Preparing for success: Navigating personal planning before a liquidity event
Entrepreneurs and startup founders often concentrate solely on their business ventures and neglect crucial aspects of their personal and financial well-being. This lack of preparation can lead to negative outcomes when it comes time for an exit event. To avoid these potential consequences, it’s important to consider the following key steps well ahead of time, ideally at least one to two years prior to a liquidity event.
Putting together the team
Young startup founders often don’t have much wealth and as a result, they tend to neglect the appointment of outside professionals to manage their personal financial affairs. However, this practice should change as their business grows in value. The first step is to find a reliable certified public accountant (CPA). Ensuring that tax returns are properly filed and tax elections are made on time is crucial. A trust and estates attorney should be next, to ensure that the founder has a comprehensive estate plan in case of any unforeseen events. The attorney can also assist with drafting documentation for gifts to family members and charitable organizations. Lastly, a startup founder should engage a qualified wealth manager to assist with financial planning, modeling early tax elections in conjunction with equity holdings. The best results are achieved when the outside advisors work together, utilizing their respective areas of expertise to make informed decisions.
Importance of financial planning
A comprehensive financial plan, crafted by a seasoned financial advisor, forms the backbone of personal planning for startup founders who are expecting a liquidity event. This plan starts by assessing the financial objectives of the founder. Once the goals have been established, the plan determines the founder’s cash flow requirements and thoroughly evaluates the feasibility of achieving these goals in the future.
While the founder is focused on preparing the business for the liquidity event, they may neglect the financial planning aspect. This is a misstep as the financial plan offers a preview of what the founder’s financial life may look like post-sale. It also allows them to test various scenarios and makes informed decisions. The same way a founder wouldn’t make a business decision without considering its impact on profits, the biggest financial decision of their life should not be made without considering the numbers provided by the financial plan.
The financial plan assesses various critical factors, including the following five key variables:
- Strategies for handling company assets prior to exit (options such as exercising and holding, exercising and selling, and 83(b) elections);
- Exit terms (price, earn-out provisions, rollover options, and tax implications);
- The timing of retirement and spending needs for a desired lifestyle;
- Investment portfolio diversification to reduce company stock concentration;
- Estate planning (including the transfer of assets before and after the sale, and charitable giving strategies).
The financial planning process enables the founder to calculate the necessary core capital, or assets needed for living expenses, with a high level of assurance even if the financial markets underperform in the future. Factors such as spending habits, time frame, and asset allocation will be taken into consideration. The more one spends, the longer the time frame, and the lower the allocation to return-generating assets, the higher their required core capital will be. Any assets beyond those required for the founder’s lifestyle can be designated as legacy capital and potentially preserved through wealth transfer methods that may minimize certain income and inheritance taxes.
Founders should consider organizing their financial life into three key strategies1:
• Liquidity—Ensuring short-term financial stability through effective liquidity management.
• Longevity— Securing your long-term financial well-being through strategic planning; and
• Legacy— Building a legacy for needs that go beyond your own.
The financial planning process, which may require multiple iterations as deal terms are fine-tuned, will generate the necessary information to support informed decision-making. Additionally, the financial plan will be closely aligned with the execution of an estate plan.
Basic estate planning
Many start-up founders often lack an estate plan. This can lead to unintended individuals inheriting their substantial paper wealth in the absence of a will. Furthermore, if the founder passes away, any assets over $12.92 million in 2023 (per individual, $25.84 million for a married couple) will be subject to a 40% federal estate tax, and potentially, an additional state estate tax in some states.2
What basic documents should the founder have in place?
Estate planning encompasses more than just making arrangements for after death. It may also encompass the efficient transfer of assets while one is still alive, designating financial authority during a period of incapacity, or granting permission for a specific medical procedure when death is imminent. Estate planning should be all-encompassing and tailored to the individual’s needs.
Will—A will is a legally binding document in which an individual appoints a personal representative to manage their probate estate, designates a guardian for their minor children, and specifies how their probate estate should be distributed. If an individual passes away without a will, they are considered to have died intestate, and the probate court will determine the caretaker of their minor children and the distribution of their assets based on state intestacy laws, which may not align with their wishes. Furthermore, a will can incorporate provisions that establish certain types of trusts, such as credit shelter trusts and marital trusts, upon the individual’s death.
Depending on the situation, trusts may offer several advantages such as reducing estate taxes, safeguarding assets, and granting more control over future distributions.
Revocable Living Trust—A revocable living trust is a legal document that serves as a substitute for a will. It is created by a grantor (also known as a trustor, settlor, or donor) who designates a trustee to manage the trust assets and specifies how the assets should be distributed upon their passing. Unlike a will, which must go through the probate court, a revocable living trust may allow an estate to bypass the probate process and its associated time and fees. Additionally, the probate process is public, so those who prefer privacy may opt for a revocable living trust as a more confidential option.
Durable financial power of attorney (DPOA)—In the event of an illness or incapacitation, having someone authorized to make financial decisions on your behalf is crucial. A financial durable power of attorney serves as the legal document that grants an attorney-in-fact the authority to act on non-trust assets.”
Medical directive—Advance medical directives are a way to plan for future medical treatment. They allow individuals to specify medical procedures they approve of or appoint someone to make decisions for them in the event of incapacity. These directives can include a living will, a health care power of attorney, and do not resuscitate (DNR) orders.
Health Insurance Portability and Accountability Act (HIPAA) Release—The HIPAA privacy rules were established to safeguard health information and a physician can use this form to communicate the details of the individual’s medical condition with an outside party without violating these rules.
In addition to the key estate planning documents, protecting a founder’s future earning potential, referred to as their human capital, is also important. Insurance is often used to transfer this risk from the individual or family to an insurance company.
Disability insurance provides coverage for unexpected illnesses or accidents and can offer stand-alone or supplemental coverage to what may be offered through employment.
Life insurance protects against unexpected death. Term life insurance is a cost-effective solution and may be purchased with different term lengths to provide more coverage in the early years and less as time goes on. It can also be used to satisfy buy-sell agreements among business partners and provide liquidity to the insured’s family in case of their death.
Permanent life insurance is typically used to cover potential estate taxes and is usually owned in irrevocable life insurance trusts (ILITs), which are trusts designed to hold life insurance policies and keep the death benefit out of the taxable estate.
In conclusion, it is clear that entrepreneurs and start-up founders must not only focus on the success of their business ventures, but also on their personal and financial well-being. Neglecting this aspect of their lives can lead to significant consequences during an exit event. By planning ahead and taking the necessary steps, they can ensure a smooth and successful transition, both for themselves and for their business. The key is to take a proactive approach and address these crucial elements well in advance, ideally at least one to two years prior to a liquidity event.
Steven Young is a Senior Vice President of Wealth Management for UBS Financial Services. He is the team lead for the Business Transition Consultants based in Indianapolis, IN.