Strategic Succession: Taking Steps to Secure Your Business's Future – Part 2

Business succession plans are a necessary step to protect your family business. The most obvious benefits of business succession planning include avoiding potential family conflict and preserving the family business for future generations. 

In part one of this series, we looked at selecting and preparing the successors. We also looked at developing sound management structures and processes. Now we offer steps three and four. 

Step 3. Structuring the Transition.

Once the heaving lifting described in the first two steps is complete, it's time to start structuring the transition.

If the owner has not previously done so, now is generally when non-operating type assets such as real estate are split off from the operating business. This allows the owner to transfer the ownership of the operating business while retaining the real estate, and the resulting cash flow, for retirement income. 

Once the balance sheet is cleaned up, if children or key employees will become the successor owners, the transition will generally be structured as an equity sale of stock in a corporation or membership interests in an LLC. This type of purchase generally involves the least amount of disruption to the ongoing operations of the business. The purchase may occur all at once, in which case the sale will likely be financed by the owner pursuant to a promissory note payable pursuant to agreed-upon terms.

 Alternatively, the owner may sell minority interests over a period of time while retaining voting control. The timing of the sale may depend on the owner’s cash flow needs in retirement and the readiness of the successors to assume full control. Minimizing taxes to the owner may also play a role in how the payment terms are structured.

Determining the purchase price is often a challenge, particularly when the successor owners have been involved in growing the business. The owner should start by obtaining a valuation of the company from a qualified professional to establish a baseline. 

Adjustments based on the contributions of the successors, forecasted market conditions, cash flow needs of the owner, and other factors may then be incorporated to arrive at an established price. If the purchase will be made over time, the successors may want to incorporate some protection against future valuation increases. If the sale is to children, the owner may further discount the purchase price and treat part of the transaction as a gift.

Even in instances where the owner is fully bought out, the owner will often stay involved in the business through an employment agreement or consulting agreement for a year or two. This can allow the business to continue paying health insurance benefits for the owner until the owner is eligible for Medicare. It also provides a resource for the successors to ensure a smooth transition.

The new owners will also need to consider documenting their relationships with each other. A buy-sell agreement should be implemented to restrict the transfer of equity and set out the details regarding when an owner can be bought out. Death, disability, termination of employment, and involuntary transfer are a few common examples of triggering events. 

The agreement should discuss when and how a successor’s employment can be terminated. The buy-sell agreement should also provide a mechanism for valuing the company if a triggering event occurs. Finally, the buy-sell agreement should provide the payment terms for how the purchase price will be paid.

Taking the time to properly plan and structure the transition of a business and prepare a buy-sell agreement for the new owners are important steps to implement an effective business transition.

Step 4. Estate Planning

Updating a business owner’s estate plan is another important piece of an effective succession plan. If the ownership of the business is not fully transitioned during life, the estate plan will need to properly allocate the owner’s assets, including the business interests, in a tax-efficient manner. If the ownership of the business has been fully transitioned, there may still be issues to address with respect to how any non-business assets are allocated among the family.

One significant hurdle in planning for a family business is how to provide for kids that are not involved in the business. Parents often struggle with how to distribute their estate if the bulk of the estate consists of the family business and one or more kids are not involved in the business. 

In these situations, it is important for business owners to remember the adage that “Fair is not equal.” Business owners can strive for a fair distribution of their estate, but that will rarely mean an equal distribution of their estate.

One option is to allow an “inactive” child to maintain ownership of the business. This would typically involve giving non-voting interests to the inactive child. This can be an option for passing a portion of the value of the company to the inactive child while protecting the business and active kids from outside interference. 

This is not a very effective option, as it inevitably leads to fights over how the company's capital is deployed, i.e., re-invested vs. distributed to the owners. Unless this structure is partnered with clear buy-out mechanisms, this structure will eventually cause a strain on both the business and the family.

Another option is to allocate non-business assets to inactive children and business assets or interests in the business to active children. This may still present a challenge for many family businesses because the large majority of their estate is tied up in the value of the business. 

However, if the owner is disciplined about taking cash out of the business, a portfolio of marketable securities or other investments can be saved and passed to the inactive children. Life insurance can be secured to provide a death benefit to inactive children. If the business owns the real estate upon which the business operates, interests in the real estate can be left to the inactive children (subject to clear, comprehensive, and long-term lease arrangements).  

Once the distribution of the estate is addressed, it will be important for business owners to consider the use of trusts in their estate planning. Trust can be used to reduce estate taxes to the owner and future generations. They can also be used to provide protection from the children’s creditors, such as ex-spouses. 

Finally, they can be used to keep the inheritance “in the family” and minimize the risk that assets will be distributed to a child’s spouse (if the child dies prematurely) or worse, to the new spouse of the deceased child’s spouse if the child’s spouse remarries. A properly designed trust for the benefit of a child can reduce the risk of those events, while still allowing the child and future generations to enjoy the benefits of those assets.

Incorporating a business succession plan into the owner’s estate plan will help insure that the business can continue to thrive and that the family relationships remain strong. If you have questions regarding that process, the estate planning attorneys at Woods Fuller can help guide you to an answer.