CSP Financial & Risk Assessment in Succession 2 — Questions and Answers
Question 1: A business owner wants to transfer ownership to a key employee but lacks funds for a lump-sum purchase. Which financing structure best addresses this?
- Leveraged buyout financed by the business's own cash flow (Correct answer)
- Immediate asset liquidation to fund the purchase price
- Personal loan from the owner to the buyer at market rate
- Third-party private equity injection with majority control
Correct answer: Leveraged buyout financed by the business's own cash flow
A leveraged buyout (LBO) uses the company's future cash flow to service acquisition debt, enabling the buyer to fund the purchase without a large upfront payment.
Question 2: Which financial ratio is most critical when assessing a succession candidate company's ability to service acquisition debt?
- Price-to-earnings ratio
- Debt service coverage ratio (DSCR) (Correct answer)
- Current ratio
- Return on equity (ROE)
Correct answer: Debt service coverage ratio (DSCR)
The DSCR measures whether operating income is sufficient to cover principal and interest payments, making it the key metric for debt serviceability in succession financing.
Question 3: In a cross-purchase buy-sell agreement, how many life insurance policies are required for four co-owners?
- 4
- 8
- 12 (Correct answer)
- 16
Correct answer: 12
Each of the four owners must insure each of the other three owners, resulting in 4 × 3 = 12 policies in a cross-purchase arrangement.
Question 4: A family business valuation reveals a 'key person discount.' What does this adjustment reflect?
- The premium paid for a controlling ownership interest
- Reduced value because the business depends heavily on one individual (Correct answer)
- Tax savings from S-corporation status
- Increased value from proprietary intellectual property
Correct answer: Reduced value because the business depends heavily on one individual
A key person discount reduces the business value to reflect the risk that critical knowledge, relationships, or skills are concentrated in a single individual who may not remain with the business.
Question 5: Which succession risk is MOST directly mitigated by maintaining a funded deferred compensation plan for successor candidates?
- Market valuation risk
- Retention risk of high-potential successors (Correct answer)
- Environmental liability risk
- Regulatory compliance risk
Correct answer: Retention risk of high-potential successors
A funded deferred compensation plan creates a financial incentive for key successors to remain with the organization through the succession transition.
Question 6: An S-corporation's built-in gains (BIG) tax applies when the company converts from C-corp status and then sells appreciated assets within how many years?
- 3 years
- 5 years (Correct answer)
- 7 years
- 10 years
Correct answer: 5 years
Under current tax law, appreciated assets sold within 5 years of an S-corporation election trigger the built-in gains tax at the highest corporate rate on the pre-conversion gain.
Question 7: A succession planner recommends a 'wait-and-see' buy-sell agreement. What is the primary financial advantage of this structure?
- It eliminates the need for business valuation entirely
- It allows flexibility to choose between entity and cross-purchase taxation at the triggering event (Correct answer)
- It guarantees a fixed sale price regardless of market conditions
- It transfers ownership tax-free through a grantor trust
Correct answer: It allows flexibility to choose between entity and cross-purchase taxation at the triggering event
A wait-and-see agreement defers the choice between entity redemption and cross-purchase until the triggering event, allowing parties to select the most tax-efficient option at that time.
CSP Financial & Risk Assessment in Succession 2
A business owner wants to transfer ownership to a key employee but lacks funds for a lump-sum purchase.
Which financing structure best addresses this?