The Entrepreneur’s Trust

Successful wealth creators whose wealth is derived from taking on risk and building concentrations in private businesses often wish for their descendants to have similar opportunities. They view  entrepreneurial careers as potentially leading to greater personal satisfaction, as well as greater personal wealth, for their descendants, and hope to inspire and facilitate such careers. At the same time, they fear that sharing their financial success too freely with their beneficiaries will have a negative impact on the recipients’ motivation to work as hard as the wealth creator did to forge their own, joyful path.

When it comes to making decisions around wealth transfer, it’s this fear that often causes the wealth creators to implement estate plans that don’t necessarily support their intent. Rather, they use trusts that are often opaque structures designed to shield their beneficiaries from decision making. The grantor may even go as far as asking the trustee to keep the trust “silent” for as long as possible so that the grantor can delay or avoid altogether having fundamental conversations with the trust’s beneficiaries around the “why” behind the plan. Sometimes the grantor addresses the wish for the beneficiary in these documents, but it often comes with strings attached, such as tying distributions to the beneficiary’s earned income or other desired behaviors.   

Moreover, wealthy children may grow into adulthood relying on a family office or trustee to do everything for them. Consequently, they may miss out on the opportunity to see how the bills get paid and the tax returns get filed or to better understand the cash flow that their wealth will generate. This type of planning has the potential to infantilize rather than empower and inspire beneficiaries, creating a generation of “perpetual children” who are ill equipped to become responsible and engaged stewards of their family’s wealth and business holdings.

Encouraging Involvement

Rather than viewing trusts as a mechanism to protect the beneficiaries from the dangers of wealth, what if trusts were viewed as supporting structures that complement the grantor’s desire to “ignite a fire” with the next generation, that is, a trust that’s designed to cultivate a spirit of entrepreneurship by positioning beneficiaries as active rather than passive recipients of their inheritance?

There are various strategies to encourage beneficiary involvement, including appointing the beneficiary to serve as a co-trustee or a member of the trust’s investment committee. The beneficiary may even be allowed to serve as sole trustee on turning a certain age or achieving financial independence. Or beneficiaries may be permitted to withdraw a certain amount of money from the trust on attaining a specified age before gaining access to the entire corpus. This type of planning provides beneficiaries with the opportunity to practice making decisions with smaller pools of money prior to being tasked with making bigger decisions over larger ones.

These solutions have advantages and, with good communication around the grantor’s “why,” can go a long way to fostering active participation. However, each option has drawbacks. First, giving outright distributions forgoes the trust’s asset protection benefits and provides few guardrails for success. Second, to avoid estate inclusion, a beneficiary who’s also a trustee is typically subject to a restrictive distribution standard, requiring distributions to be limited to a “health, maintenance, education and support” standard rather than a more flexible “best interest” standard that would allow for distributions that would support calculated risk taking. Finally, while serving on an investment committee can be informative and gives the beneficiary a vote, it does little to promote entrepreneurial risk-taking. Is there a solution that would go further towards instilling an entrepreneurial mindset in beneficiaries while providing them with the tools they need to succeed over the long term?

We’ve recently seen families use a concept that we now refer to as “the entrepreneur’s trust.” This type of trust structure is an elegant solution in which the grantor reflects on the “why” behind their intent and creates a trust with language that encourages beneficiary involvement, financial education and even collaboration on new investments into private businesses under the guidance and diligence of a professional trustee.

Key Features

Some of the key features of this type of trust include:

