BY BRAD ERIKSEN
The Great Recession caused many business owners to hit the pause button on succession planning for their businesses. During that pause, there were significant fundamental changes in the economy and the workforce that fuels the economy. Increased economic uncertainty, combined with generational shifts in the expectations and attitudes of the workforce, have made many succession plans outdated, ineffective, or outright obsolete. Now that the economy is improving, there is a feeling of urgency among many business owners, especially baby boomers, to quickly move forward with long-stalled succession plans. However, the new economy has created a new set of underlying assumptions that need to be addressed prior to any renewed implementation efforts. For this article, we will review the impact of the new economic realities on successful succession planning.
The past 10 years have seen dramatic changes in the workforce. Midlevel employees who may have previously played an integral part in a succession plan have now seen the increased risk, increased effort, and increased stress inherent in business ownership. This effect, compounded by mature employees staying in the workforce longer due to economic circumstances, has delayed the rise of those midlevel employees into management, control, and ownership positions.
While they may have been willing to take on these challenges when the succession plan was first developed, they are now a decade older and less willing to take on the risk or put in the effort required for successful business ownership. Content to remain an employee for the duration of their careers, they are no longer viable candidates to assume the management, control, and ownership of the business.
Younger workers, having been on the receiving end of downsizing and workplace stagnation, no longer have the company loyalty of prior generations. Moving from company to company to acquire new skill sets, rather than working one’s way up the company ladder, has become the rule, not the exception. Even if the company can properly identify a rising star, retaining that employee throughout their career has become increasingly rare and very difficult.
When designing a succession plan, one of the first steps is determining who to transition the business to. Typically the available choices are (i) key employees, (ii) family members, or (iii) outside financial or strategic buyers. Have the economic changes of the past decade effectively eliminated the first option? Not necessarily. However, this option has become much more of a challenge to structure and successfully implement. New retention strategies and incentives are necessary in order to create a viable succession plan that anticipates transferring the business to a key employee.
For business owners who decide to select door number 3 and simply sell the business to an outside financial or strategic buyer, the Great Recession has also complicated that process as well. Valuation is often a function of looking backward rather than forward. A “look back” valuation based on past earnings may not be representative of and bring the owner the true value of the company if the operators of the business took advantage of the recession to position the company for growth during the eventual recovery.
Using multiples of earnings to determine value can also be somewhat problematic. Valuation multiples were depressed during the recession, resulting in lower business valuations. While multiples are rebounding with the improving economy, the numbers are not consistent across industries or across different regions of the country. Relying on historic or broad national indicators of appropriate multiples may result in significantly undervaluing or overvaluing the company. This has increased the need for precisely identifying the market for the business, choosing a strategic or economic buyer, and assessing the local market for the business.
The taxation landscape has also changed dramatically from pre-recession days. The Affordable Care Act has added a host of new taxes, reduced or eliminated deductions, and raised or eliminated income caps that, often surprisingly, can come into play on the sale of a business. While the tax rates or rate increases were individually seen as relatively modest, in the aggregate they can add up to a significant tax liability.
The new tax receiving the most press is the 3.8 percent Medicare tax on investment income. While the tax is levied on “non-business” income, including interest, dividends, annuities, rents, royalties, and capital gains, the structure of the sale of the business may bring this additional tax into play on a portion or all of the sale proceeds.
Also in the press recently is the national discussion on increasing the capital gains tax rates. Currently these rates are at historic lows; however, with the increasing recovery and continued deficit spending, there is considerable pressure to raise these rates. It is often difficult to predict what congress will do with taxes, but in this instance it seems there is only one direction tax rates can go.
While the post-recession landscape for successful succession planning creates many unique challenges, with challenges come opportunities. Being aware of the current landscape is the first step in taking advantage of those opportunities. All businesses will need to continue their succession planning efforts. They will just need to do so from a different vantage point.