Succession Planning: How to Transfer Ownership of Your Business

March 30, 2020
Posted in: Uncategorized

Table of Contents

 

If you think succession planning is only for family businesses or for business owners nearing retirement, you’ll have to think again. Whether your business is comprised of family members, retirement is decades away or a few years away, a succession plan is vital to ensuring the continued success of your business. After all, you’ve invested too much time and money in your business to leave its continuance to chance. Think of a succession plan as peace of mind that your business will be left in the best possible hands should you no longer be able to operate it.

 

open sign 

 

What is Succession Planning?

 

From a business perspective, succession planning is “a process for identifying and developing new leaders who can replace old leaders when they leave, retire or die. Succession planning increases the availability of experienced and capable employees that are prepared to assume these roles as they become available. Taken narrowly, “replacement planning” for key roles is the heart of succession planning.”

As a business owner, your succession plan should include a series of logistical and financial decisions concerning who will take over your business upon your retirement, disability, or death. The first step in creating a sound succession plan is to identify the ideal successor to take over your business, and then determine the best way to transfer the business to that person or entity. A buy-sell agreement is often involved in the process and is secured with a life insurance policy or loan.

 

Here are the five common ways to transfer business ownership: 

  1. Heir:  Pass ownership to a family member.
  2. Co-owner:  Sell your shares or ownership interests to a co-owner.
  3. Company:  If there are multiple owners in your business, you can sell your shares or ownership interests back to the company to be distributed among the remaining owners.
  4. Outside party:  Sell your business to another business owner outside of your company.
  5. Key employee: Sell your business to a key employee.

 

Why is a Succession Plan Important?

 
With a succession plan in place, a company can ensure that it’s prepared to meet customers’ needs and continue normal operations and procedures on all functional levels including engineering, marketing, purchasing, human resources, supply chain, commercial, logistics, etc. in the event of a business owner’s or key leader’s departure. It’s not only important to have trained employees in place to take on specific leadership roles in the company, but it’s also essential to the retirement objectives of the key leader or business owner.

A good succession plan can help:

  • Transfer ownership when you depart the company expectedly or unexpectedly
  • Maintain your lifestyle in retirement
  • Provide for the financial security of your heirs
  • Prepare your business for handling unexpected events

 

Who Should Create a Business Succession Plan?

 
Although succession plans are commonly associated with retirement, they play an important role early in the life of a business. As a business owner, a succession plan can assure you that if the unexpected happens to you or a co-owner, the plan will alleviate stress and financial loss. The more complex the business and the higher the number of people to be impacted by your or a co-owner’s exit, the greater the need for a solid succession plan. 
 
You’ll benefit from a succession plan if:

  • You have employees:  If you employ more than just yourself, you’ll need to determine who will step in and handle human resources and payroll functions. A leadership structure should be put in place.
  • Your business involves complex processes:  If the operation of your business requires knowledge of specific or proprietary processes and/or subject matter expertise, your employees and successor will need to know how to operate the business once you depart. 
  • You have repeat clients and/or long-term contracts: After your departure, who will maintain relationships with repeat clients and ensure the fulfillment of long-term contracts?
  • You have a successor in mind: If you have someone in mind to lead your company after you exit, have you made them aware of this? Are they willing to take ownership of the company?

Unfortunately, many business owners don’t feel that succession planning is necessary so they ignore it or delay it until they’re close to retirement. If you have a small, uncomplicated business with no employees, a succession plan may not be necessary. But what would happen to your business if you were no longer able to manage the day-to-day operations? Who would take over? Would you have to close the business? A succession plan might be in the best interest of you and your business.

 

plan

 

When Should a Business Succession Plan be Created?

 
If you don’t already have a succession plan in place for your business, this is something you should work on as soon as possible. Every business should have a succession plan to ensure that all operational areas can continue functioning normally and regular clients don’t experience a disruption in service.  

You may not plan to leave your business anytime soon but unexpected exits are a reality. If you’re nearing retirement age, it’s even more important that you not delay creating a plan. When the need to transfer business ownership becomes more imminent, business owners should create a succession plan that includes when they intend to retire, and when they’ll sell or transfer ownership of the business. This will ensure that the business continues to operate smoothly during the transition.

Ideally, business owners should start the succession planning process five or more years before they want to retire. When constructing their plans, many business owners aim to transfer their businesses to family members in a way that minimizes the heirs’ tax burden and maintains cash flow to the owner post succession. Owners also want to ensure a smooth and successful transfer of ownership to the succeeding family members. 

