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Succession Planning

by Kirk Hoffman
April 2017

A succession plan for a business is one of the most important safeguards that can be used to ensure the company’s future success.  Approximately one-third of family businesses that transfer to the next generation result in success, and only 12 percent make it to the third generation.  Choosing tomorrow’s leaders and formulating a plan for retirement, death, disability, or even divorce are tasks that should be done early and reviewed often.  The transfer of power and wealth can provide a smooth transition or can be the demise of a company, depending on how future leaders are chosen and groomed, and how tax and estate planning implications are handled.

There are various business succession options available to the owners of privately held businesses. These include:

o   Transfer of ownership to the next generation

o   Employee stock ownership plan (ESOP)

o   Public offering

o   Recapitalization of the business

o   Sale of the business to a third party

o   Liquidation of the business

Transfer Ownership to Next Generation

When choosing and grooming successors for a business, business owners must consider the person’s business strength and savvy, and the psychological and emotional impacts of any decision on employees and family members.

Children who are active in the family business present both unique opportunities and potential pitfalls. There is the opportunity to take advantage of gifting and valuation discounts when transferring the business to family members.  A Family Limited Partnership often works well in these circumstances. However, there is always the risk of family disagreements and the challenge of balancing the estate with family members who are not active in the business.

Whether the successors are family or not, it’s important that the succession process begins early.  The first step is to recruit talented employees from the beginning and help them develop their leadership skills within the company.  They should also get comfortable with taking over long before they actually do so, to ensure a smoother transition.  It may also be helpful to get clients used to the new leadership before they take over.  Adequately preparing the successors is one of the best things that can be done to maintain a company’s success in the next generation.

ESOP 

If the choice is to transfer the business to the employees, an Employee Stock Ownership Plan (ESOP) may be the solution.  An ESOP is a qualified plan designed to benefit all employees and must be non-discriminatory.  Unlike other qualified plans, an ESOP can borrow money to purchase investments in the stock of the sponsoring corporation.  An ESOP is an excellent method for business owners to plan for the transfer of ownership.  In addition, an ESOP provides tax advantages to the selling shareholders that assist in maximizing the value of the business.

With an ESOP, the business owners sell their shares to an ESOP trust.  The trust in turn makes annual contributions to the accounts of the employees.  One key issue that must be addressed with an ESOP is the concept of repurchased liability.  The sponsoring corporation must create a market for the employees to redeem their vested shares upon certain events (e.g. death, retirement).  It’s important to give careful attention to this issue.

Public Offering

An alternative to the ESOP is to go public.  Using this method, corporate shares are offered to the public and traded on the stock market.  Going public is usually an expensive option that requires a sufficient revenue base and a strong business plan.  It is not optimal as an exit strategy if the business owner is near retirement; rather, this strategy is best employed early in the succession planning process while the owner is still very active in the business.  This option is most useful to provide growth capital for the business; however, it can provide liquidity to an owner in the long run.

Recapitalization

If the business owner would like to begin to transfer value while retaining control of the company, recapitalization may be the answer.  Using this method, the business issues two classes of stock: voting preferred and non-voting common stock.  The non-voting stock is transferred either through sale or gift to the successors.  The business retains the voting preferred stock until the owner are ready to transfer control.  This is more commonly appropriate when transferring a business from parents to the next generation and may be most useful to provide growth for the business.

Sale

The business owner may choose to sell the business to someone who is not currently involved in the company—a competitor, an existing customer or supplier, for example.  This can be done as a lump sum sale or in the form of an installment sale that spreads the payments and tax implications over a number of years. The sale of the business may be structured as an asset sale, a sale of stock or a combination of both.  The business owner is motivated to sell the stock in the company to take full advantage of the lower capital gains tax rates (a sale of assets usually subjects a portion of the gain to ordinary tax rates).  However, the market and other factors may dictate the nature of the sale. 

Liquidation

If there is no market for the business as an ongoing entity and other options are not available, the business owner may choose to close the business and liquidate its assets.

Buy-sell agreements

What will happen to succession plans if a business owner or a partner dies prematurely, becomes permanently disabled or gets divorced?  Most closely held businesses need to have a buy-sell agreement in place when other partners, principals or shareholders are involved.  Most commonly, this agreement states what occurs if a partner/shareholder should die, but it should also include provisions for retirement or other departure, disability and for the divorce of a partner.

A properly structured buy-sell agreement stipulates in a binding contract what occurs in each of the events outlined below.

Death: There are two general structures to the buy-sell agreement in the event of death–a cross purchase or an entity purchase.  In a cross purchase plan, each of the partners owns life insurance on the lives of the other partners.  In the event of the death of a partner, these life insurance proceeds are used to purchase the business equity from the estate of the deceased partner.  This type of plan works well in a company with few partners.  The entity purchase plan is similar, except the company owns the life insurance on each of the partners, and the company purchases the deceased partner’s shares.  This is easier to administer when the business has many partners.

Disability: A disability buy-out provision specifies the method and timing for the buy-out of a disabled partner.  This can be done with an installment sale (providing the company can afford the payments) or more likely with a disability buy-out insurance policy.  This policy provides a lump-sum benefit to purchase the business shares from the disabled partner.

Divorce: A divorce decree or the operation of provincial law can stipulate that all assets are divided between the spouses, including business interests.  Unless the couple had a pre- or post-nuptial agreement protecting the partner’s business assets, the business may end up with a new and potentially unwanted partner.  To prevent this from happening, the buy-sell agreement should include provisions in the event of a divorce.

Creating a business succession plan may be one of the most difficult management challenges.  Juggling the selection and preparation of successors with tax and estate concerns makes succession planning a complicated endeavor, as evidenced by the failure rate of second and third generation businesses.  The best way to successfully send a company into the future is to start forming a plan now.  Each type of plan has its own strengths and tax implications, so it is important to discuss the decision with a professional well versed in business succession.


The information contained in this article should not be considered legal or tax advice.

 

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