Passing the torch: business succession
In 1997, Mark died suddenly of a heart attack. Having left no plan for succession, his company automatically passed on to his wife Sheila, who had never participated in the management of the business. In the wake of Mark's death, his competitors took advantage of the uncertainty at the firm, and hired away several key managers and employees. Several long-time customers became alarmed at the management flight, and began shifting business away from the firm.
Within two years, the company that Mark had built was a fraction of its previous size. After a dispute with the remaining managers, Sheila decided to sell her interest in the company for cash.
Most business owners know that they should plan for ownership succession, but can never find the time to do so. Busy with chasing new customers, offering promotions, cutting costs, and fighting suppliers, business owners don't become aware of the urgency for succession planning until it's almost too late.
Postponing succession planning can have dire results. Should a calamity occur, the owner's beneficiaries may be saddled with hefty estate and inheritance taxes that may force them to liquidate or sell the company to pay Uncle Sam. We have seen some companies flounder when their owners passed away. In the face of uncertainty, key managers, employees, and customers left for competitors, while the owner's spouse struggled with what to do with the company and the declining company value.
Having someone on deckThe lack of succession planning can have negative results, too, even when the owner is still alive. Ready to retire, some owners just stop coming into the office regularly, and leave the management of their firms in their children’s hands, without considering the lack of management experience or internal respect from management they might have. Other clients, with the best of intentions, have planned to pass along their company to their management team or employees. However, basing their planning on unrealistic valuations of their companies, these owners often find it difficult to close their transactions.
What is Ownership Succession Planning?Ownership succession planning is the planning for the transition of company ownership and ensuring the owner’s long-term personal and financial objectives. Depending on how it’s structured, ownership succession planning can allow an owner to cash out right away, or slowly phase out his or her participation in the company.
Ownership succession planning requires the consideration of many financial and non-financial issues. Business owners must come to grips with their own personal and financial objectives, understand what a realistic value of their company is, and establish and set in motion a strategy that meets their objectives.
In pondering their objectives, owners should reflect on several key factors in planning for their succession. Owners should understand:
- What role their family will play in the succession of management.
- What economic requirements they might have for their retirement and the timing of those considerations.
- What professional role they want to play
- How they want to provide for management, employee, customer, and supplier interests.
Some business owners have a son or daughter engaged in the business, while others find that their children have no interest at all. In passing ownership to children, owners should consider who in their family wants to run the company, decide who in their family is capable of successfully running the company and, if no one from their family is interested, determine whether the company should even remain within the family.
Understanding people, the businessKnowing who in the family is interested in running the company should be evident in their current participation within the firm. However, deciding whether that person is capable is an entirely different consideration. Do they have the respect of other managers within the company? Do they understand the complexities of the industry, and the role the company plays within that industry? Do they have effective sales, communications, or operational skills? Are they good managers of people? Do they have the necessary drive, ambition and dedication? If the company is passed on to your son or daughter, will your current key managers stay?
It is possible that no one in your family will want to take on the responsibilities that you currently fulfill. In this case, you need to consider what benefit you will gain from keeping the company in your family.
Business owners also need to consider their economic needs as they plan their succession. Do you want the absolute highest cash price you can get for your company, or would you be willing to accept less to achieve other non-monetary goals? Will you draw a salary as you leave the day-to-day operations of the business? How will you sustain yourself and your family in retirement? You also need to consider whether you will be leaving the company with enough capital.
If you choose to completely divest yourself from the company, you can get cash from the sale of your stake and reinvest the proceeds. This is sometimes attractive for those interested in diversifying their financial holdings. In this instance, however, you also need to consider the tax implications of an outright sale.
As someone who has worked hard for many years building your company, you need to consider what your role in the firm will be during the transition, and after the transition. If you sell to an outside buyer or a competitor, you may be subject to an earn-out provision that would require your continued efforts on behalf of the firm. Alternatively, you may find yourself without a position at the firm.
Some business owners are willing to just walk away, but many owners find that hard to do. During succession planning, you will need to decide how active you want to be at the firm once you’ve released your stake in the company.
Keys to successionKey parts of succession planning include providing for the continuity of management, addressing the concerns of the employees, and calming any fears customers or suppliers may have on the organizational changes within your firm.
In planning for your succession, you should consider your management’s stake in the firm. No matter what transition path you take, you need to keep your managers happy and properly motivated. Often, this means giving them an equity stake in the firm, or establishing an incentive bonus plan if you don’t have one already.
Even when you sell to an outside party, the buyers may require that you obtain employment agreements with your key people. Your key managers will be concerned about the loss of independence — theirs and the firm’s — and the potential loss of their jobs. Bear this in mind as you plan, since your company will be worth less if you can’t hold on to your managers.
Employees have similar fears. In some cases, business owners concerned about their employees’ futures and the company’s independence have sold their companies to their employees through Employee Stock Ownership Plans (ESOPs). ESOPs are broad-based employee benefit plans that allow employees to become owners of the firms at which they work.
Customers and suppliers, too, have stakes in your company that you must take into account as you plan. Customers and suppliers may become concerned about the loss of their relationship with you, and about the potential loss of other key managers at your company. You must assure them, through both your actions and your words, that your company will continue to provide the same level of service, quality, and dedication that you have shown them in the past.
