There are five common ways to transfer ownership of your business:
- Co-owner: Selling your shares or ownership interests to a co-owner.
- Heir: Passing ownership interests to a family member.
- Key employee: Selling your business to a key employee.
- Outside party: Selling your business to an entrepreneur outside your organization.
- Company: For a business with multiple owners, you can sell your ownership interests back to the company, then distribute them to the remaining owners.
How a Business Succession Plan Works
A business succession plan is a document that is intended to guide through a change in ownership by providing step-by-step instructions. If a purchase is involved, the sale price and purchase terms are clearly outlined, relieving stress for the departing owner’s family. A well-crafted succession plan aims to benefit everybody—the departing owner, the business, employees, and the successor.
A small business succession plan should include the following:
- A succession timeline: Details regarding the circumstances when a succession would take place and specific dates as applicable.
- Your potential successors: A list of potential successors, including strengths and order of consideration.
- Formalized standard operating procedures (SOPS): A collection of documents, procedures, employee handbooks, and training documentation.
- Your business’s valuation: The valuation of your business should include the method by which is valued and be updated frequently.
- How your succession will be funded: Details including whether the succession is funded through life insurance, a seller’s note, or other funding options.
Who Should Create a Business Succession Plan
Succession plans are commonly associated with retirement; however, they serve an important function earlier in the business lifespan: If anything unexpected happens to you or a co-owner, a succession plan can help reduce headaches, drama, and monetary loss. As the complexity of the business and the number of people impacted by the exit grows, so does the need for a well-written succession plan.
You should consider creating a succession plan if you:
- Have complex processes: How will your employees and successor know how to operate the business once you exit? How will you duplicate your subject matter expertise?
- Employ more than just yourself: Who will step in to lead employees, administer human resources (HR) and payroll, and choose a successor and leadership structure?
- Have repeat clients and ongoing contracts: Where will clients go after your exit, and who will maintain relationships and deliver on long-term contracts?
- Have a successor in mind: How did you arrive at this decision, and are they aware and willing to take ownership?
Many business owners ignore succession planning because they don’t believe it’s necessary or put it off until they’re ready to retire. For small, simple businesses, a succession plan may not be necessary. However, consider what would happen to your business if you were no longer able to run the day-to-day operations. Who would take over? Would the business be viable?
When to Create a Small Business Succession Plan
Every business needs a succession plan to ensure that operations continue, and clients don’t experience a disruption in service. If you don’t already have a succession plan in place for your small business, this is something you should put together as soon as possible.
While you may not plan to leave your business, unplanned exits do happen. In general, the closer a business owner gets to retirement age, the more urgent the need for a plan. Business owners should write a succession plan when a transfer of ownership is in sight, including when they intend to list their business for sale, retire, or transfer ownership of the business. This will ensure the business operates smoothly throughout the transition.
The 5 Common Types of Succession Plans
There are several scenarios in which a business can change ownership. The type of succession plan you create may depend on a specific scenario. You may also wish to create a succession plan that addresses the unexpected, such as illness, accident, or death, in which case you should consider whether to include more than one potential successor.
Here are the five most common types of small business succession plans in detail.
1. Selling Your Business to a Co-owner
If you founded your business with a partner or partners, you may be considering your co-owners as potential successors. Many partnerships draft a mutual agreement that, in the event of one owner’s untimely death or disability, the remaining owners will agree to purchase their business interests from their next of kin.
This type of agreement can help ease the burden of an unexpected transition—for the business and family members alike. A spouse might be interested in keeping their shares but may not have the time investment or experience to help it blossom. A buy-sell agreement ensures they’re given fair compensation, and allows the remaining co-owners to maintain control of the business.
A buy-sell agreement with a co-owner requires a lot of cash kept on-hand. Your co-owner should be prepared to buy-out your shares, theoretically, at any moment. Many businesses will fund this 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 with the added benefit of a payout in the event of retirement or disability.
If you choose to draft a buy-sell agreement with your co-owner, you’ll want to make sure a life insurance policy is stipulated in the agreement. The company can also purchase key person insurance that pays out in the event a key member of the business dies or becomes disabled. We recommend speaking with an expert for specific help on the type of policy you’ll need.
2. Passing Your Business Onto an Heir
Choosing an heir as your successor is a popular option for business owners, especially those with children or family members working in their organization. It is regarded as an attractive option for providing for your family by handing them the reins to a successful, fully operational enterprise. Passing your business on to an heir is not without its complications.
Some steps you can take to pass your business onto an heir smoothly are:
- Determine who will take over: This is an easy decision if you already have a single-family member involved in the business but gets more complicated when multiple family members are interested in taking over.
- Provide clear instructions: Include instructions on who will take over and how other heirs will be compensated.
- Consider a buy-sell agreement: Many succession plans include a buy-sell agreement that allows heirs that are not active in the business to sell their shares to those who are.
- Determine future leadership structure: In businesses where many heirs are involved, and only one will take over, you can simplify future discussions by providing clear instructions on how the structure should look moving forward.
Failing to address these steps may lead to a chaotic transition. For example, if a future leadership structure is not implemented, and the business passes on to more than one heir, the resulting power struggle may negatively impact the business. Alternatively, each heir may incorrectly assume the other will take over day-to-day responsibilities.
