There are two sides to a succession plan. One is for the operation of the company and the other is for the ownership of the deceased owner's share.
The business owners that we work with have a high percentage of their net worth tied up in the business and sometimes the real estate within which the business operates. The most common surprise is how little attention is given to the details of a succession plan that these business owners were given by their team of advisors. They all had CPA firms, attorneys, insurance agents, money managers, and a bunch of other suits around them giving advice within their silo of expertise, without making sure the plan was buttoned down from both a financial and an operational side.
Starting on the operational side, who is going to do the work of the deceased? In companies where you have a very strong founder who is still in the trenches for many things, this is a huge issue. These owners need to have conversations with their key employees immediately to talk through this possibility. I'm talking a real nitty-gritty discussion in terms of who does what.
Multigenerational family ownership is not necessarily the cure for an operational succession plan. The roles to be assumed by a second or third generation must be planned so that the roles are properly filled. We all know that blood-line succession may work for ownership, but not always for operating the business.
Even businesses with a relatively strong management team need to iron these issues out. Owners may be surprised to learn that their team wondered what would happen if the key person didn't wake up for breakfast. Owners need to run the scenario in their heads and pretend that this all happened yesterday. The ideal outcome is to set up the operational succession plan now that would make them feel best about how the business will be run when they can't.
The owner/leader needs to make the initial assessment and decide who they think is ideal to step up to what roles and begin having conversations with them. When they've got talent that is capable, interested, and maybe even eager for the opportunity, then it is time to communicate these decisions to others on the leadership team and eventually with everyone.
These conversations will eventually need to be very detailed regarding the roles, compensation and equity incentives. Not many employee-leaders are benevolent enough to pour their hearts and souls into a privately held business for the benefit of heirs without a reasonable incentive for them. In smaller businesses, it becomes likely that your next generation of leaders will become the majority owners. When the business is larger, there are probably enough value, cash flow, and profits to present a very good financial package to the next gen leader(s), even if the family still maintains significant ownership.
This process can take a long time. Sometimes it is the owner who procrastinates. Oddly enough, the very busy business owners whose businesses are thriving are the exact ones who need it the most. The fact that they don't have the time for this is a leading indicator that they really need help.
Most of the operational issues in succession planning could be handled by the owner(s) without professional guidance. But in my experience, an outside influence from a good advisor can guide the process so that it has desirable outcomes in a reasonable amount of time. In my opinion, this can be done within three to six months with just a little focus and professional guidance.
The financial side
Moving on to the financial side of succession, there are a few key questions: Who will become the new owners of the deceased shares, and what are the financial arrangements for that transfer?
Both issues depend largely on the valuation assigned to the business. This valuation process is not something to be left until something bad happens; that can breed animosity among heirs and future owners. Businesses with the least amount of animosity and grief in a transfer of ownership are those that have had regular valuations by an outside professional and where owners and future owners are well versed in the process and the value.
While all owners probably have a general sense of the value of their businesses, having an independent outside appraisal at regular intervals is better when the Internal Revenue Service or anyone else wants to challenge your opinion of value. Do not shop for this work with a low-bidder mentality. Your criteria for selecting a valuator is their experience in your specific industry and their rate of success in defending their valuation when challenged by the IRS or any other interested parties.
The extent to which the business has any bank loans is something that may need planning. If the owner had any personal guarantees on business loans, the issue needs to be resolved with lenders before there is a problem.
The worst possible scenario shortly after the majority owner/operator passes away is that all loans get called. It may be just as bad if new owners find out after the fact that they need to step up and personally guarantee these loans themselves. That could be a significant hardship for a business trying to succeed with a pre-arranged financial succession plan.
Real estate can also cause problems. Will the real estate remain with the heirs or will the new owners also buy the real estate? If the real estate is large and extremely valuable, will the new ownership team have the capital to purchase the real estate now that they've just made a substantial financial commitment to become the new owners of the company? This may be dependent on the interest rate environment, the new owner's ability to borrow and any other issues common to large real estate transactions, such as hazardous waste testing.
As with the business itself, I strongly recommend a formal valuation of the real estate. This should be kept current, with valuation updates occurring at regular intervals. Let me explain a bit further what I mean by regular intervals. Annually is certainly an acceptable interval but may be overkill. They should start with one now, and then each year in their minutes at their privately held annual meeting, they should have a discussion with their leadership team about last year's value, and if everyone agrees that it is still valid. If not, the group can agree on a new number that has strong validity if ever challenged.
Updating the formal valuation should happen when there is a material change of facts or circumstances, and probably no less than every five years. The business itself, however, may require more frequent formal valuations if it is growing rapidly, making acquisitions or developing new products, markets or technology.
One last point about real estate: Make sure there is a lease between the actual owner of the real estate and the business. Hopefully your team of advisors was at least aware enough to segregate the real estate into a separate entity when it was acquired. The lease between the two entities should be based on fair market value. If the real estate is valuable with substantial maintenance requirements, rent and expenses, a formal appraisal of fair market rental rates would be advised.
The final piece of the financial succession is the financing of the ownership transfer. There really are only a few options:
- New buyers come up with the cash to pay the heirs;
- Old owners finance the transaction over a specified period; or,
- New buyers get a bank to finance the transaction.
As you have now grown to expect from me, this is not something that you want to figure out after the fact. Get this documented today with the facts and circumstances of today. These facts and circumstances may include the interest rate environment, the borrowing capacity of the new owners, the heirs' needs for liquidity, death taxes that may be payable, existing bank loans on the business or the real estate and anything else that may complicate the financial succession.
Part of the reason so few owners have this problem is neglect from their team of outside professionals. Every one of them is extremely busy in their own world and claims they do not have the spare time to attend to some of these issues that are non-core to their own silo businesses.
Accountants claim they are too busy doing accounting and taxes to devote dozens of hours to some of their best clients on what may really be their single most important and urgent issue. Lawyers claim that they are ready to draft whatever documents that Mr. Business Owner needs to complete the plan, but they don't have the time to devote dozens of hours to walking through the nitty-gritty. This story holds true for most financial planners, insurance agents, money managers, and any other suit that has ever been in your office. Most have an idea as to what needs to be done, but as long as they meet their own firm's objective by selling the client a line of credit or retirement plan services, they've done their job.
If business owners want help to get through this, they should start looking for help. And if they think they can go at it alone, they should get started as soon as tomorrow!
