If you’re a business owner, you have far more than money invested in your work. You may be the first to open the door in the morning and walk in on a floor that you’ve mopped yourself.
Your dreams, your vision and your hard work are what hold this place together. But there will come a day when you turn off the lights and lock up for the last time in your career.
You owe it to yourself and your vision to create a succession plan. Let’s look at three types of strategy for business succession planning and outline how you can implement your legacy plan for the future.
Succession Planning Strategy: Transfer the Company to a Family Member
Transferring the company to a family member may seem like the traditional path, but the pros and cons of the process should be carefully weighed. According to a 2019 Business Owner Survey from the Business Enterprise Institute, 39% of business owners are planning to pass on their business to a child or family member.
Pros:
- Keeps the company in the family – If your kids or family members grew up around the business, they may know the terrain well and feel at home running it.
- Provides for your family’s financial well-being – If you pass a viable business on to your kids, you can help provide them with financial security and a career.
- Perpetuates the company’s mission and culture – Your company’s mission and culture are a part of you, and carrying on that legacy through a family member is a worthy goal.
- Allows you to remain involved – As opposed to selling to a third party, you may have more freedom to be involved in the business and gradually retire, as well as providing vital coaching to the generation that takes over.
Cons:
- Family owners sometimes can’t pay fair market value – This could be a financial risk and complicate your relationship. If the payment is done in installments or by another contingent model, it puts extra pressure on the successor to turn profits quickly.
- Without proper planning, you could end up with very little upfront cash at closing – Money matters can sometimes be awkward to discuss with family, which could make your succession conversation less thorough than it needs to be. Do you need that initial cash flow to start off retirement? What will you do if it’s diminished?
- Family issues and treating all kids fairly – If you have more than one child but pass on your business to only one of them, you may create an “elephant in the room” about the equality of their inheritance.
Read more: Life Insurance Strategies for Business Owners
Recommendation: Estate Equalization
This last con, often called estate equalization, has one potential solution: designating your kids as Business Active Child(ren) (BAC) versus Non Business Active Child(ren) (NBAC). Giving equal amounts of assets to your children will help to minimize family tension while keeping the business in the family, but it takes some planning.
Business Active Child
The Business Active Child (BAC) will inherit the company and take over leadership. This is not a simple, one-time event, but rather a gradual trading of duties over time.
But what if the BAC doesn’t have near enough capital to buy you out? You may need an installment sale of some kind, or you can use gifting through a Grantor Retained Annuity Trust (GRAT) or an Intentionally Defective Grantor Trust (IDGT). Whatever approach you take, serious financial planning needs to be your first step.
Non Business Active Children
Equalizing the estate for the remaining siblings – the non business active child or children (NBAC) – is also a priority for estate and succession planning.
Life insurance is one popular method – purchasing policies on the owner and naming the NBAC as beneficiaries. The size of the policy is based on the current valuation of the business. When the owner retires, the BAC pays the premiums on these policies. The NBAC will receive the death benefit, which is based on the business’s value when the succession happened.
Other assets of your estate – vacation homes, vehicles, etc. – can also become part of the equalization discussion. Real estate owned by the business and even stock in the business can also help to equalize matters for the NBAC.
Succession Planning Strategy: Sell the Company to a Key Employee
As a business owner, you know who your key employees are. Your business wouldn’t work without them.
Selling your company to a key employee is another potential strategy for business succession planning.
According to the Business Enterprise Institute survey referenced above, nearly four in 10 owners look at management or employees as successors.
Pros:
- Keeps the company in the hands of a current employee – A key employee knows the work well, so there’s less time lost in training and trial/error.
- Maintains the culture and mission – Your key employee may have helped draft the company’s mission statement and has likely been integral in building the company culture you’re proud of.
- Allows for you to remain involved – As the owner, you have some control in this scenario as to how gradually you leave the business. You can provide coaching and wisdom to see your successor through the transition.
Cons:
- Financial risk if the key employee can’t pay full value – If a junior employee, your successor may not have the capital to fully buy you out.
- Lack of upfront cash – On the same note, the upfront payment might be lower than if you sold to a third party. This cash flow can be integral to your retirement plan and settling debts.
- Challenge of retaining the key employee for the long haul – You’ve likely had essential employees get “head-hunted” by competitors before. Holding on to a successor is crucial.
Recommendation: Executive Bonus Plan
An Executive Bonus Plan can help with long-term retention. In this scenario, you buy a life insurance policy for your key employee, usually whole or universal, and the employee determines the beneficiary. Part of the key employee’s regular benefits go to pay the premiums, and the cash benefits are released to them when they retire (or at some other future date).
Strategies like this, sometimes called “golden handcuffs,” help ensure that key employees will be around when the legacy plan falls into place at the owner’s retirement. For your key employee, this strategy can be a great boost to morale and an act of faith that you’re interested in their career long term.
Succession Planning Strategy: Sell the Company to a Third Party
Selling your business may not seem like a succession plan, but keep in mind that your employees will likely continue working for the business and the processes and vision you’ve put in place will likely remain part of the organization.
Selling to a third party remains a popular choice, with 48% of business owners saying in the Business Enterprise Institute survey they’re planning on this exit ramp.
Pros:
- Receive the highest purchase price through a strategic partner – A strategic partner is usually more likely to give you the highest purchase price, often having more financial resources than a family member or key employee.
- Maximum cash at closing – Immediate cash flow, rather than a drawn-out payment plan, can help you start retirement strong.
- Owner can fully exit if desired – Of our three scenarios, this one is the most likely to leave you clear of coaching/mentoring responsibilities during the transition. You can leave the office and go straight to the hammock if that’s your preference.
Cons:
- Potential loss of company culture and mission – Outside buyers interested in purchasing your firm have their own distinct culture, which could drown out the qualities of your organization.
- Dependent on the state of the mergers and acquisition environment and size of the company – In some ways, you’re beholden to the acquiring company’s terms and policies, rather than having the modicum of control you might have in selling to a key employee or family member.
- Owner loses control post-sale – With a third-party sale, what’s done is done, and you will have to sever decision-making ties with the firm.
Succession Planning Recommendation: Set Benchmarks
You may have received a “Letter of Intent” (LOI) before. These are usually from a larger company that is offering to buy you out or merge with you, and these letters may become more important as you near succession planning.
It will be worth a conversation with your advisor to help you find what the current industry benchmarks are for your business. As tempting as the LOI offers may be, you need context to make that decision. You should also conduct a thorough valuation and have its findings in mind as you prepare to negotiate.
You can break things down further to identify your preferred terms for the sale. You should work on an exact purchase price and outline the timing of payments that you find acceptable. You should also plan earnouts and guarantees that could come as part of the terms of sale. Your advisor can help you run different scenarios to see what works for your business and your personal financial plan.
A Guide for Business Owners
Are you a business owner nearing retirement? Or are you there already and want to clarify your plan? Looking over your plan for loose bricks and hairline cracks is worth your time and energy.
Our advisors have seen several individuals and families through this process and have helped them preserve their legacy and vision for the next generation.
Get in touch today to talk through your business and financial plan.
