You don't have to keep it all in the family
by Mark Higley
July 8, 2019

Business succession planning is a series of logistical and financial decisions about who will take over your business upon your retirement or in case of death or disability. The first step is to identify the ideal successor to take over your health care business, then determine the best selling arrangement.

While succession planning is important for all businesses, it’s something many family-owned companies overlook. According to the Family Business Institute, one in five family business owners report they have no estate planning at all, and more than a third of junior generation family business members have no knowledge of their elders’ plans for passing the company along.

Making a Plan

Succession plans are commonly associated with retirement, although they also serve an important function earlier in the business lifespan: If anything unexpected happens, a succession plan can help reduce headaches, drama and monetary loss as your business grapples with a transition.

A succession plan makes it clear who will take over the business, reducing any potential disputes. If a purchase is involved, the sale price and purchase terms are also clearly outlined, relieving some of the stress for the departing owner’s family.

A well-crafted succession plan aims to benefit everybody—the departing owner, their family, the business and the successor.

Here are the four most common types of small business succession plans:

1. Pass on to an Heir

This is the popular option for business owners who have children or family members working in their organization. What better way to look out for your family than providing them an operational enterprise, and who better to uphold the mission of your business than your own family?

Of course, like any major family decision, this can stir conflict if not planned properly.

First, there is the question of who will take over. If you have just one family member who works alongside you, this is an easy decision. But it can get complicated if you have multiple children, nieces or nephews interested in taking over the business. In that case, you need to provide clear instructions on who will take over what, and how other heirs will be compensated.

Generally speaking, you don’t want to grant ownership to family members who aren’t involved in the day-to-day business. Instead, many succession plans will include a buy-sell agreement, in which heirs who are not active in the business agree to sell their shares to those who are.

As for heirs who do work in the business, you typically still want to pick a single successor, as opposed to splitting ownership evenly between heirs. There are exceptions—perhaps a division where one successor focuses on sales and the other on product development, for example—but businesses are generally much harder to manage with multiple decision makers.

Potential Drawbacks

Making business decisions within a family can get messy. Emotions can run high, especially after an untimely death or disability. This is compounded by the fact that second-generation businesses are risky; only 30% stay afloat after an inheritance.

Altogether, this should beg the question: Is inheritance even the best idea? If your successor is skilled and business savvy, then perhaps the answer is ‘yes.’ If not, you may consider selling your business to a co-owner, key employee, or outside buyer instead.

2. Sell to a Co-Owner

If the business is a partnership, you may be considering your co-owner as a successor. Many partnerships draft a mutual agreement that, in the event of one owner’s untimely death or disability, the remaining owner will agree to purchase their business interest from their next of kin.

This can help ease the burden of an unexpected transition in ownership—for the business and family members alike. A spouse might be interested in keeping their shares, but may not have the time investment or experience to help a company blossom. A buy-sell agreement ensures they’re given fair compensation, and allows the remaining co-owner to maintain control of the business.

Potential Drawbacks

A buy-sell agreement with a co-owner requires a lot of cash be kept on hand. Your co-owner needs to be prepared to buy out your shares, theoretically at any moment.

Since not everyone keeps that much liquid cash around, many businesses will fund their plan with life insurance. Term life insurance is relatively inexpensive, and can offset many costs in the event of an owner’s death. Permanent life insurance is a bit more expensive, but can likewise pay out in the event of retirement or disability.

3. Sell to a Key Employee

When a business doesn’t have a co-owner or family member, you might consider selling to a key employee instead.

Take a look at your organizational chart. Choosing an employee who is experienced, business-savvy and respected by your staff can ease the transition. You have the ability to train them and get them on board with essential procedures and relationships before you retire. If you’re concerned about maintaining quality after your departure, a key employee is generally more reliable than an outside buyer.

Just like selling to a co-owner, a key employee succession plan requires a buy-sell agreement. Your employee will agree to purchase your business at a predetermined retirement date, or in the event of death, disability or another circumstance that renders you unable to manage the business.

Potential Drawbacks

A common drawback to key employee succession is money. Most employees aren’t in the financial position to buy the business they work for; and even if they are, having enough liquid cash on hand is another challenge.

One solution is seller financing, in which your employee pays you (or your family) back over time. Seller financing typically calls for a down payment of 10% or higher, then monthly or quarterly payments with interest until the purchase is paid for in full. The exact terms of the loan will need to be negotiated, then clearly laid out in your succession plan.

The downside to seller financing is the amount of time it can take for you, or your loved ones, to get paid in full. If you’re looking for a faster transaction, a more appropriate option might be an acquisition loan. This is a loan acquired by your buyer from the Small Business Administration or from a bank for up to 70%-80% of the purchase price.

4. Sell to an Outside Party

When there isn’t an obvious successor to take over, business owners may look to the community. Is there another entrepreneur—or even a competitor—who might purchase your business?

This is easier for some types of businesses than others. For turnkey operations, such as restaurant with a good general manager, the task is simply to demonstrate that the company is a good investment. Buyers won’t have to get their hands dirty and will still have time to focus on their other business interests.

On the other hand, if you own a women’s health company that’s branded under your own name, selling to an outside buyer poses greater challenges. Buyers will need to rebrand and remarket, and as a result, may not be willing to pay full asking price.

To avoid this issue, prepare your business for sale well in advance. Hire and train a great general manager, formalize your operating procedures, and get your finances in check. Make your business as stable and turnkey as possible, so it’s more attractive and valuable to outside buyers.

Potential Drawbacks

The main drawback to an outside sale succession plan is the unexpected: You can’t predict exactly what a new owner will do. The business’s mission could pivot; staff could change; customer relationships could dwindle. If you’re selling your business in order to retire, you’ll generally be much more detached from the business with an outside buyer, as opposed to a family member or key employee who may still seek your advice.

As with the other types of arrangements, you’ll need to draft a buy-sell agreement. Depending on the buyer’s capacity, you may need to back up the agreement with seller financing or an acquisition loan.

Update Succession Plan Regularly

Because it is a legal document, business owners should enlist professional legal help to craft the best agreement and ensure that it is properly executed. The agreement should also be updated periodically to reflect changes in business valuation; for example, you may need to increase life insurance coverage funding the buy-sell agreement to reflect an increased value of the company.

The Bottom Line

While some experts recommend starting your business succession planning three years ahead of retirement, it’s never too early to begin. The decisions you make throughout the lifespan of your business, such as whom you hire and promote, can affect your transition options later on. It’s better to be cognizant of your eventual succession options than to be taken by surprise.

And don’t forget the other key function of a succession plan, which is to prepare for the unexpected. Especially when you have family members or co-owners to consider, a succession plan greatly reduces headaches and stress in the event of an owner’s sudden departure by ensuring that you and your loved ones get the full value out of your business.