Wealth Planning Strategies for Business Owners: Succession Planning
July 18, 2022
First, business succession is challenging.
Most of those with no plan (78%) blamed their lack of planning at least partially on enjoying “managing their company too much to start thinking about a future transition,” while 42% said they were too busy to plan, and 44% felt that succession was “too far in the future” to need to establish a plan now.
The bottom line, without proper planning most businesses won’t survive past the original owner.
Benefits of Having a Succession Plan
Here are some key benefits of having a succession plan in place:
Increase current value of the business. A solid succession plan makes a business more attractive to potential buyers and may result in more favorable terms from banks on financing arrangements.
Establish financial security in retirement. Research suggests that only 18% of small-business owners participate in 401(k) plans, and many sacrifice personal savings in order to continually invest in their businesses.
Provide for family members. In the event of disability or premature death, a succession plan can help ensure that family members have access to cash or liquid assets.
Minimize taxes and efficiently transfer wealth. Estate taxes and other costs can take their toll — and often cause businesses to fail — without a proper plan in place.
Lastly, a plan can eliminate confusion by setting a clear path for next steps, reducing discord amongst family members, and providing clear communication around process and expectations. It can establish a plan to deal with certain, unforeseen contingencies (disability, early death, etc)
An effective plan should include …
Personal retirement goals for retiring owners
Goals for next-generation management
Procedure for dispute resolution
Definition of active and non-active roles for all family members, if applicable
Timeline for plan implementation
Frequency with which the plan will be reviewed
Process used to identify and vet new management candidates
Here’s an example of a how a succession planning process may look like:
The first step is defining goals and getting organized. Make sure records related to operating the business are in place and updated: operations and systems manuals and processes, training documents, financial records, competitive analysis, partnership or shareholder agreements, review contractual arrangements such as leases, plan for intellectual property (patents, etc.).
A thorough financial analysis of the business is crucial. Are balance sheets and income statements up to date and accurate for example. How much is the business currently worth? As an owner, what is your cost basis in the entity?
Define potential options for transitioning the business. Are family members, partners, or key employees a possibility? Does a sale to an outside party make sense? Is there an opportunity to transfer ownership, over time, to employees via an Employee Stock Ownership Plan (ESOP)? Consider what you want to get out of the deal and what your successors are, or might be, looking for. This is particularly relevant if members of your family will be taking over the business. Are you leaving the business entirely, or planning to work part-time? Are you considering bringing in someone else to run the business, while you still own, or part-own it, or are you looking to sell out completely?
How should the sale be structured? For example, half of business owners sell to family or employees so not surprisingly installment sales and earn-out arrangements are the most prevalent types of transactions. Is there an opportunity for a stock transfer that may have certain tax-related benefits in deferring capital gains?
Depending on the nature of the sale (transition to family members, employees/partners, outside third party), there are a variety of wealth transfer strategies that can be considered to ease transfer and mitigate taxes. For example, business succession within a family may benefit from a sale of business interests to an intentionally defective trust (which we will discuss later).
Lastly, clear communication throughout the process is critical.
The “A” Team
As part of the succession process, access to experts is critical. Here’s a visual including many different types of experts and specialists that can provide value during this process. Most business owners, hopefully, have a financial planner, attorney, CPA, finance relationship already in place. Depending on the nature of the business transition, other specialists — such as an investment banker — may be needed. Also, it’s important that these specialists work together as a TEAM, not disparate functions not communicating or coordinating with each other.
Business Valuation
One of the most important components to successful business succession is valuation. There are different methods a seller may consider, and in some cases, it may make sense to use a combination of several approaches.
First, using a market comparison to determine fair market value, based on a price a willing buyer/willing seller would agree upon with mutual knowledge of all the relevant facts, is one option that might apply. This approach may prove challenging since unique businesses or service models may make such comparisons difficult. If the business being sold is basically similar to other businesses of its kind — think dry cleaning business, for example — the market approach with some adjustments may be appropriate, However, applying the market value approach in the real business world may be difficult to find “apples-to-apples” comparisons.