If business owners plan to sell their business to a third-party buyer, allowing enough time to prepare the business for sale will help secure the best price. Taking the time to properly structure the sale will allow the owner (or the estate) to incur the lowest tax liability and the highest level of wealth protection when proceeds from the sale are received.

 

What Should Be Included in a Succession Plan?

 
A business succession plan is a document that is intended to guide the reader through a change in ownership by providing detailed instructions in a step-by-step format. If a purchase is involved in the transfer of ownership, the sale price and purchase terms are clearly outlined, which relieves stress and confusion for the departing owner’s family. If the succession plan is properly crafted, the departing owner, the business, employees, and the successor will all benefit.
 
Here’s what should be included in a small business succession plan:

  • Potential successors:  A list of potential successors, including their strengths and the order in which they should be considered
  • Succession timeline:  Details regarding the circumstances under which a succession would take place with specific dates as applicable
  • Standard operating procedures:  A collection of materials including procedures, employee handbooks, and training documentation
  • Business valuation:  Along with the business’ valuation, the method by which it’s valued should be included and regularly updated. 
  • Succession funding details:  How will your succession be funded? Include details about whether your succession is funded through life insurance or other funding options.

 

writing

 

Ways to Transfer Business Ownership

 
There are five common ways to transfer business ownership, each with its shortcomings. The succession plan you create will depend on which way you plan to transfer ownership. Your plan could also address unexpected events such as illness, accident, or death. In this case, you may want to include more than one potential successor. 
 
Here are five business succession plan types based on ownership transfer:
 

1. Pass Business Ownership to an Heir

For business owners with children or family members who work in their companies, choosing an heir is a popular option. It’s seen as a way to provide financially for your family by handing down a successful, well-run company. However, this method of ownership transfer is not without its shortcomings. 
 
To make the process of ownership transfer to an heir smoother:

  • Decide who will take over:  If only one family member is involved in the business, this is an easy decision. However, if there are multiple family members, this can get complicated if more than one is interested in taking over. If you decide to go with the heir who is the most qualified, give your reason for selecting this particular person to alleviate any hurt feelings.
  • Consider other heirs:  Include clear instructions on who will take over and how the remaining heirs will be compensated.
  • Include a buy-sell agreement:  Many business succession plans include a buy-sell agreement to allow heirs that don’t participate in the business to sell their shares to those that do.
  • Provide structure of future leadership:  If only one of many heirs will take over, provide clear instructions on how the leadership structure should be organized going forward.

 
If you fail to take the above into consideration, the transfer of ownership could be a turbulent process. For example, if the future leadership structure isn’t adequately constructed and more than one heir receives a claim to the business, a power struggle could ensue and negatively impact the business. Or, there may be confusion about who is supposed to take over the day-to-day responsibility of running the business. 

When deciding on the leadership structure, the future leader should first be chosen. This can be complicated if there is more than one heir interested in taking the reins. Again, when providing your choice of leader, give the reasons why you chose this person. Reference contributions to the business as well as skill sets.
 
Shortcomings of this Ownership Transfer Method

It can get messy when business decisions are made within a family. After an untimely death or infirmity, emotions can run high. Although a business owner’s choice of this transfer method may have been influenced by the desire to have the business operated by future generations, this doesn’t often happen. In a study conducted by John Ward of Northwestern University’s Kellogg School, only about 20% of second-generation businesses survived as an independent company with the same name. Of that 20%, only 13% were still owned by the same family. 

Although your chosen heir may decide to sell the business at some point after being handed the reins, this may still be the best option. Your dream of the business being passed from one generation to the next may not be realized, but your heir(s) will hopefully be financially secure. 
 

2. Sell Your Shares or Ownership Interest to a Co-owner

If you started your business with a partner or partners, you might consider selling your shares or ownership interest to one or more of them. Many partnership agreements contain a clause that stipulates how a partner’s shares or ownership interest are to be handled in the event of untimely death or disability. The remaining owners may agree to purchase the business interests from the departing owner’s next of kin.  

This stipulation in a partnership agreement can make the transition easier on the business and family members. For example, a departing owner’s spouse may be interested in holding on to their shares but not have the time or experience to make a meaningful contribution to the business. A buy-sell agreement will ensure that the spouse is compensated fairly and that the remaining co-owners maintain control of the business.
 
Shortcomings of this Ownership Transfer Method 

When the partnership agreement is drafted, your co-owner(s) should be prepared to buy-out your shares at any time since you can’t predict when untimely death or disability could occur. Therefore, a buy-sell agreement with co-owners requires that they maintain a considerable amount of cash on hand. 

