Business owners are no strangers to making difficult decisions. After all, it’s hard to build a company without compromising here and there. One area of decision making that can be particularly challenging to navigate is deciding on a future successor. There are a few different types of succession planning to choose from as you look ahead.
While this decision is in many ways a personal one, there are several legal and financial factors to take into account as well. Take time to review each of the succession planning options below and decide which is the best for your business:
1. Passing your business to an heir
A common option in business succession planning is to name an heir to eventually take over the company. Usually the owner will choose one of their children. Note that proper legal agreements and clear communication are keys to the success of an heir-based plan. Incorporate these measures in your Estate Planning efforts, as they will help minimize the potential for future disputes.
For example, let’s say Jerry owns a successful toy company and has three children. Jerry decides to leave the company to her oldest child, Martin. In this case, it is crucial that Jerry inform each of her three children and take appropriate steps to ensure her eldest child is aware of his future responsibilities.
Pros of Passing Your Business to an Heir
For many business owners, the most significant benefit to naming an heir is the opportunity to keep the business in the family. This can help keep the company rooted in your original ideals and give you a sense of confidence about the future.
Passing your business to an heir can also help you establish generational wealth in your family. If the family business is performing successfully, you can pass it to a child who can one day pass it to their own child (and so on). This ensures each generation can enjoy the financial benefits associated with the business.
Cons of Passing Your Business to an Heir
When naming an heir, there is the potential to stir up family conflict. In some extreme cases, legal battles can ensue for years after an heir takes on the role of successor. This can create long-lasting family divides and open the door for costly legal proceedings. For this reason, it is always recommended to discuss the details of a succession plan with the entire family.
2. Selling your business to a co-owner
In cases where there are multiple business owners, one option is to sell ownership to a co-owner. For some succession plans, this could go into effect when the co-owner passes away, retires, or otherwise needs to step back from the business.
Typically, the first step is to determine the fair value of each ownership portion. For companies with publicly traded stocks, the share price will be used to determine the price. For privately-held businesses, the price is determined by a business appraisal. The two co-owners can use this information to negotiate the exact price of the sale.
Let’s say for example, Molly and Lauren co-own a coffee shop together. As Molly prepares for retirement, she realizes she is comfortable leaving the legacy of the business in Lauren’s hands. The two could then work together to come up with an agreement where Lauren purchases Molly’s stake in the business for the appropriate price.
Pros of Selling Your Business to a Co-Owner
The benefit of selling your business to a co-owner is that your legacy will continue at the hands of a trusted colleague. This is a sound option for business owners who do not have any heirs, or who do not necessarily want their business to stay in the family.
Selling to a co-owner also provides the option to “cash out,” so to speak. The sale can provide much-needed funds for retirement or other financial needs.
Cons of Selling Your Business to a Co-Owner
Unfortunately, not every business owner is comfortable selling their stake in ownership. This often comes down to the fact that after a sale, business owners don’t have control over operations anymore. There is nothing stopping your co-owner from one day selling the business to an outside party.
Depending on the valuation of the business, selling to a co-owner may not be as fruitful as owners might hope. While it can provide some funds for the future, the amount will depend almost entirely on the business valuation.
3. Leadership Succession Planning with Existing Employee
Leadership succession planning involves naming a successor from a group of qualified candidates within the company. This can be a great way to pass the baton to a trusted employee and ensure the business is well managed in the future.
Typically, leadership succession planning starts with some form of internal training for candidates. The business owner can determine the type of training and number of employees enrolled. The overall goal is to have someone who can immediately step in for the owner if they were to pass away unexpectedly.
An example may help provide more context. John owns a manufacturing business and has implemented a mandatory training protocol for high-level employees. Within this training are specific management related courses about the future of the business. After identifying successful candidates, John decides to name one as his successor. This person is then poised to take on John’s role after he steps down.
Pros of Leadership Succession Planning with Existing Employee
Leadership succession planning is one way to ensure a qualified candidate is on standby to run the company. This can provide a seamless transition as ownership changes hands and signal stability to board members or other stakeholders.
This route also allows business owners to directly work with the employee they eventually want to name as successor. Many business owners are eager to provide mentorship and advice before handing over the reins.
The practice of leadership succession planning can also help increase morale and employee retention. If there is a possibility to move up within the company, and even one day be in charge, employees will often be more motivated to develop their skills and remain at the company.
