Drawing on founder's liquidity: how to help clients take cash out of their companies--on their terms.

• Author: Trustey, Joseph F.

Sooner or later, your small private business clients will face the difficult decision of how to turn those years of sweat equity into cash. They will likely approach you, as their CPA, for advice and guidance. Once you know the hows and whys of founder's liquidity, you can help them make the right decisions, thereby expanding your role as a trusted adviser.

Founders of successful, later-stage businesses can use one of several ways to take a portion or all of their money out of the company. However, some options--including going public or completing a strategic sale--may require owners to step down before they are ready to turn over the reins or may, alternatively, require them to stay with the company for longer than they would like. Another solution, bank debt, can provide them with instant cash but not without exposing them to new financial obligations.

Armed with the right information, you can help your clients understand both the advantages and disadvantages of these common liquidity options and present them with the alternative of private equity. Often overlooked, private equity can provide substantial liquidity for founders while leaving them in control. Moreover, it enables them to grow the business toward a final liquidity event down the road that will deliver an additional substantial return on all those years of hard work and commitment.

Why clients need founder's liquidity

There are many reasons why you or your client may broach the subject of liquidity. For example, you may recommend it in order to take advantage of the Jobs and Growth Tax Relief and Reconciliation Act of 2003, which reduces the long-term capital gains tax from 20% to 15% until the end of 2008. Entrepreneurs who sell a small portion of their businesses for cash--and then achieve an initial public offering (IPO) or strategic sale later--have the chance to benefit twice from this lower tax rate.

Another important reason for liquidity is wealth diversification. Many owners have a disproportionate amount of personal wealth tied up in their company. Turning some of that equity into cash and then spreading it across multiple investments reduces their exposure to economic fluctuations. It also enables them to take disciplined risks that are critical for growing their business without sacrificing personal wealth.

In addition, your client may seek liquidity to purchase a second home, add to an art collection, or begin to enjoy extended travel. The decision to take cash...