• The trust instrument specifically states the “why” as a material purpose of the trust—for example, the grantor’s belief that private businesses can be better vehicles to create and preserve wealth (over or balanced with passive investments) and offer practical training and a sense of accomplishment beyond a financial legacy. This provides guidance to both the trustee and the beneficiary.
• The trust agreement authorizes the trustee, in such trustee’s absolute discretion, to invest trust assets in one or more “entrepreneurial investments,” particularly if the beneficiary will be actively involved in the business, even if such business is new, untried or speculative. The trust allows the trustee to consider the beneficiary’s career, learnings and non-monetary rewards and accomplishments when making an investment decision.
• For each investment proposed by a beneficiary, the beneficiary is required to present a business plan to the trustee, estimated return on invested capital, information on advisors and co-investors and how the investment fits into the beneficiary’s overall investment objectives. The trustee is encouraged to hire outside advisors, at the expense of the trust, to evaluate the proposed investment.
• If the trust invests in a new business, the business will be held to the same standard of accountability (for example, conservative leverage and acquisition criteria) as existing family businesses held by the trust, if any.
• The trust may stipulate that certain industries (for example, gambling) are prohibited investments.
• The grantor’s advisors work with the trustee to ensure that the grantor carefully, and very specifically, waives the Uniform Prudent Investor Rule, the duty to diversify and the duty of impartiality with respect to private investments.
• The trust includes trustee indemnification language in recognition of the fact that the investment decisions are being influenced by the beneficiary as well as the grantor’s intent.

Benefits for the Beneficiary

Benefits for the beneficiary include:

• The beneficiary is an active participant, given the responsibility to develop proposals for how they will put their wealth to work.
• The process is designed to educate the beneficiaries on risk/return, evaluating investments, developing a business plan and working with advisors under the supervision of a sophisticated trustee.
• By using financial modeling to show the impact of each decision on the liquidity of the trust, the trustee gives the beneficiaries a feeling of having some “skin in the game.”
• Beneficiaries have the opportunity and space to learn from their own failures. In our experience with these trusts, beneficiaries have themselves pulled back on several of their proposals when, on further due diligence, they realized it wasn’t a good investment. Modeling to show the impact on the liquidity and future distributions were a factor in the decisions (that is, similar to when you tell your child “you can use your own funds to pay for it”).
• This structure also gives beneficiaries an excuse to say “no” to their friend’s “great investment idea” on the golf course.

Fiduciary Considerations

Trustees of this type of trust should consider:

• Concentration and prudent investment issues. The trustee should be careful to ensure that the trust agreement expands, restricts, eliminates or otherwise alters the traditional concepts of diversification and prudent investor standards to permit the type of entrepreneurial investments contemplated by the grantor.1 A general authorization in the trust document provides less protection to the trustee than one that’s specific and mandatory.2 Specifically, the trust instrument should: (1) reference the waiver of the prudent investor rule standard and its duty to diversify the portfolio; (2) explicitly refer to the grantor’s desire that the trustee make investments in defined “speculative investments” as new and untried with a clear acknowledgment of risk; and (3) allow the trustee to consider nonfinancial considerations such as the beneficiary’s career learnings and accomplishments when making an investment. Even with clear language, the trustee takes on some risk that courts will second guess their decisions.3
• Additional liquidity needs. Rarely is an investment in a start-up “one and done.” The fiduciary should account for the need to continue to fund the private businesses beyond the initial investment. It’s much harder to convince a beneficiary not to throw good money after bad after having significantly invested in a business.
• Grantor perceived control. For lifetime trusts, the wealth creator may want the opportunity to witness the trust in action and, hopefully, enhance their confidence in the beneficiary’s evolving entrepreneurial skills. However, if the grantor becomes too involved in the trust’s administration, there’s a concern that the interest could be construed as interference with the trustee and lead the Internal Revenue Service to invoke Internal Revenue Code Section 2036 to bring trust corpus back into the grantor’s estate. However, as long as the trustee retains, and documents, fiduciary decision making and doesn’t simply rubber stamp the grantor’s suggestions, this shouldn’t be an issue.4 In fact, the grantor may be able to create a letter of wishes to clarify their intent for the trustee as long as the letter clarifies, and doesn’t conflict with, the grantor’s intent as expressed in the trust document.
• Beneficiary perceived control. Ensure that the beneficiaries understand that their role is only to make proposals, and the ultimate discretion and the decision making rests with the trustee.
• Beneficiary satisfaction and duties to current versus future beneficiaries. Typically, when a trust has remainder beneficiaries, the trustee’s duty of impartiality requires the trustee to treat all beneficiaries fairly without preference for any one beneficiary.5 This can make it difficult to make a significant investment in a private venture at the behest of the current beneficiary if there’s the potential that this could disadvantage future beneficiaries of the trust. To maximize flexibility for a current beneficiary, the trust document should clearly delineate that the current beneficiary is the “primary beneficiary” whose interest should be paramount.
• Knowledge, skill and time commitment of the trustee. Corporate trustees that have robust in-house specialty asset services often possess expertise necessary to evaluate the types of private investments proposed by the beneficiaries. To the extent that the corporate trustees lack expertise in a particular area or industry, the trust agreement should provide the trustee with the ability to hire outside consultants. The trustee should also set expectations with the beneficiaries as to the cost and turnaround time to perform this due diligence.

