Business Succession Planning & Legal Considerations
Businesses must plan in the event of a closing or transfer of ownership. Regardless of whether the owners can envision the end of the business, an exit strategy should not be ignored. Experts advise that succession planning should begin at least 15 years before the anticipated end or transfer of a business. An effective plan – whether it involves private shares transferred to a high-level manager, a leadership transfer to family members, or selling the business – safeguards a smooth transfer of the business from the current owners to the next generation.
Succession planning involves a company’s partners’ explicitly defining exit-related objectives for the business’ owners and then designing a thorough strategy for takeover. The strategy should take into account all personal, business, financial, legal, and taxation aspects of achieving the shareholders’ objectives. Objectives may include maximizing proceeds, minimizing risk, closing a transaction, or selecting new investors. The strategy should take into account plans for owners’ sudden illnesses or death.
Succession Planning Steps
Determine a value for the business and each partner’s portion
Purchase life insurance for all partners
Determine the method of transferring the business
Choose a successor
When a business decides it is time to cash out, the first step is to determine a precise value for the business, or a particular owner’s portion of the business. This can be accomplished in one of several ways. A certified public accountant (CPA) can appraise the business, or all partners can reach an arbitrary agreement. If part of the company consists exclusively of publicly traded shares of stock, the owner’s interest will be determined by the stock’s market value at that time.
Once a dollar value is established, the business should purchase life insurance for all partners. Thus, if a partner dies before leaving the partnership, the death proceeds will be used to buy the deceased partner’s share of the business and disperse it among the remaining partners.
There are several methods of transferring a business. A cross-purchase agreement is formed when each partner takes out a policy on each of the business’ partners. Each partner is both the owner and beneficiary on the same policy, so that when one partner dies, the value of each policy is distributed to the enduring partners, who will use the proceeds to buy the deceased partner’s portion of the business at a previously determined price.
In an entity purchase agreement, the business purchases an individual policy on each partner, and the business itself becomes both the owner and the beneficiary of the policy. At the death of a partner or owner, the business uses the policy earnings to acquire the deceased person’s portion of the business. The cost of each policy is generally deductible, so the business absorbs all of the costs and guarantees equity among partners.
Sometimes insurers carry first-to-die policies, meaning that one policy will cover all the business owners. These policies can be less expensive because only one death is insured. For example, Jennifer, Tom, and Sam establish an ice cream shop and take out a first-to-die policy for the value of one-third of the business. When Jennifer dies, their ice cream shop gets the insurance proceeds. Tom and Sam use these proceeds to buy out Jennifer’s portion of the business. Tom and Sam then own the business 50-50.
Choosing a successor is a crucial aspect of succession planning. Many business owners find it useful to seek advice of the board of directors or of a search committee. Specialists recommend that the chosen successor be immersed in the company’s critical functions before the transfer. It is also recommended to set up a timetable for shifting the company’s control.
Business succession planning requires thorough preparation. Business owners seeking a smooth and equitable division of their interests when they close the business should seek assistance from a lawyer.