Business owners are generally masters of growing and operating their businesses, but often neglect to consider what will happen to those businesses upon retirement or death. This is understandable given that many business owners are so personally intertwined with their business that it is difficult to imagine life apart from it. However, the consequences of failing to plan for the eventual transfer of one’s business may be costly and time-consuming, and can also create unintended consequences for the business’s future.
This guide to business succession planning aims to help business owners understand the importance of putting a succession plan in place and identify options for the eventual transfer of their business.
Even before considering their ultimate succession plan, it is imperative that business owners have an emergency contingency plan in place for business continuity in the event of unforeseen incapacity or death. That emergency plan may consist of several items including: a list of phone numbers for key people, along with how and where to access important information, a financial power of attorney, and a document called a “Short-Term Contingency Plan” setting forth a plan for emergency decision-making in the event of incapacity or death. This allows the business to continue running smoothly in an emergency, regardless of what kind of transition takes place.
TWO COMMON PATHS FOR THE TRANSFER OF BUSINESS OWNERSHIP:
a. Selling the business to a third party.
b. Transitioning the business to family members or key employees.
Selling The Business
- Get Ready for a Sale
If selling the business is in the realm of possibilities for the business owner (whether in the near or distant future), preparation, both for the business owner personally and the business itself, is key.
a. Getting Ready Personally
Getting ready for the potential sale of a business involves a lot of “thought work” from both the business owner and the owner’s advisors. Some of that thought work is personal and some of it is financial.
First, the business owner should consider what “their number” is. What number would cause them to walk away from the business with no questions asked? Sometimes that number is emotionally driven and that is okay.
Second, yet related, the business owner should consider what they might need to net from the sale of the business to fund the owner’s lifestyle or meet other estate planning and charitable goals.
Finally, the business owner should consider whether they want to be finished working after the sale, or whether they want or need to remain employed by the business for a period of years.
b. Getting The Business Ready
Getting the business ready for a potential sale is equally important. The business owner should consider whether there is a gap between the way the business currently operates and the way a prospective buyer is likely to operate the business and consider measures to close that gap in order to make the business more marketable.
For many closely held or family businesses, this often means “professionalizing” the business. Professionalization may include ensuring that the right people are currently working in appropriate roles, upgrading professional advisors, and confirming that there are documented processes and procedures in place for operating the business.
It may also be prudent to work on cleaning up the business balance sheet before offers are solicited. This means working on the business’ account receivables, writing-off uncollectable debts where appropriate, and discontinuing use of the business for personal items such as cars and personal services. - Understand Different Sale Structures
When considering a sale, it is important to understand the different options available to a business owner and what kind of preparation might be appropriate for each.
a. Financial Buyers
A financial buyer (oftentimes a private equity firm) generally views an acquisition as an investment for the purpose of targeting a specific return.
The purchase price from a financial buyer is likely to be based on multiple of earnings for the company and may occur over the course of several years. Payment terms often include earn-outs or milestone payments. Consequently, a business owner can expect a financial buyer to conduct a significant amount of due diligence to protect its potential investment.
Because a financial buyer sees the business as an investment, they often want current management to stay on for a period of time, if not indefinitely.
b. Strategic Buyers
A strategic buyer seeks to acquire a company for its own long-term business plans. This could include vertical expansion (toward the customer or supplier), horizontal expansion (into new geographic markets or product lines), eliminating competition, or enhancing some of its own key weaknesses (technology, marketing, distribution, research, and development, etc.).
Because the purchase price in these situations reflects the strategic value of the business to a specific buyer, it is often higher than the price for a sale to a financial buyer.
While payment terms may still include earn-outs or milestone payments, a strategic buyer is more likely to desire the sale to be an exit for the seller given that the strategic buyer is likely to have a management team already in place. - Other Things to Consider
There are many items to consider when thinking about the sale of a business. While the list below is by no means exhaustive, consideration of the following items can be extremely impactful.
a. Consider Selling In Multiple Stages
If an influx of capital could take the business to the next level, it might be worthwhile to the seller to offer less than 100% of the business in the first transaction to achieve a higher multiple later for a sale of the remaining equity.
b. Consider Transferring Some Ownership to an Irrevocable Trust
Depending on the business owner’s financial and estate planning goals, it may make sense to transfer a portion of their interest in the business to an irrevocable trust.
