Succession Planning
What is it and why do it?
Succession planning is a proactive, strategic approach that allows an owner to exit their business on their own terms. Not all businesses are created equal, and one of the more common misconceptions we’ve seen business owners have is related to the time frame it takes to walk away or retire. The reality is the process of retiring from one’s business can take a significant amount of time. Frankly, finding a qualified buyer can take years in and of itself. “Qualified” doesn’t just mean financially; it also means someone who can continue to successfully run the business. Additionally, many business owners tend to place a higher value on their businesses than the open market. Income from the business is often a core component of one’s retirement plan so having a professional, unbiased valuation is imperative.
Other nuances of succession planning include the buyout structure, buyout funding, the exiting of multiple owners of various ages, death and disability, business legacy planning, protecting key employees, and taxes. These are all reasons succession planning should become an important business consideration sooner rather than later.
How do we address different goals of multiple owners?
Enter the “Buy-Sell” Agreement. A properly structured buy-sell agreement is at the core of any strong succession plan for a business with multiple owners. This single document can address everything from the exit of an owner to the treatment of shares in the event of an owner’s divorce.
Let’s say one owner is significantly older than the other. The younger partner wants full control when the older partner retires. The buy-sell can dictate how shares are to be sold at retirement. In this case, the younger partner would want the buy-sell to state that he or she has first rights to buy the shares. This gives them full control, protects them from going into business with someone they may not know, and the older partner still gets paid.
Let’s say we have three owners. Two out of three want to sell out, while the other wants to transfer her shares to her daughter at retirement. A properly crafted buy-sell can make this happen. However, it’s important to point out that if the other owners have 66% of voting rights, they could potentially shut this down before it’s ever put in writing.
What else does the Buy-Sell Agreement address?
One of the most popular sections within a buy-sell addresses what happens in the event an owner passes away. If A, B and C own a business together and A dies, B and C are now partners with A’s spouse. This is typically not a desired outcome for all parties involved. Therefore, buy-sell agreements are typically written to state that the surviving owners get to buy-out the deceased owners’ spouse, based on the fair market value of the business. This can be done with cash, retained earnings or a loan from the bank. The catch is most businesses don’t have that kind of capital on hand and they don’t want to saddle the business with debt. To counter this, owners typically utilize life insurance as a method of providing the liquidity needed to complete the buy-out.
The disability of an owner is another criteria that may trigger a buy-out clause within a buy-sell. Disability can often be overlooked, as many cookie-cutter buy-sells use terms such as “incapacitated” or “mentally incompetent” and don’t directly address the term “disability.” Not everyone who becomes disabled gets classified as “incapacitated”, so no buyout would be triggered. Yet, they still may not be able to perform their old job functions but get to hold onto their voting rights. It is best practice for the buy-sell to seek the opinion of two medical professionals and define disability specifically using the terminology within a long-term disability policy.
Perhaps most importantly, the buy-sell dictates how the business is to be valued should it be sold. As mentioned above, many buy-sells require at least one 3rd party valuation.
Buy-sells also dictate how to address the buying out of a divorced owner’s spouse, criminal activity of an owner, and bankruptcy of an owner.
How do you fund an owner exit?
Enter the “funded” buy-sell agreement – unless of course you want to buy-out of the first owner to rely solely with a loan from the bank.
What we most commonly come across in the industry is the use of Variable Universal Life (VUL) insurance contracts to fund the buy-sell agreement. VUL’s are typically marketed as a hybrid product that provides death benefit to buy-out your spouse if you die, yet has a living benefit of cash value that you can use to fund your exit. However, VUL’s tend to be very expensive when trying to get sizeable death benefit amounts.
The other way to fund a buy-sell is through retained earnings. Simply put, this is an ordinary investment account. This method doesn’t require expensive premiums and can avoid creditors by being directed to a separate entity. This method is usually paired up with low-cost, term insurance.
How does one typically exit their business?
There are multiple ways to “exit” a business. A common method is via a traditional buyout from an external entity such as an individual investor, private equity firm or a competitor attempting to scale. These types of buyouts are typically structured with an up-front, lump-sum payout or in annual installments over a stated number of years.
In some cases, a business owner may prefer to sell the company to someone within the company. This is known as an internal succession. Perhaps a younger family member or key employee has proven themselves worthy of taking the reins. An advantage of internal succession is that the buyer typically has an intimate knowledge of day to day business operations and familiarity with the company’s employees. One potential catch here is whether or not the ideal internal candidate can afford to make the purchase.
In either case, terms of the deal may require the selling owner to stay on as a “consultant” or in a managerial capacity. This isn’t uncommon. Both the seller and buyer typically have a vested interest in the business continuing to run smoothly. Obviously, the buyer wants to turn a profit and may need the seller to teach them or new employees how to run the show. On the flip side, selling owners may be on an installment agreement tied to profits or simply want to see it thrive as part of their legacy.
The opinions expressed in this article are those of author and should not be construed as specific investment advice. All information is believed to be from reliable sources, however, no representation is made to its completeness or accuracy. All economic and performance information is historical and not indicative of future results. Any tax advice contained herein is of a general nature. Further, you should seek specific tax advice from your tax professional before pursuing any idea contemplated herein.
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