Owners of private companies have several options when contemplating ownership succession. They can choose to:
- Sell the company – to a competitor or other third party buyer, to their management team, or to their employees.
- Gift shares to children or relatives.
- Offer their shares up to the public market (IPO).
- Liquidate the company through an orderly sale of its assets.
- Do nothing at all and let heirs figure out what to do.
- You can always sell your business to a third party.
The main advantage to this is that you can receive most if not all of the sale proceeds in cash, leaving no residual interest in the business. You’re outta there.
Selling to a competitorSales to competitors can be lucrative for the seller. A competitor will usually pay the highest price of all potential buyers because they can eliminate price competition from the acquired company, expand market share and cement their position within the marketplace, consolidate overhead, and leverage strategic assets to create additional value.
Conversely, selling to a third party buyer leaves the company vulnerable to the changes a new owner may institute. Acquisitions are typically undertaken so that the buyer can earn rates of return higher than they would have earned on their own. In order to achieve those rates of return, the buyers almost always make changes to consolidate overhead. They may eliminate dual positions, close facilities, and/or sell off assets.
Sellers must also consider the taxes they must pay on the sale of their business interests. The amount of the tax depends on whether assets or stock are sold, the basis (the price at which they bought in at) of the shareholder in the stock of the corporation, the period of ownership, and other factors. Additionally, depending on the terms of sale, there may be liabilities for which the seller is responsible.
Some owners decide to sell to their management team instead of to third party buyers. These owners realize that the management team has been instrumental in building the value of the business, and want to let the management team make a go of owning the company. Because management teams often lack the capital to execute a cash buyout on their own, management teams will need accommodations from the seller.
Owners can accommodate the management team in several ways. One way is to permit the buyers to use the assets of the corporation as collateral for the loans used in the buyout. A second way is to provide seller financing so that the buyers have cash flow available to both support debt payments and reinvest in the company. A third way is to reduce the seller’s asking price.
If the owner decides to sell to the management team, tax and risk issues will arise. While the taxes are similar to the taxes payable in an outright sale, the risk exposure is frequently greater, since the seller usually has some continuing financial interest (either a seller’s note or equity) that could go unpaid if the new buyers are unsuccessful. Some companies default on the seller’s note, requiring the seller to re-engage himself in the business, or re-negotiate his ownership transfer.
Selling to employeesIn the case where owners want to sell their shares to the entire staff of the business, an Employee Stock Ownership Plan or ESOP is the preferred choice. An ESOP is a qualified employee benefit plan that permits the company to make tax deductible contributions that are invested in employer stock. The shares are then allocated to participants on a nondiscriminatory basis.
The federal government has encouraged ESOPs in the U.S. through a number of tax incentives. One major factor driving the growth of ESOPs is the ability of companies sponsoring ESOPs to borrow funds, and use these funds to purchase the sellers’ shares. The company then makes annual contributions to the ESOP that are used to repay the loan. Both the principal and interest payments on the loan are tax deductible, provided certain regulations are met. In other words, the U.S. government has chosen to subsidize the sale of employer stock to employees to more broadly distribute stock ownership.
ESOPs also offer a tax incentive to sellers. An individual who sells shares to an ESOP may be eligible to defer capital gains taxes on the sale of his or her shares.
ESOPs have eclipsed management buyouts as the primary means for an owner to sell his or her stock to employees. The ability for the ESOP to repay in pretax dollars the debt undertaken to buy the stock, and the ability of the seller to defer capital gains taxes are compelling reasons to choose an ESOP.
Ownership transition does not always have to mean that the owner sells their stock to unrelated parties A very common means to transfer ownership is the “keep it in the family” strategy through planned giving.
There are tales of many businesses that have survived generation after generation. One of our clients is a 150 year old company that was founded to make buggy whips for settlers moving to the American West. While its core business has changed over the last 150 years, the company has survived through many generations of family ownership through estate planning conducted in each generation.
At the time stock is transferred from parent to descendant, the value of the transfer is investigated. Sometimes the transfer is not taxable. In some cases, a gift transfer tax is charged. Thus, owners who choose to gift their shares to their children will not only not be paid for their interest, but may also have a tax liability to contend with. It takes careful planning to minimize the potential taxes payable in the gifting of shares.
A much desired but difficult to achieve exit strategy is to execute an Initial Public Offering (IPO). In an IPO, the owner of a business sells stock to investors at a price established by an investment bank. After the IPO, the owner may sell additional stock provided that the sale meets corporate and Securities and Exchange Commission rules.
There are significant hurdles preventing IPOs from being an exit strategy for private companies. The first is whether an investment bank considers the company of interest to public investors. If investors are interested, a valuation for the business must be established that would be successful in retaining investor interest over time. Further, is there an adequate fee opportunity for the investment bank in underwriting the offering? And, does the business owner want the reporting, financial disclosure, and public relations responsibilities associated with running a public firm?
Once the stock is sold in an IPO, the gain on the sale of stock is taxed, and the seller pockets the proceeds. Continuing risk for an owner depends on the extent to which the owner was able to sell all of his or her shares.