If you’re like me, you were completely unemployable when you started your company or jumped into the family business. I say that affectionately. You sought independence and developed the attitude that working 60 hours per week for yourself handily beat 40 hours working for anyone else. Things were lean at first and your only focus was securing enough work to survive while completing that work in a timely manner and eventually getting paid. Making an actual profit on that work was a welcome result too, but certainly not guaranteed.
Now, new business rolls in and your focus has shifted to somehow managing all the balls in the air. Along the way you’ve had to learn accounting, human resources, insurance, law, banking, etc. and at some point realized that for the business to grow and survive beyond you there would need to be an incredible team in place.
The question you’ve arrived at today is, “what is the plan to keep this business going either when you’re ready to call it quits or, in the worst scenario, if you die unexpectedly?” According to the Family Business Institute, only 30% of businesses survive to the second generation, 12% into the third, and only 3% into the fourth.1 Creating a successful business succession plan is typically a multi-part, multi-year project. It can be emotional, complicated, and time-consuming. It’s ok to not have all the answers today, but it is not ok to bury your head in the sand. Most families are extremely reliant on the cash flow generated from the business, while the business typically accounts for the largest asset on an owner’s personal balance sheet.
I’ve broken down the process of creating a successful business succession plan into two phases. In Phase One it’s important to protect the business from a shock, such as the loss of an owner/operator. What is the plan for the business if an active owner can’t show up tomorrow? In Phase Two we create a plan to grow the business for an ultimate transfer to internal successors or an outside entity. What steps can we take to retain and incentivize the best people (including key family members), grow the value of the business, and eventually step away to enjoy the fruits of your labor in the future? Phase Two will be discussed in a follow-up post.
Identify the Key People
Who in your organization is willing and capable of running the business in your absence? Having an open dialogue with your key people is crucial to successful planning. Oftentimes, those who can run the business simply do not want to. They have chosen to work for you precisely so they don’t have to think about the business when they leave at night. They don’t necessarily want the risk or the effort that comes with running an organization and they’ve grown fond of a consistent paycheck. By having these discussions, you gain clarity on whom to focus your efforts on.
For businesses with at least two active owners, the most likely successor is the other partner(s). A formal discussion still needs to be had to determine if each partner would ultimately go it alone or would want to share ownership and responsibilities with a key person.
Value the Business
You can’t truly complete a business succession plan until you have a good grasp of what the business is worth. There are many methods to value a business and we’ve seen it all. Some young companies take a back-of-the-napkin approach and agree on a simple multiple of sales approach while others look at a multiple of earnings. These basic methods could be fine as a starting point, however as the value of the business grows in significance it’s important to have a very specific valuation. There are firms, perhaps your own CPA firm, that can be engaged for a formal business valuation. Typically, specialized firms offer both a “quick and dirty” valuation method and a comprehensive, deep dive, industry-specific valuation. Clearly, the more complex and valuable the business is, the more you’ll want to opt for a comprehensive valuation. Coming out of either of these methods should be a formula which allows the business to be valued as time goes on and under different market conditions.
Implement the Plan
Now that you’ve identified the key people that want to take over the business and you’ve agreed on a valuation it’s time to put a plan in place. Working with a financial advisor and attorney that specialize in business planning, you can now craft a formal buy-sell agreement and create a strategy to protect the business from the loss of an owner or key employee.
Buy- Sell Agreements
As an example, consider a business with two equal 50/50 partners, Alex and Charlie. They have both agreed that they would want to own the business outright in the absence of the deceased partner, so they enter into a formal buy-sell agreement. Assuming Alex dies, he (and his spouse) agree to sell their ownership to Charlie based on the predetermined business valuation formula. Further, Charlie agrees to buy the ownership units. The terms of the sale are also agreed upon in the buy-sell document.
Consider that there are several ways this agreement can be funded:
- Personal assets – are there adequate liquid and available personal assets to fund this purchase?
- Borrowed funds – can an owner secure financing from a bank to provide the liquidity? What will the interest expense be? Will this loan affect the business’ ability to borrow for other purposes?
- Sinking fund – would it make sense to create a fund inside/outside the business purely for this purpose? Will there be enough time to fully fund this account? Is this the best use of these funds?
