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Succession Planning: Business succession planning: Procrastinate and it will be too late.

You have spent an entire career building a successful business – now what? The single most significant concern facing owners of family or closely held businesses is how to effectuate an orderly and financially successful transfer of the business to the next generation, to key employees or to a third-party buyer. Since, for most business owners, the business is the single largest component of their net worth, it is an essential and necessary portion of their retirement and estate planning. Unfortunately, most business owners do not find business succession planning to be a high priority and, in most cases, simply ignore it and stay occupied with the operation of the business until it is too late, often with catastrophic financial consequences.

A poll of small business owners conducted in 2004 indicated that while a slight majority of them had a general plan to either sell the business to a third party or have a family member take over, only one third had considered who that successor would be. Experts in the field estimate that an effective succession plan needs to be adopted and implemented 15 years before consummation of the contemplated transfer. Personal experience indicates that a less conservative 5-10 year period is the minimum. Selection of the appropriate strategy, finding the appropriate people to implement that strategy and then finally executing that strategy takes time.

The first and most important thing to be accomplished in any business succession plan is to decide which of the three generally available options is best to maximize the value of the business. Those three basic options are:

(1) Sale of the entire business, as a going concern, to a third party;

(2) Sale to certain key employees;

(3) Transfer to one or more family members by sale, inter vivos transfer or transfer at death.

Analysis of which of the three options at best requires an objective and dispassionate assessment of the strengths and weaknesses of the existing employee base, including family members. It is very difficult to set aside loyalty to long-term employees and to family members, but such analysis is the cornerstone of any effective succession plan. Business reality must take priority over emotional issues. The long-term success of the venture must be the primary objective.

Of particular importance is not to confuse business succession planning with estate planning. As Thomas Jefferson once observed: “There is nothing more unequal than the equal treatment of unequal people.” While this comment was probably offered as a rationalization for his status as a slave owner, it is applicable to succession planning in a closely held business. Not all family members have the same skills, interests or aptitudes, and to treat them equally within an estate plan by making them equal owners in the family business is a mistake. Although it is difficult, family members must be evaluated, as any other employee would be evaluated, as a viable candidate to take over the management and control of a business. To deviate from that strategy is an invitation to disaster because the result is almost inevitably family disagreements, which lead to the ultimate detriment of the business. In virtually every case, there is a way of providing for children with other assets of the estate to the extent that they are not qualified or interested in being actively involved in the business.

Although the overwhelming majority of small businesses in America are family owned, Small Business Administration statistics show that only 30% of family-owned businesses survive to the next generation, and worse yet, only 15% survive to the third generation. Although there is no empirical data commonly available, many experts attribute this dismal statistic to the lack of an objective business succession plan.

Having decided to adopt a business succession plan, perhaps albeit belatedly, where does the process start?

1. PICK A STRATEGY AND BE OBJECTIVE. Make the hard choice as to whether it is best for the long-term viability of the business to pass management and control to family members, key employees (existing or to be recruited) or whether to sell to a third party. Be honest and objective, and make the hard decision for the right reason. Example of WRONG Reason: “Maybe he will grow into the job eventually.” Example of RIGHT Reason: “He has the right set of skills to take over this company and, given a period of time, can acquire the experience to do the job.”

2. PICK A TARGET DATE. Everything takes time to implement. Finding and training the right person or finding and courting the right buyer is not done overnight. Whatever the strategy that is adopted, it is essential that there be a date on the horizon for which all parties can plan.

3. OBTAIN A THIRD-PARTY VALUATION OF THE BUSINESS. No matter whether the succession plan involves gifting and estate transfers to family members, sale to existing employees or sale to a third party, the starting point is the value of the business. The sooner that value is known, the sooner the appropriate financial transactions can begin being structured. A succession plan is a business transaction, and an accurate value is an essential part of any business transaction.

4. SHARE THE RESULTS OF THE DECISION OPENLY WITH ALL CONCERNED. Just as important as being honest with oneself in the decision process is being honest with employees and family members. Any successful business succession plan requires consensus and cooperation among all those concerned. Forming that consensus can take time and so the sooner the business succession plan is announced, the better.

5. BEGIN IMPLEMENTATION OF THE PLAN WELL IN ADVANCE. Change is always a somewhat scary process. The longer the process, the more time there is to allay those fears. If there are certain key employees who are deemed to be essential to the long-term viability of the business, part of the business succession plan should be to secure the long-term loyalty of those employees and dispel any insecurities that they might have about their continued employment after implementation of the plan. Programs such as stock option plans and stock appreciation right plans might be considered.

6. BE FLEXIBLE. A business succession plan, like any other plan, may need to change depending upon changed circumstances.

7. INTEGRATE THE BUSINESS SUCCESSION PLAN INTO YOUR ESTATE PLAN, AS APPROPRIATE. Beyond the scope of this article, there are a number of things that can be done to structure a succession plan to minimize estate taxes. As an example, if the succession plan contemplates a transfer to family member employees, an annual gifting program can be established by which incremental portions of ownership are transferred free of gift or estate taxes. This necessarily requires the involvement of accountants, lawyers or other qualified advisors.

8. PREPARE FOR THE UNEXPECTED, HAVE A WELL CRAFTED BUY-SELL AGREEMENT. Last, but most important, once a business succession plan has been decided upon, it is imperative that there is an appropriate Buy-Sell Agreement in place to deal with unforeseen contingencies. This rule is equally applicable whether the succession plan is to involve family members, key employees or a third-party sale. A Buy-Sell Agreement is a document executed by all owners of the business establishing procedures for what happens to the interest of an owner in the event of death, disability or other such event. Making sure that the Buy-Sell Agreement is consistent with the succession plan – and allows the implementation of the succession plan in the event of such an unforeseen circumstance – is essential.

For example, suppose that the succession plan calls for the sale of the business to one or more key employees at some date in the future, but prior to that date the controlling shareholder in the business becomes permanently disabled. Because all had contemplated that the transferring shareholder would be actively involved in the business until retirement, disability could create a significant problem, not the least of which is that the purchasers/employees might not yet have the financial resources to acquire the disabled shareholder’s interest. A well thought out Buy-Sell Agreement might provide for the accelerated purchase by the employee/minority shareholders and might further provide for a disability insurance policy to fund all or a portion of the purchase price, thus allowing the succession plan to be implemented, albeit earlier than contemplated.

Human nature causes us all to put off unpleasant and difficult tasks. No successful businessperson relishes planning the end of his or her career years in advance, but it is a necessary task. Like completing any other task successfully, it requires careful thought and the advice of others with particular expertise such as CPAs, lawyers, insurance brokers and other consultants. The cost in dollars and time invested is modest, but the returns in peace of mind are great. It is an exercise that every business must engage in to insure the long-term survival of the business and to maximize the financial reward to its owner.

About The Author

Richard Abbey has been a member of Abbey, Weitzenberg, Warren & Emery through several name changes since 1973. His practice has focused on real estate, commercial, corporate and financial institution litigation and transactions, including acting as primary counsel to Exchange Bank and Sonoma National Bank and as regional litigation counsel for Westamerica Bank. Recently, his practice has included an emphasis on corporate and partnership disputes with a focus on the wine industry. Mr. Abbey received a B.S. from U.C. Berkeley in 1969 and earned his J.D. from UCLA in 1972.

Abbey, Weitzenberg, Warren & Emery, Attorneys and Counselors at Law, 100 Stony Point Road, Suite 200, Santa Rosa, CA 95401, 707-542-5050 • www.abbeylaw.com