What Is Succession Planning? And Why Do You Need It?

Succession planning is a proactive, strategic approach that allows owners to exit their businesses on their own terms. Not all businesses are created equal, and one of the more common misconceptions we’ve seen business owners share 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 him full control, protects him from going into business with someone he may not know, and the older partner still gets paid.

Let’s say we have three owners. Two 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. It’s important to point out that if the other owners have 66% of voting rights, they could shut this down before it’s ever put in writing.

What else does a 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 desirable 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 use 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 retain 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 important, 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 third-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 the buy-out of the first owner to rely solely on 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. VULs are typically marketed as a hybrid product that provides a death benefit to buy out your spouse if you die, yet has a living benefit of cash value that can fund your exit. However, VULs 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 with low-cost, term insurance.

How does one typically exit one’s 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 buy-outs are typically structured with an upfront, 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 himself 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 catch here is whether the ideal candidate can afford to make the purchase.

Terms may require the selling owner to stay on as a consultant or in a managerial capacity. 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 him 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.

Copyright 2024 The Business Journal, Youngstown, Ohio.