THE KEY TO SUCCESSFUL SUCCESSION PLANNING

The greatest part of America’s wealth lies in family-owned businesses. According to the US Census Bureau, family firms comprise 90 percent of all business enterprises in North America.

 

Strategic Succession Planning

Just as a successful business plan is important to the definition and goals of a newborn company, a succession plan is valuable to the continuity and continued growth of the company from generation to generation. I often talk with small business owners who have either started a business or bought and established a business, to find them working 40,60,70 hours a week in that business. Most have their business registered incorrectly, no designed management system, nor do they have any type of pay structure or method of growth within the company; they fill a societal need and they continue to work. I often tell these clients, “You didn’t buy a business you bought a job.”

My goal for most small business owners is to focus on the investment details of your business, not the operations. The goal is to incorporate this into your personal financial growth and retirement.  This blog is to help you develop a focus on making your business an increasing value to your personal financial life.

 

The Goals of the Business

• to generate profits and create shareholder wealth

• exploit market opportunities

• reward efficiencies.

These things can become direct conflicts with the recognized goals of the family.

For most business owners the business is the largest asset that the owner may have, and once the owner is deceased the business valuation is highly compromised and devalued.  Just about all non-publicly traded businesses are non-liquid assets, so a buyer or investor who makes an offer will make it far below market value. An illiquid business will continue to lose value in many aspects; the business will lose cash flow because of the owner’s expertise. The business will lose customers who will then seek business elsewhere, and once those 3 things begin to happen the business loses value quickly. If an investor happens to come to the business at the right time, the investor’s knowledge and expertise may not be sufficient enough to take the business in the future. Expertise and knowledge do not just pertain to how to do the business but it is also deeply dependent on relationships and contacts and understanding what person is valued at doing certain parts of the business that aren’t discussed. Those hidden values are often required.

So again, when an investor does come around, he will want to make the purchase of the business based on some internal rate of return. Normally this is going to require a much decrease in the value of the business. Then if the business is partially sold, family members may find themselves at the mercy of the new business owner.

The Ultimate Goal of Succession Planning

• to understand the value of the business

• preserve its value and future growth potential

• to pass it along intact.

 

What is Succession planning?

Succession planning is a strategy for passing on leadership roles, often the ownership of a company to an employee or group of employees. Also known as “Replacement Planning,” it ensures the business will continue to run smoothly after a company’s key people move on to new opportunities, retire, or pass away.

I look at a succession planning definition as a strategic plan as one that facilitates the continuity of the transfer of a business from one shareholder to another. It is a set of agreed and intended actions to make a smooth and legal transition of ownership. I define succession planning this way so as not to sound ambiguous or confusing. As every detail of a succession plan must be addressed, it is important to implement the process. There are tax issues and legal issues to be cognizant of, as well as, making a guideline that is clear and sound to confront potential dissatisfaction of family members.

In the United States of America, small businesses employ over 113 million people in non-farm jobs. This equates to 57% of the American job force. That contribution to employment comes from 5.5 million family-owned businesses and $8.3 trillion that contributes to this country’s Gross Domestic Product {GDP}.  As you read these statistics you need to understand that, if you are a small family-owned business, you are part of this data. You will have to decide where in these equations you want to ultimately fall under. Many of you who own your small business and run it pretty successfully will be there for an average of about 24 years. You will be at the helm of that company for 24 years; 47% of your small businesses will collapse because of your death and almost 30% will collapse because of an unexpected death. That contributes to the loss of over 53 million and 33 million jobs respectively. Those numbers drop significantly when there is a successful succession plan; 16% loss when precipitated by death, and 6% with an unexpected death.

The probability that a business will survive after the 1^st generation is just as bad. About 40% of all businesses will survive after the 1^st generation founders that have developed systems to sell their business have the continuity for partnership change or have been passed down to the next generation to run the business. From the 2^nd generation to the 3rd the success is only 13%. Again, if you look at the statistical contribution, in this case, contravention to employment in the country is 60% unemployment or over 68 million.

Small businesses that have fewer than 500 workers employ 55 million, and these same companies that employ fewer than 20 workers employ over 20 million which is 61% of the 114 million employed. Yet 80 percent of these same businesses will not fire their people when times are hard. Owners view themselves with high standards and hold their status in the community in high regard.

