Why Having a Succession Plan Is Important
There are many reasons for having a solid business succession plan in place.
One is to prevent disruptions or even chaos in the event of the unexpected. Another is to ensure that your business, or your portion of it, doesn’t end up in the wrong hands, or even end up being liquidated in a fire sale. Taxes are another consideration. Finally, it is essential to have trained individuals – family members or trusted employees – who can assume your role once you’re off sipping drinks on the beach in retirement.
Overall, a good succession plan should focus on:
- Transferring ownership when the time comes
- Maintaining your lifestyle in retirement
- Providing for your heirs financially
- Preparing the business for the unexpected or unforeseen
Types of Succession Plans
Regardless of the structure of your business, SCORE – the nationwide network of volunteer business mentors – sees four options when the time comes, whatever the reason, to transfer ownership:
- Transfer the business to your heirs
- Sell the business to your partner(s)
- Sell the business to a key employee
- Sell the business to an outside buyer
A sole proprietorship is the most straightforward type of business for succession planning. You can always train a family member to take over the reins when you retire, and you can leave the business to your heirs through a will or living trust, preferably the latter since it avoids probate proceedings.
All this, of course, assumes that one of your family members wants to run your business. If not, then you will have to train an employee to take over, and even then, you may have to award the employee ownership interest or the right of first refusal should you decide to sell at some point, or should your heirs so decide after you’re gone.
If you’re involved in a partnership, matters can get a bit trickier. The partners should agree on how to handle retirement and other succession issues before establishing the business. A partnership agreement is the perfect vehicle for doing this.
If a partner decides to leave the business, the question of the valuation of his or her interest comes into play. If, for instance, there are five partners all with equal 20 percent interests, and each put up $20,000 to fund the business but the business has grown since then, how much is the retiree owed? A mechanism for determining this - called a buy-sell agreement - should be part of your business planning.
The buy-sell agreement must also include provisions that detail what happens should one partner pass away. The usual tool for this is life insurance.
One version of an insurance-based buy-sell is called a cross-purchase agreement, in which each partner buys a life insurance policy on the other partners. When one partner dies, the others use the proceeds from the policies to buy the deceased partner’s share at a pre-agreed-upon price.
An entity-purchase agreement involves the company itself buying a policy on each partner. When one partner dies, the company will receive the benefits and use them to buy out the decedent's share of the business.
The partnership agreement or operating agreement should also address the issue of transferring or selling a partner’s ownership interest in the business. Should there be a right of first refusal so the other partners can buy those interests before it is sold or transferred to someone else?
If the business is a Limited Liability Company (LLC), the operating agreement among the members should likewise address:
- Designating who controls the company, which member or group of members
- Naming the successor or successors to the controlling person or team
- Setting the terms and conditions for the sale and transfer of ownership interests