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Succession Planning

SUCCESSION PLANNING FOR BUSINESS OWNERS

Owning a business can deliver substantial rewards, including the rewards of seeing your hard work evolve into a successful enterprise, being able to provide for yourself and your family, and creating new jobs that offer a source of pride and financial security for your employees. The demands and challenges of managing the day-to-day aspects of a business, along with the complexities and emotional issues of succession and exit strategy planning, often lead owners to delay planning for what will happen to their enterprise when they step away from managing the operation. Every closely held business should plan for the eventual transition of management and ownership in order to ensure the successful continuation of the company when the founder is no longer involved. A simple illustration of this necessity is the fact that less than 30% of family and closely held businesses survive into the second generation, 12% are still viable into the third generation, and only about 3% of all family businesses operate into the fourth generation or beyond. Whether or not the business survives the transition overwhelmingly depends on the quality of thought and planning given to all elements of the succession strategy.

Aligning Objectives and Transfer Structure

It is not uncommon for the majority of a business owner’s net worth to be tied up in their enterprise. As such, a succession plan usually goes hand-in-hand with the business owner’s estate plan, and it should align with the owner’s goals and intents.

There are generally only five ways to dispose of a closely held business:

  • a private sale to outsiders;
  • taking the business public;
  • a private sale to insiders;
  • testamentary disposition (transfer of property at time of death through the terms of a will or trust); and
  • liquidation.
 

Because each of these scenarios has dramatically different income tax, gift tax, and estate tax implications, it is important to know far in advance how to structure the succession plan in order to minimize the tax impact on the seller, on the estate, and on the buyer-particularly if the buyer is an insider or family member. At the same time, the plan must maximize the value to the seller. If an owner is relying on the sale of his or her business to provide financial security during retirement, then it is important to understand what the company is worth and what the key drivers are of the company’s value. An independent valuation by a qualified appraiser will help provide this understanding.

A valuation works in concert with the succession strategy, providing a cost basis in the case of a bequest, or a defensible negotiating position in the case of a sale to an outsider. Estimating the value of an enterprise is critically dependent on the owner’s exit strategy and what they want to accomplish. Most owners want to receive the highest price negotiable for the sale of their business; however, in the case of a sale to insiders or a transfer to family beneficiaries, tax issues usually demand the opposite strategy. In this situation, in order to maximize value to the seller while taking potential tax consequences into consideration, the appraisal may need to be for the “lowest defensible” value. For many business owners, this may seem counterintuitive; however, a lowest defensible value may be optimal when the owner’s intent is to minimize the amount of income and gift taxes owed. Qualified appraisers may use “Lack of Marketability” or “Lack of Control” if applicable to justify discounts to the fair market value of a business.

The Right Time to develop a succession plan

Entrepreneurs should think about succession as a regular part of their overall strategic plan-while they are still active in their enterprise. If a business owner begins planning early, he or she may be better able to seize opportunities to teach and train a successor, to share their vision, and to pass along the benefit of their experience and knowledge. By knowing that they have a committed, and sometimes contractual, succession plan in place, entrepreneurs and their successors are often better able to assess longer term investments and may be more flexible in targeting key value drivers. Additionally, key employees and successors may be more highly motivated to perform and to achieve shared goals that can help maximize the value of the company.

Communicating your plan

Owners are encouraged to communicate their intentions in advance of the succession action to help eliminate any uncertainty about what may happen in the event of a transfer. This can have a positive impact on retaining and attracting the best talent. Furthermore, in cases where the succession is occurring among family members, communicating the owner’s plans to all the family members can help minimize potential discord.

Many business owners will eventually need to determine when will be the right time to step out of the business and how they will do it. By planning ahead, business owners can ensure the continuation and growth of a business, prepare for tax obligations, and make the ownership and management transfer as smooth as possible.

Tools and strategies frequently utilized

  • Qualified Employee Stock Ownership Plan
  • Gifting Shares Utilizing a Family Limited Partnership
  • Phantom Stock Plan
  • Executive Retention or Incentive Bonus
  • Key Man Life Insurance
  • Non-Qualified, Selective Deferred Compensation Plan
  • Incentive and Non-Qualified Stock Options
  • Dynasty Trust
  • Executive Financial and Estate Planning
  • Profit Sharing Plan
  • Business Recapitalization and Strategic Planning
  • Buy/Sell Agreements or Stock Redemption Agreements
  • Severance Benefits
  • Key Employee Training and Education
  • Defined Benefit Pension Plan
PRIMARY COMPONENTS OF SUCCESSION PLANNING

Management Succession and Transition

  • If selling to an outsider, make certain key employees have a compelling incentive to stay
  • Evaluate potential successors, assessing their ability to run your business
  • Provide assurance to employees regarding who will be in charge when the owner is no longer running the business
  • Maintain positive relationships with customers, vendors, and creditors so the business may continue in the absence of the primary owner
  • Minimize or eliminate family discord by communicating the owner’s intents and wishes for the continuation and growth of the business

Ownership Design

  • Define how assets will be transferred (which may be different than transferring management)
  • If transferring ownership to key executives, establish a buy-sell agreement to facilitate purchase at fair market value
  • If selling the business to employees, consider establishing an Employee Stock Ownership Plan that could be used to create a market for the owner’s shares
  • If transferring ownership to the next generation, consider establishing a family limited partnership and/or some type of trust depending on the owner’s desires

Tax Mitigation

  • Consider the impact of tax laws and establish a succession plan to minimize income, estate, and gift tax liability
  • Generate income for the primary business owner, possibly through annuity vehicles established to manage tax consequences