Many businesses opt to fund their succession plans with term life insurance to offset the costs associated with the untimely death of an owner. If you choose to incorporate a buy-sell agreement with co-owner(s) in your partnership agreement, you’ll want to stipulate that a life insurance policy is part of the agreement. Key person insurance can also be purchased which will issue a payout to the company in the event a key member of the business dies or becomes disabled. 

 

office

 

3. Sell Your Shares or Ownership Interest Back to the Company

This option is also available to businesses with multiple owners. An entity purchase agreement or stock redemption plan is an arrangement where the business purchases life insurance on each of the co-owners with the other partners as beneficiaries. That way, if a partner dies at a time when the surviving partners would not otherwise have enough cash to buy the deceased partner’s ownership share, the life insurance proceeds will make that purchase possible. The business uses the life insurance proceeds to purchase the business interest from the deceased owner’s estate, thereby giving each surviving owner a larger share of the business. 
 
Shortcomings of this Ownership Transfer Method 

An entity purchase is similar to a cross-purchase in which you can sell your shares or interest to co-owners. However, a cross-purchase is more financially sound in most situations. When co-owners purchase shares directly, the stock’s basis is revalued at its current price. In an entity purchase, the original basis stays the same and your co-owners will be responsible for paying taxes on potentially higher capital gains. 

Despite this shortcoming, entity purchases can still benefit a business when there are a large number of co-owners. It can be tedious to draft cross-purchase agreements with each owner, whereas entity agreements are much simpler to implement and can typically be funded with one life insurance policy for each co-owner.
 

4. Sell Your Business to an Outside Party

When you don’t have an obvious successor to transfer or sell your business to, you may want to look to others outside of your family and company. Maybe a competitor or another business owner would be interested in purchasing your business. To ensure that you get a fair price, you’ll want to perform a business valuation. A business valuation is “a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect the sale of a business”.  The business valuation should be updated frequently. 

To effectively price your business, determining its EBITDA can give an indication of its profitability. A company’s Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is one of the most widely-used metrics for valuation analysis and securities pricing analysis. In theory, EBITDA allows for a more refined analysis of a company’s profitability because non-operational expenses (expenses that don’t occur in the normal course of business) aren’t taken into account. EBITDA is intended to be used to compare the profitability of different companies.

Selling a business to an outside party is easier for some business types than for others. For instance, if you own a business that is more turnkey in nature, all you would need to do is show that it’s a good investment. This would be more attractive to potential buyers because they won’t have to put in much effort and can still focus on their other business endeavors.

On the other hand, if you own a company that is personally branded like, say, a law firm named Law Offices of Patrick Martin, it could be more challenging to sell the business. Potential buyers may not want to put in the time to rebrand and remarket the business and may forego the purchase or ask for a price reduction as a result. 

To get the best price for your business, take the time to prepare it for sale. Get your finances in order, hire a well-qualified general manager, and ensure that operating procedures are in place. The more stable and ready your business is, the more attractive and valuable it will appear to potential buyers. 
 
Shortcomings of this Ownership Transfer Method

The primary shortcoming of selling your business to an outside party is not knowing what the new owner plans to do with the business. The new owner could adopt a new mission for the business, replace current staff, and neglect the customer relationships that you took so long to develop. If you’re selling your business due to retirement, these issues may not be as important to you with an outside buyer.  You’ll generally be more detached from the business as opposed to if you were transferring or selling to an heir or key employee. 

Just as with other types of transfer arrangements, you’ll need to draft a buy-sell agreement. Depending on the buyer’s financial position, you may need to help them secure an acquisition loan.   
 

5. Sell Your Business to a Key Employee

If you don’t have a family member or co-owner to transfer your business to, you might consider selling it to a key employee.  This is an ideal option if you’re concerned that selling to an outside party will diminish the quality of your product or service. When deciding which employee to sell to, consider those employees who have the experience, business acumen, and integrity to carry out your business’ mission and ensure its continued success.  Key employees are generally those closest to the top of your company’s organizational chart.

Just as with selling to a co-owner or outside party, you’ll need to include a buy-sell agreement in a key employee succession plan. The employee will essentially agree to purchase your business at the time of your retirement, or any event that renders you incapable of operating your business like death or disability.
 
Shortcomings of this Ownership Transfer Method

Most key employees don’t have the financial resources to purchase a company from their employers. Even if they have impressive investment portfolios, they may not have the liquidity needed for the purchase. 

