy and other avenues. As in other phases of the business-building cycle, risks exist in this stage that should be carefully mitigated through insurance, legal considerations, and planning. With careful forethought, the right deal team, and smart decision-making, more favorable outcomes than David and Abby’s can be achieved.
Michael Nathanson is the chair and chief executive officer of The Colony Group, a Boston-based Registered Investment Advisor.
1. For some family businesses, we could be talking about generations instead of decades.
2. Note that, in this chapter, we use the term “entrepreneur” instead of “executive.” We discuss the difference in the Introduction to this book, where we also state our intention to use the term “corporate executive” to include both. Liquidity events can happen for both executives and entrepreneurs, but they are a more central focus for entrepreneurs, justifying a change in convention for this chapter.
 For greater depth on this topic, see David Brooks, The Second Mountain: The Quest for a Moral Life (New York: Random House, 2019).
 In Marshall Rowe, Jim Fitts, and John Weeks, Your Next Adventure: Planning for Life After the Sale of Your Business (Lioncrest Publishing, 2019), the authors suggest an approach in which multiple “clocks” need to be considered.
 See I.R.C. § 368.
 See Marshall Rowe, Jim Fitts, and John Weeks, Your Next Adventure: Planning for Life After the Sale of Your Business (Lioncrest Publishing, 2019), in which the authors argue for a “T minus 5 timeline.” They note that T minus 5 is based on the Bigelow Company’s concept of “The Life Arc of an Entrepreneur Owner-Manager” where transaction preparation steps begin several years before any sale. See www.bigelowllc.com.
 Actually, there is even some opportunity for planning after the event. For a discussion, please see Nathanson, Stelljes, and Lee, “Post-Liquidity Events: Planning for Optimized Results,” Financial Advisor, June 30, 2016.
 For an excellent discussion of assembling a liquidity-event planning team, see Marshall Rowe, Jim Fitts, and John Weeks, Your Next Adventure: Planning for Life After the Sale of Your Business (Lioncrest Publishing, 2019).
 Some entrepreneurs might actually welcome the idea of working for others after spending many years bearing all the risks and making all the decisions themselves. Still others must ask themselves if they are even qualified or capable of working for someone else. Every case is different, and every entrepreneur is different.
 The analysis will differ for a “serial entrepreneur” who may be able to generate cash flow from another business.
 The terms “C corporation” and “S corporation” come from the subchapters of the Internal Revenue Code under which these entities and their owners are taxed – Subchapter C and Subchapter S of Chap. 1 of Subtitle A of the Internal Revenue Code. The terms are actually defined in § 1361(a) of the Code.
 See I.R.C. §§ 11, 301, and 316.
 See I.R.C. §§ 1361–1368.
 See I.R.C. § 1361.
 See Treas. Reg. §§ 301.7701–1, 2, and 3.
 There are a number of important distinctions, including with respect to employment taxes, and a thorough choice-of-entity analysis would address considerations beyond the implications for potential liquidity events.
 C corporations often try to convert distributions to shareholders into deductible expenses such as compensation, but there are limits on the effectiveness of these techniques.
 Care must be taken when converting a limited liability company into a corporation, as adverse tax consequences can be triggered.
 See I.R.C. § 1202.
 See I.R.C. § 83.
 See I.R.C. §§ 421 and 422.
 See I.R.C. § 83(b).