Small Business Succession Planning
If you’re like many small business owners, you’ve probably had the thought:
“This place would fall apart without me.”
With a solid business succession plan, you can avoid just such a fate.
What Is Succession Planning?
Succession planning provides a template for transitioning a business from the current owner to the next. It is part of an exit strategy that focuses on the people who will pick up the mantle if the current owner retires, dies, or becomes ill or disabled.
An effective succession plan begins with an assessment of the current state of the business. The next step is to set a vision for the future of the business and determine the type of leadership that will best meet those goals. Finally, it provides details on executing the leadership change to ensure a smooth transition.
Because a succession plan must address both expected and unexpected events, business owners should put it into place well in advance of when it might be needed and revise it periodically to account for possible changes.
The details of a small business succession plan will vary depending on many factors, including whether the business owner plans to pass down or sell the business to family members, key employees, or an outside buyer.
What to Include in a Succession Plan
The goal of a succession plan is to put the best people into the positions where they can be most effective. Business owners also need to consider the company’s current position and their vision for the future of the business.
A thoughtful succession plan developed with an understanding of the business needs and goals ensures the company will have the necessary leadership for a successful transition.
Typically, succession plans include these elements:
- Long-term goals for the business
- List of potential successors, their potential roles, and a plan for training them for leadership
- Timeline for succession
- Business valuation
- Plan for financing the sale
Why Small Business Owners Need a Succession Plan
More often than not, small business owners are the glue that holds the business together and drives its growth. Because small businesses often don’t have layers of seasoned management, they are at risk of failure without someone who can step into a leadership role.
Here are some of the benefits of succession planning:
- It helps maintain the value of the business. If death or a sudden illness forces business owners or their heirs into a quick sale, they likely won’t get full value for the company. Likewise, if successors are unprepared to take over management, they might weaken the business as they struggle to master the learning curve.
- It ensures continuity for the business. A succession plan ensures a smooth and orderly transition for the business. It reassures customers, employees, and other stakeholders that the business will continue uninterrupted.
- It assists in estate planning. A solid succession plan should be part of an estate plan that addresses any tax exposure resulting from the sale of the business and assists in tax planning.
- It keeps control of the business with those you designate. A succession plan can keep the business from falling into the hands of those you don’t want involved in the business. It can also protect heirs in the case of divorce or other changes in the family structure.
Ways to Transfer Business Ownership
The type of succession plan you choose depends on your current business operations, business needs, family dynamics, and your personal finances and those of the parties who will take over the business.
Before you set your succession plan in stone, it’s important to consult with all interested stakeholders. In addition to your family and key employees, be certain to include financial advisors, your CPA, lawyers, and others who can help to identify issues your plan should address and offer advice. You might even want to connect with other business owners who have been through the process to get their experiences and insights.
When the business is owned by two or more people, owners typically arrange for the remaining owners to buy out their shares. Partnership agreements and articles of organization for limited liability companies or articles of incorporation corporations usually include procedures for transferring ownership.
If you’re the sole owner of the business, you’ll have to decide whether you want to sell or transfer the business to family members or key employees or whether you want to sell to an outside buyer.
Each succession strategy poses its own challenges.
Selling to Family Members
If you want to keep your business in the family, you’ll first have to determine whether family members are interested in running the business. When you are passing down the business to the next generation, you’ll also want to make sure your succession plan provides for the time and resources you’ll need to train your designated successors for their new leadership roles.
Family-owned businesses might present additional opportunities and challenges, such as the need to compensate those family members who don’t want to be involved in the business. Succession planning should give careful consideration to family dynamics in order to avoid in-fighting and acrimony among family members, and it should provide clear instructions about who will take the leadership role in the business.
Selling to Key Employees
The biggest challenge when selling the business to loyal, long-time employees is often financial. You might have to accept a lower valuation if you sell to your key employees, and your employees might not have the ability to buy the company outright.
If your employees can’t afford to pay the full sale price for the business, consider a buyout over a period of time. Arranging payment in installments can also provide you with cash flow to meet your retirement income needs.
Selling to an Outside Party
If neither your employees nor your heirs are equipped or willing to take over the business, selling to an outside party might be your best alternative. Keep in mind that selling to an outside buyer requires a longer timeline. You or someone else (if you are unable) will have to identify potential buyers, allow them to conduct due diligence, and negotiate the sale.
If you are retiring, the timeline and the management of the process are not likely to be a problem. But remember that your succession plan should also prepare for the unexpected, and if you’re unable to spearhead the process, you’ll need a family member or trusted professional, such as a business broker, CPA or lawyer, to oversee the sale.
Financing Your Succession Plan
In a perfect world, your business partners, family members, or employees have access to the capital they need when the time comes to implement your succession plan. More often than not, however, your planning will need to include methods for financing the acquisition.
As discussed above, a small business owner can finance family members or employees who purchase the company by arranging for installment payments, a promissory note, or another form of debt financing.
For partnerships and other businesses with multiple owners, a life insurance policy can provide financing to buy out the shares of an owner who dies. Depending on the number of owners involved or other factors, such as age differences between the owners, financing can be arranged using a cross-purchase agreement or an entity purchase agreement.
In a cross purchase agreement, each owner takes out a life insurance policy on the others and uses the death benefit to buy the deceased partner’s shares in the business. The deceased owner’s shares are then distributed to the remaining owners.
With an entity purchase agreement, the business buys a life insurance policy on each of the owners and becomes the beneficiary. If one of the owners dies, the business uses the death benefit to buy the deceased owner’s shares from their estate.
Under this arrangement, the shares of the deceased are retired rather than distributed to the remaining owners. The remaining owners then own a larger percentage of the company.
When Do You Need a Buy-Sell Agreement for Succession Planning?
The best laid plans can fail once the business owner is out of the picture. Family members might argue over who controls the company, heirs might fight over their inheritance, and your business partners can disagree.
Unlike a succession plan, a buy-sell agreement is an enforceable legal contract. It can ensure that the plans you make for succession will be carried out.
You can use a buy-sell agreement to identify a buyer, set the terms for the sale of the business, and establish a sale price that can’t be disputed by the other owners of the business or family members. A buy-sell agreement can also allow heirs who aren’t active in the business to sell their shares to those who are or to another owner.
Creating a succession plan that addresses both expected and unexpected events provides essential benefits to small business owners. When developing an effective exit plan to ensure a smooth transition, enlist a team of experts to ensure the plan reflects your interests for the future of your business.