I bring up this statistic and you may think they don’t have anything to do with succession planning, but they have precisely everything to do with succession planning. With the standards that business owners hold themselves, a large number won’t consider succession planning because they wish to avoid family conflict; over 32%, studies have shown, won’t consider discussing for fear of family dissent and 40% would rather sell the business outright.

There are 4 aspects to developing a sound business:

A Business Plan

A Marketing Plan

An Advisory Board/Council Board

A Succession Plan

The 3 Categories of the Succession Plan.

Family

Goals and Communication

The most sensitive and valuable part of the succession plan is family communication. These succession planning strategies should be discussed at the outset so everyone in the family can make their adjustments and no one will be caught by surprise.

Estate tax

The transfer of ownership and shares of the business will have many tax implications, preparing for them would also prove to be wise. The transfer of shares will require an exchange of cash or some other equity. How your business is registered will determine your estate tax strategy

Promotions

This is part of the communication and goals define who will be in line for promotions; what are their roles everyone else must know their roles and whom they answer. Every change should be well documented and signed.

Shareholders

Ownership shares

Shares are not just transferred to just one person, often the transition provides for shares to many people but making sure there is some majority of ownership in the right hands is most valuable. Understanding valuations is vital; getting accurate and frequent appraisals of the business will again save valuable litigation and conflict in the future. If 4 owners own 25% of the business each, the number of shares may be irrelevant at that time; but when shares are passed along and transitions have developed the share count should and will increase.  Still equaling valuation now, the business has gone from 4 owners or business partners to 13 business partners.

Voting Shares

All shares do not have to be voting shares; small businesses can also have preferred shareholders as well. Preferred shares have no voting rights. On the other hand, preferred shares will be paid before voting shareholders, and dividends will be paid on a consistent timeline. Preferred shares are not based on the company’s performance but based on the desired interest rate for a certain period. The company can also have within the covenant of the preferred shareholder agreement that they wish to call back the shares at the shareholder value, and the shareholders can cash in their shares at any time and the company is obligated to pay. Preferred shares are a valuable way for a small business to obtain needed capital.

Hierarchy

 Common shareholders are valued based on the voting rights of the shares. There must be an understanding and strategy of the original shareholders that by splitting up the shares, added conflicts could arise where the successors could revolt and vote based on their majority of common shares. One shareholder who is not in top management may try to manipulate his shares to get something in the normal workplace. Certain rules have to be established so that shareholders cannot impede the CEO from doing his job effectively. The CEO cannot walk into every meeting with the threat of losing his job at every quarterly meeting. As mentioned, Preferred Shareholders do not have a vote, but it should be decided if they are entitled to attend shareholder meetings. It may be possible that within the structure of the business, a sibling is subordinate to an employee who is not a family member or owner. How will the subordinate family owner perform his duties?

The business

Operations/Structure

Managerial hierarchy

Chain of command and the structure of communication within the company.

Retirement

If you are successful enough to be able to retire from your business and hand it down to your children or someone else and can retire comfortably, you need to take homage to your feats and pat yourself on the back because that is a monumental exercise of an enterprise. Successfully and strategically exiting the business with growth and prosperity for the shareholders is the key to it all.

Retirement plans also have to be developed within the company and those retirement plans can be established with a Supplemental Executive Retirement Plan, known as SERPs. Normally SERPs are used to keep key employees in your business and not lose them to competitors but a SERP can also be used as a Supplemental plan for top executives, who are also key employees of the business.  It is also known as a golden handcuff; it too is funded with permanent life insurance and provides multiple benefits. SERPs are probably the most used strategy to fund top executive retirement plans by publicly traded companies, but they too can be used for small businesses.

Another way to fund a retirement plan is with an Executive Bonus Plan or 162 Plan. You are probably asking why not a 401k or an IRA. To set up a 401k for a small business can be quite costly, and neither plan allows for you the owner to set aside as much as it may require for retirement, and to do that an IRA or 401k doesn’t work. As of this posting, a 401k has an annual maximum contribution of $19,500 and an IRA has only $6000.

