Creating a thriving, profitable enterprise that sustains through the years is the shared goal of small business owners everywhere—doing so requires foresight, planning, careful execution, and hard work. Most small business owners also hope to see their company continue on after they retire (or at least hope to sell profitably), but many do not realize that carrying out an effective succession requires the same strategic elements as running a business. In truth, coming up with a business succession plan involves giving detailed consideration to many independent issues, and usually requires a long term commitment to implementation. Still, designing such a plan is crucial to successfully passing a company to the next in the chain of ownership, whether it be a family member, an up and coming talent within the company, or otherwise.
Small business owners face many obstacles when preparing their business to survive their exit. The business itself must possess enough liquid assets to fund a buy-out of a departing owner, if that owner sells his or her interest back to the business, and to deal with any tax consequences. The business’ new leaders must be ready to successfully run the company, in order to avoid fallout from both customers and employees. Successor roles must be clearly defined within the company; ownership and management are different things, and the lack of openly communicated expectations can promote infighting between those assuming new responsibilities. Additionally, the departing owners themselves must prepare for the succession, both financially and emotionally.
Clearly business owners have a lot to grapple with, even when they plan to exit on their own terms. In reality, though, a predictable departure cannot be guaranteed. As such, business owners must protect their company against the consequences of unexpected injury or even death. In a family owned business, an estate tax could leave the family with no choice but to liquidate. Such a scenario emphasizes the need to create a business succession plan early on in a business’s existence. Although the day to day time commitments of running a business make it hard to plan for succession, a prudent owner must realize the importance of the matter and find time to prepare for the future. This article looks at the methods available for passing the business along, the training process necessary to develop new leaders, the availability of selling the company as an alternative option, and the various insurance policies obtainable to guard against risk.
Mechanisms for Passing the Business to Family Members
The business owner looking to pass the family business along to the next generation has many options to choose from, each with various tax and income consequences. The owner can sell the business to a family member, paying taxes on the increase in the company’s value at the capital gains rate. The money for the sale could be paid over time, allowing for a nice retirement income, but these payments would end up back in the owner’s estate to be taxed upon the owner’s death.
Business owners can also award the company to a family member as a gift, removing the company’s value from the owner’s estate. The gift tax exemption currently features a lifetime limit of $5 million above which a gift tax will apply. This limit is set to drop back to $1 million at the end of 2012, unless Congress chooses to extend the $5 million cap, making this an important year for business owners thinking of passing their business. Also, giving away the business as a gift would prevent the owner from receiving income on the sale. However, a part-gift, part-sale arrangement (possibly, the owner would sell the business for the amount the value exceeds the gift exemption) would avoid any gift tax and also would give the owner income from the sale.
Irrevocable grantor trusts provide another useful way to pass along a business. An IGT, a separate legal entity into which the owner would place the assets of the business, allows the owner to continue to own the company for income tax purposes, but removes it from his or her estate. The owner will continue to pay income taxes, making the “gift” even more valuable to the family member, and can also continue to draw income.
Recapitalizations serve as still another option for business owners. Giving shares to the family member would have the effect of transferring ownership, yet the owner could provide different voting power to different shares, allowing for the retention of whatever amount of control the owner wants to keep.
Again, business owners have many options for passing along their company. Getting an early start on succession planning, and also getting help from legal or tax experts, will ensure that the transfer of ownership happens as smoothly as possible. However, owners have more to worry about than the legal transfer of ownership—they must also prepare the next generation to successfully run the company.
Preparing the Next Generation
The obvious inquiry of business owners when contemplating a succession is whether the successor is ready to run the company. To make sure that the company does not fall apart when the owner leaves, he or she should spend considerable time developing a successor while still with the company. This involves both working closely with the successor, sharing the knowledge the owner has built up over the years, and stepping away so that the successor can learn to do things independently. It may also involve a trial period with some sort of third party review, or even the retention of veto power by the owner. For family members especially, it means starting them in positions appropriate to their qualifications. Beginning a career in the mail room not only develops an understanding of the company from the bottom up, it also legitimizes the successor in the eyes of other employees. Finally, owners must keep in mind that sometimes people (even family) don’t have what it takes to run a business, and that the only choice is to choose a different successor.
