Business Succession

BUSINESS SUCCESSION PLANNING
by Cary R. Rosenthal, Attorney at Law, Rosenthal & Associates, P.C., Chicago, Illinois

        An owner’s interest in a closely held business is usually their largest and most important asset. Most business owners neglect the inevitable: ownership transition. Business succession planning is the systematic consideration of ownership transition, and it is no simple task. Only 35% of successful family businesses survive through the second generation, and of those only 20% survive through the third generation.
        And while the planning process may not yield the perfect plan, and circumstances may ultimately render the perfect plan useless, the process itself usually proves beneficial. Done properly, the process educates the parties involved and improves communication. Better communication, in and of itself, improves the chances for intergenerational business survival.
        More specifically, business succession planning is:

• the analysis of business ownership structures;
• communication and analysis of the needs and desires of current owners, potential future owners, and the business itself;
• analysis and discussion of future ownership alternatives; and
• application and integration into a coherent plan.

        Ideally the plan is a written one which everyone involved understands and supports. In this way a business succession plan is similar to a retirement plan, a budget plan, or any other plan. The owners identify point A, their current position. They also identify point B, a realistic assessment of their best ownership transition strategy, or contingent strategies. Simply put, the plan is a road map for getting from point A to point B.
        Effective business succession planning requires realistic introspection, communication, hard (often emotional) choices, foresight, accurate assessment of the character and judgment of others, acceptance, accurate assessment of business prospects, trust, patience, compromise, and persistence. Owners, would be owners, key employees, family members, and professionals must all demonstrate these qualities.
        In addition, the constituents must invest time, energy, and financial resources in the process, and work well with retained professionals. Vanity and greed easily derail the process. Professionals must be prepared to deal not only with a wide range of technical issues, but also with the full spectrum of the best and worst human behavior.
        The first professional that should be engaged in the process is the company accountant. He has an existing relationship of trust and confidence with owners, key employees, and family members. He knows the players, the business situation, interpersonal histories, and future plans of the company. He has a proven track record of communicating difficult tax and financial concepts to the owners. He will be called upon to deal with business valuation issues and projections, and is usually involved in implementing the selected succession plan.
        An attorney with sufficient training, expertise, and experience is essential. Only an attorney can render legal advice and draft documents. The attorney must be well versed in the areas of income taxation, contract law, estate planning, transfer taxation, state and local taxation, corporate governance, other business entity governance, debtor and creditor law, lien preferences, asset protection, pension law, and employment/labor law, to name a few. No one professional commands competency in all areas, so the attorney must consult other attorneys as required in each step of the process.
        The succession attorney should have experience resolving disputes between business owners - actual experience with dispute situations is crucial to a full understanding of it, and is the key to addressing it in a timely and effective manner. Business experience and good communication skills are of course very important. The attorney must be able to identify and overcome conflicts of interest that undoubtedly will arise in the succession planning process. In some cases it may be advisable for each owner, key employee, family member, or other constituent to retain their own legal counsel.
        Insurance products are often used in implementing a succession plan. In situations where the prospects of the business die with the owner it may be the only solution. These typically include professional service firms where the viability of the business is tied to the personal relationships of the owners. When the owner dies, the clients make new relationships and take their business elsewhere.
        Other situations also call for the use of insurance in the succession plan implementation. An insurance consultant, who can provide detailed and comprehensive alternatives and analysis in this regard, is almost always required. Financial planners also often play a role in determining funding options and retirement issues.
        Some situations call for the services of a business broker. There may not be a key employee or family member to act as successor for the business. The owner may contemplate a retirement in which he wishes to completely disengage from the business. In such cases the owner may be advised to consult with a business broker or investment banker in order to select an option that maximizes the value of the business.
        Each constituent and professional must work well together and integrate their unique skill and knowledge offerings. They must be aware of their limitations, and know when to consult professionals or colleagues with special expertise. Everyone must work together and focus on the ultimate goal, as defined by the client. Succession planning in some cases is a lengthy process, but can offer handsome rewards in terms of improved business viability and tax exposure reduction.

The Tools of Business Succession Planning

• Financial Statements
  

        Financial statements are a picture of the company’s financial condition on the date of the statement. Any business plan begins with the financial statements. The ultimate value of the plan depends on how well the financial statements reflect and report the true condition of the company.

• Budget Projections
  

        If financial statements are pictures, budget projections are paintings. Budget projections show what the creators—the owners and the company accountant who create budget projections - expect to see in future financial statements. Financial statements describe historical, and current, financial condition of the company. Budget projections are the best guess as to where the business will be some time in the future. The budget should account for historical trends, new investments, and other conditions which bear on future business decisions.