Case Study: Trust in Action

Josie is a self-made businesswoman who dropped out of college at the age of 22 to start a jewelry company.  Her business became incredibly successful, and Josie eventually sold 80% of the company to a private equity firm for $300 million.   

Josie has always considered herself an entrepreneurial artist who learned many valuable financial lessons through trial and error and by aligning herself with amazing mentors. She attributes much of her happiness not to her success, but to the journey she took to get there, understanding that her grit and failures made her success that much sweeter.

Josie would now like to share her success with her two children, Sam (age 24) and Bella (age 29), but is afraid that giving them too much too soon will rob them of the opportunity to develop the drive and passion that she knows they’ll need to forge their own path in life.

Working with her advisors, Josie decided to create an entrepreneurial trust for her children. In the trust instrument, Josie made it clear that Sam and Bella have the right to propose speculative investments to the trustee but are required to present the trustee with a sound business plan for each investment. She also made it clear that the trustee will have the right to hire outside advisors to evaluate these investments, at the trust’s expense.

Several months after the trust was established, Sam and Bella presented the trustee with a proposal for the trust to make a 15% minority investment in a start-up B2B technology company. After evaluating and discussing the proposal with Sam and Bella, the trustee decided to deny the request to make this particular investment, citing concerns over the management succession plan for the company and the company’s ability to raise sufficient capital to fund its long-term business plan.

Three months later, Sam and Bella were offered a real estate investment opportunity by one of Sam’s former college roommates to invest in a new office building complex in downtown Seattle. Although Sam and Bella initially considered bringing this investment to the trustee, after spending time on the business plan and applying some of the lessons they learned from working with the trustee on their first investment proposal, Sam and Bella decided not to move forward with this opportunity.

A few months later, Sam and Bella came to the trustee with a business proposal for the trust to acquire a 10% ownership stake in an early-stage biodynamic cattle feed company. As part of the proposal, Bella would serve on the company’s board of directors. As the trustee didn’t have the in-house expertise to fully evaluate this proposal, the trustee hired an outside consulting firm to provide a due diligence report on the company and the industry. After reviewing the business proposal and the consultant’s diligence report, the trustee was comfortable with the cash flow profile of the company and the long-term growth projections for the industry and ultimately approved the investment.

Rather than handing out money indiscriminately to her children, or creating a trust with opaque rules for distributions that shielded her children from decision making, the entrepreneur’s trust provided Sam and Bella with accountability for their investment decisions, educated them on how to put together a business plan and allowed them to celebrate their successes and learn from their own mistakes throughout the investment process.

Endnotes

1. Uniform Trust Code (UTC) Section 1006.

2. Compare, e.g., In re Wellington Trusts, 2015 N.Y. Slip Op. 31294 (N.Y. Surr. Ct. 2015) (trust agreement provided that the trustee was under no obligation to diversify investments), withe.g., McGinley v. Bank of America, N.A., 109 P.3d 1146 (Kan. 2005); Americans for the Arts v. Ruth Lilly Charitable Remainder Trust #1, 855 N.E.2d 592 (Ind. Ct. App. 2006); Adams v. Regions Bank, Civil Action No. 3:14cv615-DPJ-FKB,  2016 WL 71429 (S.D. Miss. Jan. 6, 2016).

3. Matter of Dumont, 2004 N.Y. Slip Op. 50647U (2004).

4. CompareKlauber v. Commissioner, 92 F.2d 1007 (2d Cir. 1937); Comm’r v. Douglass’ Estate, 143 F.2d 961 (3d Cir. 1944); Goodwin’s Estate v. Comm’r, 201 F.2d 576 (6th Cir. 1953).

5. UTC Section 803.