To overcome this challenge, seller financing is an option to consider. In this financing arrangement, your employee would typically make a down payment of 10% or higher then monthly or quarterly payments to you (or your estate) until the loan is paid in full. The exact terms of the financing should be clearly detailed in your succession plan. 

 

books

 

How to Create a Business Succession Plan

 
There are several options for creating a business succession plan. You might want to create both an emergency succession plan, in the event that you need to exit the business unexpectedly, and a long-term succession plan, for your anticipated departure. You may choose to create your own succession plan or engage the services of a professional if your plan and business structure are too complex to create the plan on your own. 

Whether you create your plan yourself or hire a professional, there are several key steps necessary for creating a thorough succession plan. They are:
 

  • Determine timeline: Specify the conditions under which the succession will take place (i.e. retirement, disability, or death) and the date it will begin (i.e. retirement date).
  • Choose a successorIf a predetermined individual or entity won’t be purchasing the business, include the names and profiles or qualifications of a few potential candidates. 
  • Formalize and include standard operating procedures:  Document your standard operating procedures, including any recurring processes or meetings. Include employee handbooks, operation manuals, an organizational chart, and any training documentation.
  • Calculate business value:  There are several methods you can use to value your business. Once it has been calculated, include in the succession plan the business value and the valuation method used. The value should be updated frequently. Even if you aren’t planning to sell your business, conducting a business valuation has many benefits. It helps you develop a retirement income strategy, properly value future owners’ shares, and purchase adequate insurance for protection planning. It can even make it easier for your business or potential buyers to get loans or attract investors.
  • Fund your succession plan: Explain how your succession plan will be funded. Clearly detail how the successor will purchase the business (unless the business will be handed down to an heir). Funding options include life insurance, acquisition loan, and seller financing.
  •  

Hiring Professionals for Business Succession Planning

 
Many business owners choose to engage the services of a professional because succession planning can be a complicated process. If you decide to go this route, the professional can help you determine the value of your business and the appropriate type of succession plan for your particular business. They can also help you create any supporting documentation you need such as financial statements and projections. The type of professional you’ll need to hire will depend on the complexity of your business as well as the event (retirement, disability, or death) you’re planning for.

If you’re a sole proprietor or your business is small, has few employees, and your financial structures are simple, consider taking advantage of free services like Service Corps of Retired Executives (SCORE) and Small Business Development Centers (SBDCs). Both of these organizations are under the guidance of the U.S. Small Business Administration (SBA) and can provide one-on-one training and mentorship to help you create your succession plan.

If your business is small with multiple employees and simple to complex financial structures, consider engaging the services of a certified public accountant (CPA). You could also hire a business attorney to draft the succession plan. If your business and financial structures are complex, both a CPA and business attorney should be consulted to ensure that there are no glitches when the succession plan goes into effect.

If your business is mid-size (between 50 and 250 employees) to large (500+ employees or an average of $7 million in annual receipts), you may benefit from working with an accounting firm that has extensive experience in creating business succession plans. Performing an online search should yield more than a handful of such firms in your area or, if you belong to a trade or industry organization, ask other members for referrals.

 

women

 

Final Thoughts – Succession Planning: How to Transfer Ownership of Your Business

 
While many experts recommend beginning succession planning around five years before retirement, it is never too early to get started. Having a solid plan in place for how your business will transition (which includes who will take over and how your heirs and co-owner(s) will be compensated) can eliminate future headaches in the event of your abrupt exit.  It can also help you obtain the best price when selling your business.  

You don’t want to spend decades running and building a business only to have to liquidate and shut it down because you failed to properly plan. This will be unprofitable for you (in the event of retirement or disability) or your heirs (in the event of your death). 

Once your plan is created, give yourself a pat on the back— creating a succession plan is a big accomplishment. But don’t just file your plan away and forget about it. Your succession plan should be reviewed regularly and updated as necessary to reflect organizational changes, tax law updates, business valuation changes, or other developments such as new industry trends. Failing to account for these changes could render your succession plan ineffective. Reviewing your succession plan annually with your advisory team will help ensure a successful and seamless transition — no matter when or under what circumstances it takes place.  

In the case of family-owned businesses, changes in family dynamics also need to be considered. The desires and goals of family members can change over time and business owners must update their succession plans to reflect these changes.  Family members may lose interest in taking the reins, and your own plans for the future may shift.

When planned for, change can be exciting and may provide your company with numerous unanticipated rewards. Developing a succession plan can help you identify all the positive aspects of your business and inspire employees at all levels to maintain a strong work ethic and degree of motivation in the event of your planned or unplanned departure. 
 

All rights reserved @ Personal Loans 2020