Before instructions can be given on who will take over leadership of the business, a future leader should be chosen. This is likely to be complicated when more than one heir is interested in taking over. Business owners can reference current business contributions and responsibilities from potential heirs to assist in choosing a successor.
Making business decisions within a family can get messy. Emotions can run high, especially after an untimely death or disability. Further, second-generation businesses rarely survive the transition, as they’re often sold by the inheriting family member, or fail outright.Only about 30 % keep the same name and ownership following an inheritance.
Altogether, this should beg the question; is inheritance even the best idea? If your successor is skilled and business savvy, then perhaps the answer is “yes.” If not, you may consider selling your business to a co-owner, key employee, or outside buyer instead.
3. Selling Your Business to a Key Employee
When you don’t have a co-owner or family member to entrust with your business, a key employee might be the right successor. Consider employees who are experienced, business-savvy, and respected by your staff, which can ease the transition. Your org chart can help with this. If you’re concerned about maintaining quality after your departure, a key employee is generally more reliable than an outside buyer.
Just like selling to a co-owner, a key employee succession plan requires a buy-sell agreement. Your employee 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 manage the business.
A common drawback to key employee succession is money. Most employees aren’t in the financial position to buy the business they work for. Even if they are, having enough liquid cash on hand is another challenge.
One solution is seller financing, in which your employee pays you (or your family) back over time. There’s typically a down payment of 10% or higher, then monthly or quarterly payments with interest until the purchase is paid for in full. The exact terms of the loan will need to be negotiated and then laid out clearly in your succession plan.
4. Selling Your Business to an Outside Party
When there isn’t an obvious successor to take over, business owners may look to the community: Is there another entrepreneur, or even a competitor, that would purchase your business? To ensure that the business is sold for the proper amount, you will want to calculate the business value properly, and that the valuation is updated frequently.
This is easier for some types of businesses than others. If you own a more turnkey operation, like a restaurant with a good general manager, your task is simply to demonstrate that it’s a good investment. They won’t have to get their hands dirty unless they want to and will ideally still have time to focus on their other business interests.
Meanwhile, if you own a real estate company that’s branded under your own 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.
Instead, you should prepare your business for sale well in advance; 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.
One of the main drawbacks to an outside sale succession plan is the unexpected: It’s nearly impossible to predict exactly what the sales process will have in store. The process of selling a business to an outside party is complex and could encounter roadblocks like: your business not being as valuable as you anticipated, lack of credible buyers, your business not being able to sell at all, and more. Business brokers, like VNB Business Brokers, are experienced and well-versed in all aspects of selling and purchasing businesses on their clients’ behalf.
Consider outsourcing to a business broker so that you can focus on running your business and maintaining its value while professionals handle the sale. In addition to taking care of potential problems, VNB will ensure all steps of the process including finding and vetting buyers, structuring your deal, preparing documents, and negotiating terms. After one quick call, VNB Business Brokers will be able to tell you things like: what your business is worth, if the valuation price can be increased and how long it will take to sell your business.
5. Selling Your Shares Back to the Company
The fifth option is available to businesses with multiple owners. An “entity purchase plan” or a “stock redemption plan” is an arrangement where the business purchases life insurance on each of the co-owners. When one owner dies, the business uses the life insurance proceeds to purchase the business interest from the deceased owner’s estate, thus giving each surviving owners a larger share of the business.
An entity purchase is similar to a cross-purchase, in which you sell your shares to a co-owner or co-owners. In most circumstances, a cross-purchase is more financially viable. When co-owners purchase shares directly, they get a “step-up in basis,” which means the stock’s basis is revalued at its current price. With an entity purchase, the original basis remains, and your co-owners will be liable for potentially higher capital gains.
Despite this drawback, entity purchases can still be beneficial when you have a large number of co-owners. Drafting cross-purchase agreements with each owner can be cumbersome. An entity purchase agreement, in comparison, is much simpler to implement. It can typically be funded with a single life insurance policy for each co-owner.
How to Create a Succession Plan
There are several key steps necessary to create a comprehensive small business succession plan, and several ways to go about creating your plan. Some business owners may choose to create their own succession plan, while others may wish to engage the help of a professional, depending on the complexity of the plan and the business.
Whether you create your plan yourself or engage a professional, the five steps to writing a succession plan are:
- Determining timeline: Define when the succession should take place, either on a predetermined date or in the event of death or disability.
- Choosing your successor: If this is not a purchase by a specific party, consider choosing three or more potential candidates, filling out a profile for each.
- Formalizing your standard operating procedures: Document your standard operating procedures (SOPs), including an organizational chart, employee handbook, operations manual, and any other recurring meetings or processes.
- Valuing your business: Several methods exist to value your business. Once you have calculated your business’s value, it should be updated frequently.
- Funding your succession plan: Define a specific path that lays out how the successor will purchase the business. Options include life insurance, loan, and seller financing.
Read more related articles at:
Your Business Needs a Succession Plan: Here Are the Basics
Strategic Business Plans: Why This Success-Focused Tool Is A Must-Have
Also, read one of our previous Blogs at:
Does My Business Need a Succession Plan?
Click here to check out our On Demand Video about Estate Planning.
Click here for a short informative video from our own Attorney Bill O’Leary.