All growth and appreciation after the transfer, including any windfall and liquidity benefits from a future sale if the transfer is done far enough in advance of the sale, will accrue to the trust and not to the owner’s estate, saving future transfer taxes (estate tax and generation-skipping transfer tax).
It is prudent to consult with a trusts and estates attorney as early as possible when considering the sale of a business.
c. Consider Involving an Investment Bank
Many small business owners think that an investment bank would not be interested in a business of their size. To the contrary, however, investment banks often package together several smaller businesses for a financial buyer who is interested in the acquisition for strategic reasons.
Transitioning the Business
Like the sale of a business, a business owner’s transition of their business to family members or key employees can be much more successful with significant preparation.
- Get Ready for Transition
If transitioning the business to family members or key employees is a potential avenue for the business owner, it is important to prepare both personally and professionally for the transition (regardless of whether it might happen soon, at retirement, or at death).
a. Getting Ready Personally
Getting ready for the potential transition of a business involves perhaps even more “thought work” than with the sale of the business.
A business owner should consider what their objective is in transferring the business. For example, if the goal is for one child to own and operate the business, are there sufficient other assets to equalize the other children who are not involved in the business?
Will the transfer involve any gift or inheritance? Will it happen in stages or all at once? Are there key employees the business owner wants to include in the transition?
An experienced trusts and estates attorney may be able to help the business owner think through some of the personal issues that may affect gift and estate taxes.
b. Getting the Business Ready
When considering transitioning a business to family members or key employees, one of the best ways for the business owner to set themselves and their successors up for success is to review and update the buy-sell agreement, or if there is no buy-sell agreement in place, to have a buy-sell agreement drafted. It is important to note that there are different types of buy-sell agreements, each of which come with advantages and disadvantages.
A Cross-Purchase Agreement: A cross-purchase agreement is a type of agreement where the remaining business owners agree to purchase the departing owner’s share of the business. This is a more complex transition and can be appropriate when there are several other owners and may require the remaining owners to obtain financing for the purchase.
A Redemption Agreement: A redemption agreement is a type of buy-sell agreement where the business itself agrees to purchase the departing owner’s share of the business. This can simplify the sale process and reduce the financial strain on the remaining owners. However, a redemption agreement can have drawbacks, including reducing the business’ equity and cash flow.
A Hybrid Agreement: Finally, a hybrid agreement is a type of buy-sell that combines elements of both cross-purchase and redemption agreements. It will specify who will have the first option to buy the departing owner’s share of the business with other parties/entities having subsequent options. This type of agreement can provide all parties with options and balance their respective interests and objectives.
A business law attorney (or a trusts and estates attorney) can help the business owner think through all the key considerations and make recommendations regarding the most appropriate type of agreement for the scenario. Regardless of which type of buy-sell agreement is used, careful consideration should be given to the tax implications of any purchase to both the business and its owner.
Steps to Take Now
If a business owner is considering the sale of their business, here are three steps to take now to streamline the process and optimize profits.
- Clean Up & Optimize Balance Sheet
Business owners should consider removing certain personal items from the company balance sheet (e.g. the building out of which the business is operated, company car, old/uncollectable promissory notes). - Get Corporate Records in Order: if applicable (buy-sell agreement, stock certificates, written actions, etc.)
- Get Financials in Order
- Good: Keep track of EBITDA (earnings before interest, tax, depreciation, and amortization)
- Better: Have audited (or at least unaudited) financial statements prepared each year
- Best: Increase your credibility with potential sellers by obtaining a Q of E (quality of earnings report)
Conclusion
The sale or transition of a business is often one the most impactful moments in a business owner’s career and should be treated with careful consideration at every step.
The business owner should include their team of financial advisors, tax professionals, and attorneys in the process to maximize results and achieve their objectives.
The information provided herein is general in nature and it should not be construed as legal, tax, or other professional advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