What do you do when you max out at $20,500?  Within corporations, there is a level of investment that separates top management from the employees of a company, and the Executive Bonus Plan and the Supplemental Employee Retirement Plan are just that. Employees are given 401k’s because the likelihood of them exceeding $20,500 on an annual basis is very slim. For upper management, the Executive Bonus plan has been created, which is a non-qualified plan and its contributions are endless. Both of these plans are funded with high-performance life policies. For decades life insurance plans have been used for retirement. When you see a CEO getting that $100 million severance at his retirement it is not funded by stock, it is funded by life insurance.

 

What Is The Process Of Succession Planning?

Business succession planning is the key to successful strategic planning. Those who make strategic plans early will be rewarded by thwarting conflict down the road. This level of productive organization will combat ill-timed emergencies which could be costly and detrimental to a small business. In other words, if you are not strategically developing systems of succession you are merely planning to fail.

This reminds me of the parable in the book, The Art of War by Sun Tze.

A father has 3 sons: a herbalist, a general practitioner, and a surgeon.

The herbalist can tell you of the ailments that you will experience in the future and give you preventatives to ward off such ailments; he doesn’t make much. The second son was a general practitioner who helps with your ailments and how to live comfortably with them; he lives the life of the middle class. The 3rd son, the surgeon, has to cut out what has ailed you to the point that it has become dangerous to your life. He’s quite expensive, and he’s rich.

If I had to look at the 4 steps to the process of succession planning in its simplicity, I would initially use this as a basic succession planning template.

CEO Succession Planning

Regardless of the number of business partners or shareholders in the business, the CEO should write the succession plans. The leadership succession plan should be designed by the one who guides and provides leadership to the organization, and often that is the CEO.  The plan would then have to be agreed upon by all those who have an interest in the plan; not to be confused by those who may be affected by the plan, such as employees, family members, or others. This decision is the importance of a succession plan and how it will benefit the company and who will be able to help grow the company in the future. The shareholders and any other interested parties are the decision-makers of the plan. If one of the interested parties is an employee, that employee may be chosen to be part of top management and become a shareholder; even that employee, who will become part of the business partnership, should have a say in the succession plan.

Providing A Clear Transition Plan

Defining the roles as well as making every shareholder and stakeholder of the company aware of the transition is vital. Making people within the company aware of how the company will look at some time in the future is only good business. It provides clarity for your employees so they know their roles and the roles of others. It helps the vendors know that relationships will change and they too will adjust accordingly. Have you ever had a relationship with one person with a vendor for years and then call and suddenly find that he has retired or no longer works there? You feel somewhat slighted as a customer; that familiar relationship has been broken; now you no longer want to work with that vendor and you start looking elsewhere to do business. You don’t want to lose a business relationship this way.

Developing An Advisory Board would be a valuable part of your organization’s structural growth. Developing a group of professionals as a tool for the input and council to your business can be a valuable tool. It’s like having a host of mentors at the table advising you on all aspects of your business. Those members would provide relevant, objective, and independent advice continuously. The benefits of this type of outside analysis could provide strategic planning to finance, marketing, promotions, how to promote family members, salary valuation, and establishing the rights and duties of family members and their responsibilities that come with family ownership; settling family disputes within the business and clarifying boundaries.

Within Your Succession Plan Should Also Have Established Dates

Deciding and planning what is going to be your new purpose in life. These things can and should be practiced by taking extended vacations. This allows you to find yourself outside of the workplace and it also allows the business the ability to function without you.

• The date you will retire.

• When you will train and name your successor or successors.

• Choosing their replacement.

Remember when you lift one to a higher position, that person’s position has to be filled and trained for as well. A true difficulty will be for the founder or boss to walk away. Being a chairman or co-CEO would be or should be the second phase of the boss transitioning out of the business, but the decisions should be left to the new Chief Executive.

Key Person Protection. A key-person policy on the life of the business owner may provide the business with needed funds while the business is adjusting to management and ownership changes after the business owner’s retirement or death.  When I spoke of bringing an employee who will sign into the business partnership agreement, this is a key employee. The value that a key employee to a company can be enormous and can also be costly if you lose that individual. Many circumstances could lead to a valued employee no longer being at the company, but the cost of losing such an individual could be substantial. What would be the cost of bringing someone else into the position and training them; how much would you lose in business during this training and transition period?

