Business Succession Planning for Small Business Owners
Over the years you’ve been focused on building your business, but you may not have put much thought into how you’ll leave it behind someday when the time is right for you. However, failing to plan for your transition out of your business can result in some serious unintended consequences.
Although succession plans are commonly associated with retirement, they are important to have in place at any point during the business lifespan. Planning ahead for when the unexpected happens to you or a co-owner can help reduce headaches, disputes and monetary loss as your business grapples with such a transition.
Business succession planning is essentially a series of decisions about who will take over your business upon your retirement, death or disability.
The first (and sometimes the most difficult) steps are to think through and investigate your available options and identify a successor to take over the business. The method at arriving at these decisions will vary, depending on whether you are the only owner or whether you have co-owners in the business.
This article briefly discusses the most common ways to transfer ownership of a small business, which include:
1. Selling your shares or ownership interests to your co-owner(s) of the business
2. Passing ownership interests to a family member
3. Selling your business to one or more key employees
4. Selling your business to an outside buyer
1. Selling Your Business to Co-Owner(s)
If you are in business with one or more partners, you may sell your interest to your co-owners. You and your co-owners must agree on how to buy and sell ownership interest in the company. Since this matter can be contentious if it has to be decided when an issue arises, it’s extremely helpful for partners to agree on and enter into a buy-sell agreement long before the need arises. A buy-sell agreement addresses, ahead of time, how the co-owners will buy out an owner’s interest in the event of that owner’s retirement, untimely death or disability.
Buy-sell agreements often structure the purchase to be completed over a period of time (e.g., 5 years) in the event the company and/or co-owners are unable to buy the partner out with one lump sum. This type of agreement can help ease the burden of an unexpected transition — for the business and family members alike. A buy-sell agreement ensures that the departing owner and his or her family are given fair compensation, and allows the remaining co-owner(s) to maintain control of the business.
Since it’s impossible to foresee what the financial situation of each co-owner will be when the time arises to buy out a partner, many business owners choose to fund their buy-sell plan with life insurance. Term life insurance is relatively inexpensive, and can offset a lot of costs in the event of an owner’s death. Permanent life insurance is a bit more expensive, but can also payout in the event of retirement or disability. When life insurance is used, it’s referenced in the buy-sell agreement.
2. Passing Ownership to Family Members
Many business owners who have children or family members working in their organization desire this option if possible, but it’s not as easy as it might seem, especially if you have multiple children or family members who might feel they deserve to take over the business. Such a major family decision can lead to conflict if not planned properly.
When you have multiple children or family members and multiple members are interested in taking over the business, it’s vital that you provide clear instructions on who will take over what in the business.
You don’t want to give ownership to family members who aren’t already involved in the business, who don’t have significant outside work experience, or who you believe will be unable to effectively run the business. As for your capable heirs who do work in the business, you’ll want to keep the succession plan as clear and simple as possible. Businesses are generally much harder to manage with multiple decision makers. Therefore, if you have any doubt that your multiple heirs can effectively work together, you should consider choosing a single successor, as opposed to splitting ownership evenly between your heirs.
If you believe your heirs can work together to run the business, consider placing each heir into a specific leadership position (e.g., one successor can focus on sales, and the other on product development or operations management). Finally, be sure to start training and grooming your heirs as early as possible prior to handing over the keys to the kingdom.
If transitioning the business to your heirs ultimately seems to be a course that will be too messy and risky (only about 30% of businesses stay afloat after the transition to a second generation), you might consider selling the business to an outside party or key employee in order to preserve the value you’ve built.
3. Selling Your Business to One or More Key Employees
When you don’t have a co-owner or family member to entrust with your business, you might consider selling it to a key employee or a group of employees instead. There are a lot of options for structuring the sale of the business to employees and, depending on the financial condition of your employees, the purchase price may need to be paid over time, but if you want to give your business every chance to succeed in the hands of your employees, there’s more to think about than structuring the actual purchase.
If the business will be transferred to one key employee, you’ll want to select an employee who is experienced, business-savvy and respected by your customers and staff in order to ease the transition. If a group of employees will be the successors, be sure you can identify the specific roles each will fulfill, as discussed in the section above about transferring the business to multiple heirs.
Ensure that you plan ahead so you have the ability to train the employee(s), and get them on board with essential procedures and relationships. It normally takes longer for owners to phase themselves out of ownership through a sale to key employees than it does through a sale to a third party.
Just like selling to a co-owner, a buy-sell agreement is helpful to a key employee succession plan. Through the buy-sell agreement, your employee(s) will agree to purchase your business at a predetermined retirement date, or in the event of death, disability, or other circumstance that renders you unable to continue to manage the business. The buy-sell agreement will specify either an established selling price or a formula or method for determining the selling price, and it will lay out the payment terms.
4. Selling Your Business to an Outside Party
Selling your business to an outside party is easier for some types of businesses than others. If you own a more turn-key operation, and you have a good general manager on board, your simply need to demonstrate that it’s a good investment to a potential buyer.
On the other hand, if you’re recognized as the face of the company or you own a company that’s branded under your name, selling could potentially be more challenging. Buyers will recognize the need to rebrand and remarket, and as a result, may not be willing to pay full price.
With either scenario, you should prepare for the sale of the business well in advance: tighten up your books and records, hire and train a great general manager, formalize your operating procedures, and get all your finances in check. Make your business as stable and turnkey as possible, so it’s more attractive and valuable to outside buyers.
As with key employees and co-owners, you may be asked to accept the purchase price over time. If you agree to such an arrangement:
- be sure to get the largest down payment possible,
- have the buyer sign a promissory note for the payments to be made,
- protect yourself by obtaining a security agreement and lien on the business assets, and
- if the buyer is another business, try to get the principals and their spouses sign personal guarantees to increase your chances of getting paid one way or another.
It can be difficult to sell your business to an outside party. You may have a strong idea of what your business is worth and you may not find a buyer willing to pay your asking price. It’s a good idea to obtain a valuation of your business from an independent business valuator, or a seasoned business broker, when you begin to consider marketing your business for sale to an outside party.
Bottom Line: Plan Ahead and Update Your Succession Plan Regularly
While some experts recommend starting your business succession planning 3 years ahead of retirement, it’s truly never too early to begin. Many decisions you make throughout your business lifespan can greatly affect your transition options later on. Therefore, it’s good to develop a plan now and continue to build your business with the end in sight.
Also, you never know when the unexpected might occur. Having a succession plan in place can help ease the burden of a sudden and unexpected transition — for the business and family members alike.
Once in place, your succession plan should be reviewed regularly and if you have a buy-sell agreement it should be updated periodically to reflect changes in co-owners or key employees, changes in business valuation, increases to life insurance coverage to fund the buy-sell agreement as the value of company increases, and other changes.