Allison Lennarz of Kaufman & Canoles, P.C.
Successful entrepreneurs, with numerous demands on their time and the perception that other responsibilities are more pressing, find ample excuses to postpone hard discussions about what will happen to their business following their demise. Many wait to address this inevitability until terminal illness or imminent death leaves no alternative. Under such circumstances, succession planning becomes emotional, highlighting weaknesses and aggravating friction among family members. Business is more likely to be disrupted when transitions are sudden and rash. To minimize risks and maximize opportunities, owners should therefore undertake business succession planning while they are still healthy and in control.
A threshold planning issue concerns what happens to the firm at the owner’s death: liquidation, sale, or continuation of the business? Liquidation may be the only available option if inadequate planning leaves the firm unable to meet its obligations after the owner’s death, or the owner’s estate with taxes or other debts. While liquidation usually results in a significant loss of value, the sale of a business as a going concern will likely generate more money for the owner’s beneficiaries. The owner may direct the sale of the business if the owner has particular expertise that cannot be replaced or the family has no interest in continuing the business. Often, however, the owner wishes to pass ownership and control of the business to one or more family members.
Successfully transitioning a business to family members requires years of careful preparation and communication. First, the business owner must prime the family by presenting the succession issues and articulating a clear vision, including the broad ownership, governance, and management goals of business. These in turn will direct the organizational structures which connect the family with its assets and values and which balance the family’s economic and non-economic goals.
In many cases, an owner’s successor is an obvious choice. In the event the successor is not predetermined, a succession committee may be tasked with deciding who will select the successor and setting the criteria for selection. The best candidates are those who want the job for the right reasons and who have the trust and respect of family members and employees. Candidates do not just appear; they are developed, ideally by involving children at an early age, designing positions to match their interests, providing responsibilities and training, and possibly requiring work outside the organization. These strategies should promote competence, foster independence, and provide exit strategies.
Incumbent business owners must prepare not just their successors but themselves, both financially and emotionally. A successor might not be able to afford the outright purchase of ownership interests, so the plan must include financial arrangements that ensure the incumbent’s financial security. The plan may also include a clearly defined role and responsibilities for the retiring incumbent that may diminish over time. Finally, the succession plan should be timed so that transition occurs when the incumbent is secure and confident in the successor’s competence and status in the business and family. A team of outside professionals can provide critical objectivity, problem-solving experience, and financial and legal expertise necessary to value the business, to draft operating or buy-sell agreements, trust instruments and other documents, and to perform other necessary tasks.
Ownership and management of the firm may not always transfer to family members equally. If a business owner’s children make unequal contributions to the business but share ownership and management rights equally, problems resulting from resentment among siblings or spouses are likely to impact the business. Therefore, a succession plan must realistically acknowledge and address the family dynamics, passing the business to family members willing and competent to run it and providing for non-business assets to pass to other family members. Alternatively, the plan may call for a capital structure with preferred or voting and non-voting stock, or an operating agreement that separates management powers from ownership, to give those active in the business the authority needed to fulfill their responsibilities without enough power to abuse their positions. Such structures may also segregate investment assets of a business (such as real estate or intellectual property) from the operating assets of the business, to accomplish estate planning, tax and creditor protection goals. In all events, preservation of family harmony depends upon achieving the perception of fairness in planning the transfer of business and non-business assets.
A prerequisite to the fair allocation and preservation of family wealth is a clear understanding of the value of the business, along with how intrinsic characteristics of the business and outside influences impact the value. While methods such as net asset or market value may be used to value the business, business valuation remains more inexact art than precise science. Business value will determine how much life insurance may be needed to fund the purchase price to be paid to beneficiaries who will have no ownership interest in the firm, or to augment the owner’s estate to the extent that the business will pass to some family members but not others. If certain employees contribute disproportionately to the value of the business, the succession plan should include one or more of the following: a board of advisors that may include non-family members to periodically review the operations of the business; employment agreements with key employees to prevent the death of the owner from jeopardizing their employment and to assure that key employees do not abandon the company following the death of the owner; and key person life insurance, payable to business to compensate for loss of leadership and management skills of owner, in order to recruit or retain talented management.
Business succession planning must take place within the context of a larger estate plan; indeed, succession and estate plans cannot be made independently of one another. In addition to addressing transition matters, an effective plan should include lifetime strategies to reduce estate and gift taxes, such as annual and lifetime gifting, creation of grantor retained annuity installment sales to intentionally defective trusts, and similar tactics. A business succession plan is much more than the transactions necessary to transition ownership and minimize taxes: without it, neither the family nor the business will thrive.