How much time would other employees have to exhaust to fill the gap until the new person gets up to speed? Key person insurance helps fulfill the value lost due to transitioning.

Formulating A Good Buy/Sell Agreement

This too, is another important element of the succession plan. It tells who is selling and who is buying shares in the company. So, what is a Buy/Sell Agreement?  The Buy/Sell Agreement sets the parameters as to how the sale is done as well as the legal and tax issues.  It is a well-documented transfer and distribution of shares once an occurrence happens to lead to the vacancy of one of the owners. The valuation of the business is vital in a succession plan. The frequency of valuation of the business is important to agree upon as well.  How often will the business be appraised – once every 3 years; or every 2 years; this is a decision by the CEO but agreed upon by all owners.

The objective is for the parties, within a business partnership, to have the most current valuation of the company for the buy/sell agreement. Most buy/sell agreements are funded with life insurance. This is most beneficial for planning, funding, and maintaining adequate life insurance.

There Are 2 Types Of Buy/Sell Agreements

• Entity Plan Agreement
• Cross-Purchase Plan Agreement

No one type of buy-sell agreement works better than another. Neither provides value one way or another depending on your type of business nor does the type provide for taxable gain versus another. You simply have to look at the plan and decide on your relationship with your partner.

The Entity Plan

Under the Entity Plan, the business buys the insurance used to fund the buy-sell agreement. The Business will buy a life policy for each of the shareholders.

The values of an Entity Plan are as such:

• Fewer life policies are required.

• The policy cash values are available to the business

• The financial aspect of the business paying for the premiums rather than the individual shareholders

The disadvantages are as such:

• Because the cash value is available to the business, it is also subjected to creditors.

• Because the business makes the premium payments, it doesn’t raise the cost basis for the individual shareholder, which makes for higher estate costs.

Cross-Purchase Plan

With the Cross-Purchase Plan or Cross-Purchase Buy/Sell Agreement, each shareholder purchases life insurance against all other shareholders.

The Value of this type of Plan is:

• Each shareholder is the owner of the cash value of the policy.

• The cost basis of the surviving shareholders is increased and thereby creating a tax benefit.

The disadvantages are:

• Many life policies are required.

• The insurance premium risk may not be the same for each shareholder depending on their health and age.

• The concern of one shareholder letting the premiums lapse

• Deciding how the buy/sell agreement will be funded

What is most important to the buy/sell agreement is how the purchase is going to be funded. If the interested buying party is someone outside of the company, that person would be responsible for his funding of the purchase. But what happens if one of the shareholders becomes deceased? How will the other shareholders be able to buy out the deceased family? Often the most sustainable method of funding a buy/sell agreement is through life insurance; more specifically a type of Indexed Universal Life policy.

Surviving family members also benefit significantly from an insured buy-sell agreement. The agreement gives relief and simplicity when one of the owners has died. There is an assurance that the deceased owners’ shares will be sold at a fair and predetermined price. The insurance that will provide for the buyout will also eliminate the responsibility of the surviving spouse to manage the deceased interest in the business. It also protects the family from future business loss of the business possibly closing or selling the shares to an outside investor who will more than likely purchase the shares at a much-discounted value than what was predetermined. So, the family is protected from the possibility that the owners may not have sufficient funds to buy out the deceased owner, and the family is not dependent on the company’s growth or earnings to be compensated.

VALUATION

Market Value > Investment Value > Liquidation Value

Current cash flow does not solely determine the value of a company. Future cash flows are more valuable to the business valuation. Investors who may want to buy into your company will be using a business valuation formula to calculate return on investment. Their small business valuation will be based on what you are going to do in the future, not the present. For Publicly traded companies figuring the market value is simple – multiply the number of shares verse the stock price. Determining the value of a small business is far more complicated. Do you understand the metrics of your business? We can certainly discuss these things in the future.

Business valuation appraisals in a family business succession plan to transfer assets within the family will create efficiency as well as smoothness of the transition.  If a business doesn’t take the business valuation methods seriously, they will find themselves in great conflict when the time comes for the transfer; and you may never know when that transfer may occur. Deaths can and often do come when least expected, if the death is of the CEO, then mass chaos will resonate, then so will litigation costs, family feuds, loss of control of the business, and loss of valuation.