A less obvious issue business owners face is whether their customers and employees are ready for new leadership. In small, family-owned companies especially, business often stems from customers’ relationship with the owner. They receive and come to expect not only a certain level of service, but also to receive that service from someone they know and trust. Retaining customers through a generational jump is something owners often take for granted, but businesses routinely lose customers with such changes in ownership. To guard against this, owners must integrate their successor early, establishing relationships through customer contact while the owner acts as an intermediary. This takes time, and goes hand in hand with successor development—no matter how much time they have spent together, customers will be left unimpressed by incompetent leadership.
The same holds true for employees of the company. Working under an inept leader creates a frustrating business environment. Further, up and coming talent in the company won’t want to stick around once it becomes clear that promotions correspond to family relation, not merit. On the other hand, a successful family successor can energize the company. Employees should respect a capable leader, especially if his or her involvement with the company goes back a long time and began with a humble role. The talent within the company should see the family succession as a commitment to maintaining the company—alternatively, the company could be sold, most likely resulting in different ownership altogether.
Even if employees approve of the chosen successor, problems arise when filling the void left by the owner. To avoid this, owners must clearly define the roles of those taking over his or her responsibilities. Again, this shows the importance of properly training a successor. The new leader must know what the position entails, and must possess the skill to do what needs to be done. Failure as to either could create areas of uncertainty where different employees fight over control.
Selling the Company
If business owners fail to find a suitable successor, or simply want to make more money off the transaction, selling the company to an outside party might be the best option. A successful business sale requires choosing the sale structure that best addresses the financial needs of the owner, maximizing the value of the company in order to get the highest price, and making sure that certain obligations (such as those to employees) are carried out.
An owner looking to get out right away might consider an outright sale. The ownership changes immediately, and the owner profits immediately as well. Also, this structure places no lingering time constraints on the owner, a desirable feature for owners looking to start their next business endeavor as well as for owners ready to retire. Alternatively, an owner can pursue a gradual sale, passing control to the buyer over a period of time. Much like passing to a family member, this allows for the owner to train the new leadership. Also, this structure gives the owner the ability to slowly transition into retirement, which could have importance both for financial and mental/emotional reasons. Finally, if the situation calls for it, a lease agreement might be arranged. This would accommodate a business owner planning a leave of absence, but who would like to reclaim ownership of the company.
Before selling, owners should do what they can to maximize the value of their company. This should happen both internally by identifying any weaknesses in the business and attempting to fix them, and externally by paying attention to market and industry trends that affect the selling price. Owners must advertise, either on their own or with the help of a business broker, in order to find reliable potential purchasers. They will also undergo a valuation process, which means that the company’s books and records must be in order—likely, financial information must be available for at least the three prior years.
Upon sale, the owner must take care of obligations to employees. Owners must give employees sixty days of notice in order to satisfy the WARN Act, although this only applies to companies with more than 100 employees, and most likely won’t be relevant to small businesses. Owners must distribute remaining paychecks within a certain time frame. Also, owners must file federal tax returns for their employees and make the required deposits of these taxes. Last, owners must cancel or transfer any business licenses that no longer serve a purpose.
Guarding Against the Unexpected
Again, succession planning is difficult enough even if everything goes as projected. However, business owners must be able to deal with unexpected events and their consequences. A basic way to protect against the risk of future injury is by purchasing insurance. Many companies protect their important people using key man insurance. Owned by the business, the policy can cover multiple people deemed important to the company. In the case that these people die or become disabled (depending on the policy), the company can receive the amount needed to adequately replace them. This money goes to the business, not the individual. As such, ordinary life insurance policies remain critical for families that rely on the success of the business for their income.
Other varieties of insurance plans are available for small businesses, depending on what the business does. Products liability insurance protects against loss from the harm caused by defective products. Professional liability protects against malpractice and other negligence-based disputes regarding services rendered. Small businesses that operate out of the owner’s home should consider home based business insurance, since ordinary house insurance ordinarily does not cover home based business losses.
Properly planning for a business succession involves many steps. Owners must consider the consequences of various transitional mechanisms, and select the one that best achieves their financial and ownership goals. They must commit to developing their successors, both by increasing their skill and by building customer/employee relationships. They must organize the business, making it appealing for either a family heir or an outside buyer. Additionally, owners should protect against accidents and misfortune by purchasing the right kind of insurance.
In passing a business to the next generation, owners face many obstacles. Yet, by taking the time to address the important issues and starting early enough to prepare for the transition, owners can achieve their succession goals smoothly and effectively.
Written by Nathaniel Weimer