By Brad Eriksen
September 2010
In any discussion of business succession planning, it is first helpful to understand the nature of succession planning.
• Succession planning is NOT simply preparing a will or living trust to dispose of one's assets.
• Succession planning is NOT simply handing out equity compensation to key employees.
Succession planning for a closely held business is an orderly, structured plan for the transfer of the ownership, control, and management of the business. Each of these elements — ownership, control, and management — must be separately evaluated and a transition plan for each element developed.
Ownership
Ownership of the business is most likely going to be transferred to one of three groups: family members, key employees, or outside third-party buyers. Selecting which group to shift the business to is itself a significant decision that requires the business owners to understand their goals and objectives. Deciding who, within a particular group, to shift the business to involves significant due diligence in order to ensure success.
When transferring the ownership of the business to one or more family members, typically children, the decision-making process involves dynamics beyond strictly business considerations. Equitable division of the owner's estate, sibling rivalry, special-needs children, and other factors must also be taken into consideration, as well as business experience. One unique consideration is transitioning business to family members is the potential for transferring too early or too late. If you move the business down to the next generation too early, they may not have the skills necessary to run the business. The older generation may have to reinsert themselves into the business, thus undermining the confidence and authority of the younger generation. Transfer the business too late and the younger generation becomes impatient and may move on to other opportunities.
Selecting key employees to take over the business also takes careful consideration. Often employees are viewed simply as employees, and not as potential owners. It may be difficult to evaluate which, if any, employee has the ability to "think like an owner." If no employee appears suitable to take over the business, then a long term-plan to recruit such an employee, integrate the employee into the business, and implement a transition plan is necessary. Such a process can take five or more years.
When selling the business to an outside third party, there are essentially two buyer groups to consider: economic buyers and strategic buyers. An economic buyer buys the business strictly as an investment and will base the purchase price in large part on the financial performance of the business and the expected return. A strategic buyer may be looking to expand a product line, develop an additional distribution mechanism, or otherwise add value to its existing business. Selling the business to a strategic buyer may bring a better price because it may fulfill a strategic need for the buyer. But this also runs the risk of exposing confidential proprietary business information to competitors.
Control
What is not commonly understood is that control of the business does not necessarily have to follow ownership of the business. While it typically does, that is not necessarily always the case. Control of the business, whether at the ownership (shareholder) level, governance (board) level, or management (officer) level, can be allocated in any number of ways. Use of voting and nonvoting ownership interests, ESOPS, or trust arrangements can pass on the economic value of the business without passing on control of the business. Similarly, use of outside directors or professional management can effectively put operational control of the business beyond reach of the owners of the business.
Management
Transition of the management of the company is often the most overlooked element in developing a succession plan. An owner may simply be looking to sell his ownership interest in the business and move on. However, if the purchase price involves a significant portion that is to be paid over time or the purchase price includes earn-out provisions, it is incumbent on the owner to make sure that the next generation of management can successfully manage the business in order to ensure payment of the deferred purchase.
It is also important to remember that the transition of the management can be separated from the transition of the ownership or control. That is to say, the business owner can retain ownership of the business while shifting the management to key employees or professional management. Transfer of the ownership or control can occur later, through the owner's estate plan or other tools.
As can be seen, there are many moving parts to consider when developing a succession plan for a closely held business. There is no "one size fits all" technique available. Careful planning, documentation, and implementation are necessary to ensure a successful transition. Use of the entire professional team — accountant, attorney, appraiser, and financial planner — is necessary to obtain the results desired.