Another method to determine a value for a business is to use a multiple of earnings. With this approach, you simply multiply earnings of the company by a specific factor, such as 3X EBITDA (earnings before interest, taxes, depreciation and amortization). For example, you might multiply your annual revenue by three in order to come up with a value for the business. The multiple that you use can vary significantly from one business to the next. Typically, a common multiplier will be used for an industry and type of business.
By using the discounted cashflow model, you calculate how much cash flow the business will create over a period of time. Then you use an expected rate of return, such as the rate of government Treasury bills, to calculate how much money you would need to invest to earn that rate. This method has some subjectivity to it since the valuation specialist will have to determine an appropriate discount rate (which will be discussed later).
Lastly, a simple way to estimate a value for your business is simply to look at its assets. If you were to buy everything that the business owns, how much would it cost? Look at the total company assets and compare them to the liabilities. The difference between the assets and the liabilities represents the current asset value of the company. But remember, this method does not take into consideration the goodwill you have built for your business, which will have an effect on future earnings. Nor does it factor in your market share, which may well influence the true value of the business.
Considerations on Structuring the Sale
Asset or stock sale?
How much cash up front? How much financing?
Will previous owner(s) stay on in some capacity?
Is there an earn-out clause or similar agreement?
Here are some other considerations related to the sale of a business.
First and foremost, how will the sale be structured? Full cash sale or a mix of cash up-front and a note? Over how many years will the note be paid, and at what interest rate? Will there be performance triggers as part of the sale?
In many cases, a former owner of a closely held business will remain in some capacity as a consultant to the new ownership to smooth the transition.
For example, an earn-out clause or agreement may be an option. In this arrangement, the seller finances the business and the seller’s payment is based on the earnings of the business over a period of years. There are several ways to calculate an earn-out (tied to profits of the business, (for example). Payments may be spread out based on profits; if profits are high, the payout is made more quickly and vice versa.
An earn-out agreement can provide benefits to the seller and buyer.
Seller — the ability to spread payments over several years may help manage the tax bill, an advantage that the buyer has incentive to operate the business at a high level to pay off the seller financing as soon as possible
Buyer — financing spread out over several years, which makes it easier to fund the business sale
One potential drawback to the seller is that earnings may not grow fast enough to pay back the financing quickly or the buyer may go bankrupt, so the agreement should include contractual protections (specified minimums, etc.) to mitigate this risk.
Cross Purchase Agreement
Closely held businesses must plan for the transfer of ownership not just upon a sale, but also upon an event arising with one of the owners (death, disability, retirement, etc.). A buy-sell agreement establishes a legal obligation for one party to sell, and the other party to buy a business interest upon a specified event. Details such as what will trigger the agreement are included in the contract. A properly designed buy-sell agreement will specify the buyer(s) of the business interest as well as the price (or define the process for valuation).
These types of agreements are typically funded with life insurance which can provide liquidity for surviving owners to purchase remaining business interest from family of the prior owner. This agreement also helps to convey to creditors (banks, etc.) that there is a plan for business continuity in place.
In this chart we feature a cross-purchase agreement where partner/owners of the business buy and hold life insurance policies on each other.
Some key considerations:
Surviving owners receive a new cost basis on the purchase of ownership interest from prior owner (based on the price paid at time of transfer)
Business valuation is key in order to make sure the plan has adequate coverage to execute the buy-sell transaction upon a triggering event
Takeaways
Significant changes may be on the horizon in the future as our nation grapples with federal debt and the pressures of entitlement programs. Investors would be well served to keep a close eye on how these changes will impact their personal finances. The best preparation is to consult with a financial advisor or tax professional, who can offer some perspective on your specific financial and tax situation, help you understand the risks, and position your assets accordingly. The markets and the regulatory environments are always changing, and in uncertain times like these, sound financial advice should be at the foundation of any long-term investment strategy.