Even though many parts of the succession plan are highly important, and they all are, none of them can give the true measure to the overall scheme of the succession plan as does business valuation.  As a rule of thumb business appraisal, should be done periodically. Agreeing on the frequency is tantamount to the buy/sell agreement, because of the accuracy of the valuation at the time of implementation. It sets the purpose for the state in state taxes, and whether you’re able to meet those obligations. 64% of those who partake in setting up a good succession plan have experienced an increase in the valuation of their business.

Another important aspect of having a continuous business valuation is the handling of day-to-day operations and strategic market competition.  Let’s say one of your competitors is much bigger than you but does not have any type of succession plan or marketing plan; do you think they will have a concrete valuation of their business? They will probably base that business on current cash flows. This will allow you to go and make an offer to buy them at a much lower multiple because they don’t have a sense of their valuation.

A company valuation determines shareholder value, retirement planning, estate tax computations, transfer of ownership values, valuations of buy/sell funding, and because your business is the biggest asset you may own.

The objective is for the parties to have a clear calculated business valuation of the company for the buy/sell agreement. This is most beneficial for the planning, funding, and maintaining of adequate life insurance. This is most vital to the succession and the estate building of shareholders who leave the company.

What makes calculating business value a vital part of the buy/sell agreement, which, in itself is vital to the succession plan, is based on how you will fund the succession plan. Again here, the most cost-effective way to fund a succession plan is via life insurance. Indexed Universal Life policies, which have more cost, are most efficient because, in the long run, they will be cheaper than any other whole life policy. Within an Indexed Universal Life policy, you have the flexibility to raise the benefits of the policy without any additional medical background checking. Because as we grow older health issues will occur and getting a new policy for each valuation change can be very pricy. Do not get term insurance.

If you are getting a business appraisal every 2-3 years or how frequently you decide, the last thing you want to do is get medically checked for more insurance every time. Then it will become more expensive than just getting one policy that you can increase the value on.

 

What Does Succession Planning Mean to Your Type of Business?

How this applies to you and your family business is you understand your company’s valuation. It is from here that all of your agreements can begin.

Family-Owned Business

The further business expands beyond the immediate family the more difficult and the more detailed the succession plan needs to be. Having a succession plan under these circumstances is even more critical. The key to a small “mom and pop” business is to succeed the parents, will it be to all of the children, if so, who will be the head person?

How are the shares divided? Do the children already work for the business? If so, who will replace their jobs if they are promoted to a higher level in the business? How will the transfer of ownership be funded? If the transfer is based on death, then a sufficient life insurance policy should be in place and would be the optimum choice. When the family-owned business consists of 2 or 3 immediate families, which many often do, then the need for a succession plan is most dire. This is normally where businesses begin to fail after the 1st or 2nd generation.

The complexity when you start adding more family members or extended immediate family members is emotional attachments or the notion of entitlement. If you think about a business that has 2 siblings starting a business in their 20s before they were married and before they had other family interests besides each other the business is simple. If advanced 25 years later both siblings are married with children, and some of those children are working in the business. Children may be due an inheritance but it doesn’t necessarily have to come from the business, and a family business succession plan will address those issues. The succession plan process for these 2 siblings should have started on the day that 1 sibling said they were getting engaged. Keep in mind that a succession plan is not carved in stone, it is a living breathing document that should change every time a change is made and is conveyed to all shareholders and stakeholders.

Small businesses with multiple partners

When you are dealing with partners of a business the primary element of the succession planning tools is the buy/sell agreement. Business valuation is vital to the buy/sell agreement. Cross-selling is the most common type of buy/sell agreement. That is a method by which each shareholder takes on insurance for each shareholder, based on the percentage value of the business.

Business valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Here various valuation techniques are used by financial market participants to determine the price they are willing to pay or receive to affect a sale of the business.

Conclusion

Regardless of your structure or how your business is established, you can see how a succession plan is vital to the continuity and legacy of a business. If you wish to start the process of developing a plan specifically for your business click on the link below. We will start with a brief consult and start the business valuation process.

A customized step-by-step can begin and you will be on a resilient path of increasing personal wealth and preparing for an above-adequate retirement. This process will be the guide for your business’s future growth for generations, building healthy relationships contributes to the overall family wealth.