A Primer on Business Succession Planning

May 6, 2022 10:00:00 AM

  

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Business owners can be so concerned with day-to-day operations that they fail to prepare for the inevitable day when they are no longer able to run their business. There always seems to be time until there is no more time. Business succession planning may be the “single-most neglected aspect of running a company. Further, this issue is relevant to business clients as well as to attorneys who run their own practices. Whether plans to depart the business are imminent or far-off, it is important to act now, as proper business succession planning can often take several years to implement.

The following are some succession basics, including common planning techniques attorneys should consider.

What Events Trigger Business Succession?

A business interest can change hands for several different reasons, not just because the founder is ready to retire. Business succession may take place when the owner 

  • receives an attractive offer to buy the business;
  • receives an offer to join another company;
  • is not happy with the direction of the business, the market, or the economy;
  • is suffering from poor health or a disability; or
  • wants to take their career in a different direction.

Departing owners who do not plan to transfer their business interest through gifting and who need to fund their retirement may contemplate selling. Businesses with the following characteristics are often more attractive to buyers:

  • A history of profitability
  • An advantageous location
  • An industry with a promising future
  • Quality inventory
  • A strong customer base

Even if all of these elements are in place, a question remains: can the business operate effectively in the absence of the current owner? Sometimes the owner is synonymous (and even eponymous) with the business to the point that it can barely exist without them.

Alternatively, a business may not be attractive to buyers because it is too small, lacks assets, or has declining profits even with significant assets. In this case, the best plan may be to sell only the assets.

Methods of Business Succession

More business owners have set up succession arrangements over the last decade, but thirty percent of them still do not have a formal plan according to a Northern Trust survey. Those who have a succession plan should revisit it regularly to ensure that it is updated and relevant.

A business ownership stake can be transferred to a co-owner, a key employee, or an heir of the current owner. It could also be sold to an outside party or back to the company for distribution to the rest of the shareholders.

A solid business succession plan should be in place at least five years before the owner plans to retire. Of course, as with creating an estate plan, it is never too early to start. 

The following steps are often part of an effective business succession plan: 

  • Establishing a timeline
  • Identifying possible successors
  • Formalizing the company’s operating procedures
  • Setting the method for valuating the business
  • Creating a plan to fund the succession

Valuation and the Psychology

Valuating the business can present Goldilocks’s problem of finding the number that is just right. The value of a business should be high enough to compensate the outgoing owner adequately, but low enough to be affordable if a family member or key employee will be the successor. Depending upon the departing owner’s goals, the right number may be the price that the business stake would fetch from a noninterested third party.

Of course, business succession is not just a matter of money: it is also about legacy. The outgoing owner has poured their efforts into what may have been their life’s work and it is ending. While the owner will be leaving the seat of company power, they may want to leave a lasting mark on the firm. A consultant or therapist could help the outgoing owner deal with their feelings about giving up control of the company. Alternatively, it could be beneficial to keep the founder in an emeritus role in the company, allowing them to retain an office and a salary. The founder could still help produce business gains because of their reputation and relationships built over the years.

The Process of Business Succession

When the time is right to start the succession planning process, the owner meets with an attorney, accountant, and a consultant to create a road map for transitioning the business. Estate and business planning attorneys call this a “design meeting,” which will include an examination of the plan’s economic feasibility. Preparing the documents could take four to nine months, which provides ample time for the potential successor to be vetted by an outside source if necessary. Placing a value on the business can be difficult because it will likely change upon the departure of the outgoing owner. The business’s value may be five to seven times the company’s earnings before interest, tax, depreciation, and amortization (EBITDA), but it depends upon each business’s unique circumstances.

In addition to a valuation of the business, the plan will often include the rate of sell-down by the outgoing owner and buy-in by the incoming owner. An executive committee may run the company during the succession process. The plan should also establish a timetable to complete the transition.

The main document for the business succession will be the letter of intent, which will include a description of the price, shares, payment method, compensation, and timetable. Other business succession documents may include the following:

  • Equity purchase agreement with full disclosure
  • Stock pledge agreement
  • Buy-sell agreement
  • Corporate resolutions to support the transition

Additional Information About Business Succession

Expand your knowledge at WealthCounsel’s upcoming Business Law In Focus webinar, “Tax Minimization Strategies in Business Succession,” on Tuesday, May 17, at 1 p.m. (ET). It will include a discussion of various techniques for passing on a family business, as well as common income tax considerations, potential tax traps, and how to minimize income tax consequences. Click here to register.

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