Succession planning: Is your business prepared?
Proper succession planning can help ensure continuity for your business.
The majority of a business owner’s time is spent focused on growing revenues, streamlining operations, improving product and creating a legacy. But what happens when an owner wants to exit the business or is no longer able to physically participate in day-to-day operations? Business succession planning is one of the most important strategies to have in place as it allows a business owner to accomplish pre-determined goals, provide financial flexibility to his/her family, exercise some level of control on the future outcome of the business and benefit from potential tax advantages.
One of the first objectives of effective wealth management is working with clients to minimize risk exposure. Some risks include business continuity, valuation risk and consequences of the owner’s unexpected disability or death. Proper planning can help to minimize these risks. Business owners have spent their lives building their businesses, providing for their family and their employees. They have been in control of their destiny. The business is what they know. Succession planning helps the owner plan for the next stages of their life by addressing some of the following questions: How much income will I need in retirement? How involved do I want to be in the business going forward? How do I invest outside the business to meet my goals? What legacy do I want to leave? Proper planning can help ensure a successful transition and create a lasting legacy.
“I talk to business owners every day and they all have great visions for their companies, but many of them fail to prepare for what happens ‘next’ with their company. Succession planning can be a blind spot for many,” says Larry Ryan, Executive Vice President and Chief Lending Officer, Commercial Banking.
Business owners can meet their goals via a variety of succession planning strategies:
1.) Pre-sale strategies. Whether an owner has a goal of keeping the business in the family, or selling outright, it may be prudent to transfer a portion of his/her ownership after the owner’s current and future financial needs are met. Tools include Family Limited Partnerships (FLPs), Grantor Retained Annuity Trusts (GRATs), stock recapitalizations, and outright gifts. In each one of these strategies, a business owner is able to pass on some of their ownership interest tax-free to specified beneficiaries.
2.) Buy / Sell agreements. Buy/sell agreements make good business sense for many owners. At a minimum these agreements should include provisions for permitted transfers, involuntary transfers, offers to purchase, puts, and valuation methodology. One common approach to this type of agreement is stock redemption, where a business buys life insurance policies on the key members of the Company. Upon the passing of an owner, life insurance proceeds are available to buy-out a deceased business owner’s share. This allows for a smooth transition of the business to its operators and insulates the business from a liquidation scenario. Another variation of the buy/sell agreement involves the business owners entering into a Cross-Purchase agreement. In this arrangement, each owner individually agrees to purchase the interest of a departing owner at a pre-determined price if a triggering event occurs. Trigger events may include the retirement, disability or death of an owner. There have been instances where the estate tax liability of a deceased owner has forced remaining business owners to sell the company prematurely. Proper planning can help protect a company, and the remaining shareholders, from this unfortunate outcome.
3.) Sale to employees through an Employee Stock Ownership Plan (ESOP). This strategy allows the business to remain closely held and may provide tax benefits to the owner. For more on ESOPs, read the MB Insights article, “Planning for the future? An ESOP could help your company.”
4.) Sale to a 3rd party. The sale to a non-family member/entity is a common outcome if there are no family heirs or key employees interested in and capable of assuming ownership control and continuing the business operation. The third-party sale may be the best option for the owner to meet future retirement needs. Prior to marketing the business for sale, an owner should give careful consideration to the minimum sales price needed to generate sufficient income to support the owner’s lifestyle in retirement. The owner should work closely with his or her advisors to prepare the business for sale, value and market the enterprise, and evaluate/negotiate/finalize purchase offers. Often, a strategic or financial partner will buy a business outright at a multiple of earnings before interest, taxes, depreciation and amortization or revenue. Alternatively, a sale may be accomplished through an installment note where the owner receives income (via the interest on the note) and is able to defer capital gains across the lifetime of the note.
We have only touched on a handful of approaches to business succession planning. A business owner devotes his or her life to establishing, nourishing and growing a business. Consequently, there should be adequate consideration given to the most appropriate way to transition the business once the founder decides to exit the business. While a structured and planned exit is optimal, business owners should account for the unexpected. Proper planning helps ensure the continuation of the business and allows a business owner to exit in a manner that is consistent with his or her wishes.