Business Succession is a 4-Step Process

Business owners often don’t want to think about the eventuality of their retirement, death or incapacity.  Even those who think a business succession plan is a good idea do not want to take the time to work out the details about who will run their business when they can no longer do so.

In promoting succession planning, I have found that it is often effective to discuss the consequences of a business owner’s death or disability to his or her family and the business.

For example, with the absence of planning, there are predictable problems that will affect the business:

  • Disruption of management
  • Impairment of business credit
  • Damage to employee morale
  • Potential liquidation of assets
  • Disagreement among family members

The business owners family will also face serious problems:

  • Loss of family income
  • Lack of a ready market for the sale of their business interest
  • Lack of cash to pay estate settlement costs
  • Likelihood of business valuation and tax concerns

There are four main steps to creating a succession plan:

Step #1

Selecting a Successor

A business successor can be one person or several.  The successor could be a family member or could be unrelated to the business owner, such as a key person (or persons) within the company.  A good successor could also be a trusted business advisor, such as an attorney, CPA, or financial advisor.  The successor could even be a competitor – business owners could be each others successors.

Some of the attributes of a good business successor include enthusiasm, creative thinking, complementary talents and similar goals.  Business owners should look for someone who has a history of past successes.

Step #2

Negotiating the Purchase Price and Valuation

Once a business owner has identified a successor, the next step involves valuing the business and setting a price.  Some businesses use rule-of-thumb valuation, such as one-and-one-half times revenue.  Others call in a valuation expert.

It is usually wise to work with a professionally trained, experienced business valuation analyst because the value of each business regardless of size, is unique and determined by many factors.  These include market conditions, market share, location, quality of management, product life cycle, and other intrinsic factors that make it difficult to set a fair price for a closely held business.

Also, by bringing in an objective third party, it is less likely that the Internal Revenue Service or probate court will question the validity of the price set on the business.  For example, if potential successors are lineal descendants, the business owner will need to make sure the business valuation and the buy-sell agreement (discussed later) stand up to the Internal Revenue Code scrutiny and the “arm’s length” tests of Chapter 14 of the IRC code.

Step #3

Developing a Buy-Sell Agreement

What is a buy-sell agreement?  It is a legal document that sets forth the details of how a successor or successors agree to purchase a business interest from the owner’s estate.

There are three main types of buy-sell agreements:

  • Cross-Purchase
  • Stock Redemption
  • Wait-and See

In future posts – I will explain them in further detail.

Step#4

Funding the Buy-Sell Agreement

Once a type of buy-sell agreement is selected, there is still another question that must be answered:  Where will the monies come from for successors to buy out the retiring, disabled or deceased owner?  Insurance provides several advantages that other options like cash or borrowing do not, such as the following:

  • Policy benefits guarantee the cash to satisfy the need for buy-sell agreement funding.
  • Premiums present a minimal strain on the working capital of the business versus other funding mechanisms.
  • Cash values of the policies are available for corporate emergencies or business opportunities.
  • The business itself can help an owner to fund the business succession plan through creative use of life and disability insurance.

Despite its benefits, however, insurance is not the only way to fund buy-sell agreements.  Therefore, I will briefly cover the other funding alternatives and the respective pitfalls in future posts.

February 10, 2010  Tags: , , , , , , , ,   Posted in: Business Owner Succession

Leave a Reply