Cons of Leadership Succession Planning with Existing Employee
The main disadvantage to leadership succession planning is that it requires strong internal infrastructure within the company. There needs to be a set protocol in place to train and mentor potential candidates. While small business owners can successfully implement leadership training, this type of planning is more frequently implemented in larger businesses with more resources.
4. Selling Your Business to an Outside Party
Yet another option for future succession is to bring in an outside party to sell the company to. This could involve selling to an investor, a competitor, a management firm, or other interested party. Selling to an outside party is a great option to walk away from the business -- if that’s what you want.
The process of selling to an outside party also starts with a business valuation. This can be done in a few different ways, depending on how ownership is held. After an appropriate value is determined, the business owner can complete the sale of the company.
In a hypothetical situation selling to an outside party would look something like this: Sarah has owned a brewery for years but now is ready to retire. Her local business has a strong brand and customer base. Sarah reaches out to her contacts in the industry to alert that she wants to sell her business. Once an interested buyer steps forward, an appraisal is used to determine the business value and Sarah can officially sell her brewery.
Pros of Selling Your Business to an Outside Party
The pro of selling your business to an outside party is the chance to profit as you walk away from the business. Perhaps the responsibility is too much or you don’t want to pass down the company, selling to an outside party can provide extra income during succession planning no matter the reasoning.
Aside from the financial aspect, selling to an outside party could represent the opportunity for your business to grow in the future. If you did not have the capital to expand the brand as you wanted, an outside investor may be able to do so. This can further grow your legacy.
Cons of Selling Your Business to an Outside Party
Anytime a business owner considers selling, it’s important to address the possibility that the future of the company may not be what they had in mind. An outside party might be a great option at the time, but after the sale is complete you may not always agree with how the business is managed. As a former owner, it can be difficult to watch your company move forward without you or your vision in mind.
5. Buy/Sell Agreements
There are two main types of buy/sell agreements that can be used in business succession planning. First, a cross purchase plan can be implemented to allow business owners to purchase on another’s shares. This works by having two co-owners take out life insurance policies on the other owner. When one owner dies, the proceeds from the policy will allow the other owner to purchase their portion of the company and move forward.
The other main form of buy/sell agreement is through an entity purchase plan. This involves the business itself taking out a life insurance policy, and naming itself as the policyholder and beneficiary. When a business owner dies, the proceeds from the policy are used to purchase their ownership share. The cost of the policy is often deductible.
As an example, let’s say a group of five friends from college own a successful T-shirt design company together. Later in life, they collectively decide on a buy/sell agreement as the preferred succession plan. With five co-owners it wouldn’t make sense to use a cross purchase plan, as there are too many people to hold separate policies on. Instead, the group creates an entity purchase plan where the business can buyback shares.
Pros of Buy/Sell Agreements
Through the careful use of life insurance policies, business owners can ensure they have the funds to purchase other shares in the company. Buy/sell agreements can provide a clear vision for future ownership and help ensure a smooth transition as owners change.
These agreements can also offer a solution for businesses with multiple owners, such as those in the hypothetical example above. Often with so many people involved it can be difficult to select an heir or one owner for the company. With an entity purchase plan, ownership shares are essentially sold back to the business. The remaining owners can then decide on the best way forward.
Cons of Buy/Sell Agreements
The main disadvantage associated with buy/sell agreements can occur in situations where there are disparities between co-owners. For example, if one partner is 65 and the other is 35 the cost of life insurance policies will vary greatly. In cases such as this, an entity purchase agreement would be the most appropriate; however, all owners need to agree on it.
Another example that can make buy/sell agreements more complex is the number of owners and their various ownership shares. If the company is not divided evenly, some owners may not be on board with the possibility that they are bought out by life insurance proceeds.
Create Your Business Succession Plan Today
A business succession plan can help provide a clear roadmap for the future. While it can be difficult to think through, a succession plan can help your business in more ways than one. Namely, establishing a clear path forward can signal longevity to stakeholders and employees. This is also a great way to protect your future legacy.
The various types of succession plans represent a variety of options for owners to choose from. Whether you opt to name an heir or sell your ownership to an outside investor, make sure you weigh the various pros and cons. Often, the most challenging aspect of business ownership is stepping away from the reins. If you are interested in talking through your business succession planning needs, reach out to our team for more information.
When it comes to the various types of succession there is no one-size-fits-all answer. The right way forward will depend on future goals, family needs, and your vision for the company. Think about succession planning as a new opportunity for your legacy, and choose what feels right for you.
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