• Business Valuation
  

        Businesses should periodically obtain a valuation analysis from a certified business appraiser. A realistic, impartial valuation completes the financial picture of the business. The business succession planner, along with owners, prospective owners, and the company accountant, will use the financial statements, budget projections, and business valuation, along with the needs and desires of the owners, prospective owners, and the business, to negotiate and develop a comprehensive succession strategy.

• Business Entities
  

        Businesses may operate as sole proprietorships, partnerships, limited liability companies, limited liability partnerships, business trusts, C corporations, and S corporations. Each form offers unique tax, control and asset protection features. The succession planner must be well versed in the alternative forms to assist the owners, with input from the company accountant, to make the best choice of entity type.

• Gifts, Sales, Wills, Trusts, and Employee Stock Ownership Plans
  

        The succession planner must as well be versed in the various techniques of transferring business ownership, along with the tax consequences of each. The transfer must be integrated with the individual owners’ overall estate plans.

• Family Limited Partnerships, Self Canceling Installment Notes, Notes, Private Annuities, Insurance, Employee Benefits, Employment Agreements, Consulting Agreements, and Pension Plans
  

        In addition to techniques of transferring business ownership, the business succession planner must understand and apply compensation, gifting, and funding alternatives. Again, the company accountant must be consulted.

• Buy Sell Agreement Agreements
  

        Buy sell agreements are often overlooked, or inadequate. An ounce of prevention is worth a pound of cure, and good fences make good neighbors. It is easier, less disruptive, and less expensive to work out buy sell arrangements before the need for a transfer of interest arises. A good buy sell agreement provides for more than just the death or disability of an owner - it must as well anticipate dissension in the organization.
        The succession planner will work closely with the owners and the company accountant to establish mechanisms for ownership transfer at all potential transition triggering events. Simply executing a form will not do. The parties must understand their alternatives and reach a well thought out agreement which anticipates various scenarios and contingencies affecting the ownership posture of the company.

• Insurance, Annuities, and Other Funding Vehicles
  

        Life insurance products offer predictable liquidity at unpredictable times. In this way life insurance smoothes transitions in business as well as personal contexts. The income and estate tax consequences of using life insurance can be particularly beneficial if structured appropriately.
        Life insurance can: (1) fund the implementation of a buy-sell agreement; (2) provide for the survivors of a deceased employee; (3) provide alternative inheritance resources for persons not involved in the business; and (4) soften the transition resulting from the loss of a key employee.
        The primary disadvantage of using life insurance products pertain to cash flow requirements. Also, a person with health problems may not be able to purchase insurance at any cost. When there exists cash flow considerations or insurability issues, other payment arrangements include: (1) cash payout at the transition point; (2) use of a debt instruments, such as a note, to fund the payout; (3) installment payments; (4) creation of a private annuity in exchange for the payout; (5) transfer of an existing insurance policy; or (6) a sale leaseback arrangement.
        A cash payout is self explanatory. Likewise, the use of debt instruments is straight forward. An installment arrangement involves a purchase of a business interest over time, with the actual transfer occurring only after payment is made in full. A private annuity is an arrangement whereby an owner’s interest is transferred in exchange for a lifetime payment.
        It is also possible to transfer an existing insurance policy for the purpose of funding a buy sell arrangement, but this may create complicated transfer for value issues in which the death benefit may be includable in income. Finally, if the company has tangible assets, those assets can be transferred in exchange for an ownership interest in the business. Along with this transfer, the party being bought out might lease those assets back to the company.

• Mediation
  

        Good business succession planners must know their limits. Their competence is generally limited to legal, tax, and business issues. But they should also be sensitive to underlying family and personal issues. Even the most sensitive planner may be unable to work through certain difficult situations alone. A good family counselor, with experience and training in the family business setting, can reduce tensions, identify issues, and facilitate communication.
        Destructive conflict can often be avoided with a relationship audit, or other mediation techniques. Even the healthiest relationships can be improved. Those who rely on the business (such as owners, employees, and customers) have too much at stake. A counselor can provide insights and methods to maintain or improve relationships and organization dynamics.

Conclusion

        Your business is your life’s work. Will it continue on after you are done with it? Will you be able to maximize your return on your life’s work by selling your interest? Business succession planning is about all of these things, and more. Business succession planning is an investment in the future for the owners, the business, the employees, and the clientele of the business.