- Installment payments –Are the operating revenues sufficient to cover these payments? What risk does this pose to the selling party?
- Life Insurance – are both parties insurable and willing to undergo the medical requirements to obtain the coverage? Are the premiums reasonable?
Most agreements between healthy partners are ultimately funded with life insurance as a means of providing the purchasing partner with instant liquidity to complete the transaction. Life insurance, in lieu of the other options, is easy to administer and can prove to be the least expensive method.
In this example, Alex and Charlie have agreed upon a formula that currently values their business at $5,000,000. In this case, Alex purchases a $2,500,000 life insurance policy on Charlie while Charlie purchases a $2,500,000 policy on Alex. When Alex dies suddenly, Charlie receives a check for $2,500,000 from the life insurance company. Does Charlie get to throw a party and spend this money? Sorry, Charlie (I couldn’t resist)! No, he doesn’t hold the cash long because he is legally obligated to purchase Alex’s shares and thus writes a check to Alex’s surviving spouse or heirs in exchange for the remaining shares of the business. It’s clean, it’s quick, it’s easy, and the business now continues beyond this massively disruptive event.
In a second example, Mom and Dad own 100% of the shares of the company, while daughter Jane is the key-person and successor. Dad and Jane operate the business and are involved on a daily basis. Mom loves the business and has certainly given it her blood, sweat, and tears since the beginning, but no longer serves in an active capacity. Mom and Dad have decided that they’d like to own at least the lion’s share of the company during Dad’s lifetime so they can fund their retirement and enjoy the fruits of their hard work. Without Dad, however, Mom isn’t comfortable owning the business alone, taking on the responsibilities that come with it, and retaining the risk that the business fails during her later years. Thus, they wish to pass the business efficiently to Jane upon Dad’s passing. With the business worth $5,000,000, Jane may not have this kind of money lying around.
Mom, Dad, and Jane enter into a buy-sell agreement whereby Mom is agreeing to sell her shares to Jane based on a predetermined formula (which may or may not include some justifiable discounts) and Jane is agreeing to buy Mom’s shares. Jane then purchases a life insurance policy on Dad for $5,000,000. When Dad dies suddenly, Jane receives the insurance proceeds income tax free, writes Mom a check for the company shares, and Mom likely won’t pay tax on the sale. How? Mom received a step-up in basis upon Dad’s death so her basis and sale price are essentially the same. Proper planning can be very efficient indeed.
Key-Person Life Insurance
When designing a defensive plan for a business it’s impossible to overlook the impact of a loss of a key employee. For some businesses, a key person has specialized knowledge, skills, and/or relationships that drive the revenue of the company. For other firms, a key person oversees the operations of a company and acts as the promise keeper, completing work in a timely fashion. In either case, the business comes to a halt in the absence of this person.
In the case of Alex and Charlie, they are both key to the success of their business. Alex is the rainmaker and brings in the work. Charlie is the operations master and makes sure Alex’s promises are delivered. To complete their defensive planning, they would add a key person life insurance component. Instead of purchasing the $2,500,000 policy on each other to simply facilitate the buy-out, they may choose to increase that amount to $3,500,000. After the buy-out, the surviving partner would be left with $1,000,000 which is used to attract (as best he can) a replacement for Alex. In addition, capital intensive businesses can then show the banks that the company has sufficient capital to continue in light of recent events.
In the case of Dad and Jane, it’s clear that in addition to the buy-out Dad should purchase key-person life insurance on Jane. As he steps away from the business more and more, Jane becomes more and more important to the business and to Dad. If she were to pass unexpectedly, the business needs cash to find a replacement and Dad needs time to find and develop a new succession plan. Both will require cash.
While these examples are very real, there are tremendous variations of the examples discussed here. Every business and every company have a unique dynamic. Sometimes the business is a closely held, sole-family owned operation. Sometimes, there are many non-family owners of a company. Presented here, however, are the basics building blocks of a successful business succession plan. The point is to GET STARTED.
For those sports fans out there, think of Phase One in light of the old saying “Offense fills the seats, but defense wins championships.” Look out for Phase Two where we discuss the high-flying offense of succession planning.
If you haven’t already and you’d like to discuss developing a succession plan, you can schedule an introductory call here.
1. The Economist – “Succession Failure” – February 4th, 2016