As we continue our series on business succession this article builds on our first two topics: the buy-sell agreement and the implications of a business transition on estate planning. Next, we’ll discuss choosing your successor.
Business transitions often happen out of crisis or necessity. It is common for business owners to be so involved in the daily operations of the business that they fail to either recognize the passage of time or the potential challenges associated with a lack of proper succession planning. For most business owners, the company represents a significant part of their personal wealth but also represents an equally significant part of their identity and accomplishments. Letting go, regardless of the economic compensation, isn’t easy. However, taking a methodical and careful approach to this decision will result in a much higher level of success and overall satisfaction for the owners as they start a new chapter in their life.
It is critical to start succession planning by thinking through the basics of the process and its intentions. Careful consideration must be given to who should be involved, from the current management team and outside advisors to appropriate members of the owner or owners’ family. Gathering the appropriate information and details related to various succession alternatives allows you to act from an informed position. Gauging the level of interest as well as understanding the capabilities of those you are considering s is also essential to success.
Below are several common options to consider in business ownership succession.
Transfer to Family Members or Children
Transferring ownership of the company to family members is frequently one of the first considerations for a business owner, especially if the business was started by an earlier generation. In many situations, one or more members of the family are already involved in different areas of the business or the owner(s) has a strong belief in keeping the business “in the family”.
There are several important considerations that must be factored into this decision. The first consideration is to separate what might be an emotional draw for the business owner(s) versus the practical reality of the knowledge, skill and desire of the family member(s) that are considered for potential ownership.
The following are important factors to consider in evaluating family members for ownership opportunities:
- Relationship among family members and level of involvement of each in the business
- Ownership mentality and level of skill and desire of those being considered for ownership
- Financial situation of family members being considered for ownership
- Impact on your overall estate plan
- Belief that this outcome is optimal for both the business and you
- Acceptance of this strategy by non-family management team and potentially acceptance by vendors and customers
Transparency is essential for this type of ownership transition to work. Clear and open discussions must occur with the family and with the current management team. The planning and discussion can allow for the current ownership team to gain context and answer potentially emotion-driven questions from siblings or other family member. Open dialogue is also key in dealing with practical operational questions and gaining buy-in from non-family members of the management team or key stakeholder groups.
The Management Team
You have worked diligently to build a management team that you are confident can continue to grow your company. They embody the same values and mindset as you and they have the leadership skills to attract the future talent required to separate your company from its competitors. For many business owners, transitioning ownership to the management team seems most logical since this is the group of people that are most familiar with the operations of the company. Additionally, the transition of ownership to the management team likely means the company will continue to operate in a manner that you are familiar with and believe contributes to continued success. A very common assumption is that the current management team is interested in owning the company. This is an assumption that requires careful verification for each member of the management team that you are considering for ownership.
Some of the important considerations when considering management in the succession plan include:
- The skill set, age, and career plan for each member of the management team
- Strength, Weakness, Opportunity, and Threat (SWOT) analysis to identify gaps in skill set or competency for existing management team
- Structuring of the company and plan for structure of ownership for the transition
- Financing and tax implications of the ownership transition for the business, exiting owners, and new management team owners
Structuring is key in transition to management or any third party, particularly if you have any non-operating assets in the company that are not essential to operating the business. Direct conversations among all parties involved are important in driving the correct course in this process. Members of the management team may express concerns about the cost and financing arrangements associated with becoming an owner. They also may prefer continuing being a regular employee and not taking on the additional risks of being an owner of the business.
Employee Stock Ownership Plans (ESOP)
An ESOP is an employee benefit plan that gives employees ownership interest in the company in the form of shares of stock. The first draw to an ESOP is often based on the belief that it saves federal income tax for the company or ownership group. When considering who to transition a business to, an ESOP is ideal when owners want their company to remain relatively the same after they leave. This plan allows the company’s owner(s) to easily find a buyer while continuing operations. It also allows the owner(s) to keep working at the company and ease out of ownership.
The following key considerations are necessary in assessing whether an ESOP makes sense:
- Desire to make each employee across the business an owner
- Costs associated with operating an ESOP, including annual valuation and administration costs
- Degree of turnover in the business and expected future turnover
- Relative age and composition of work force and implications on plan upon retirement
Of note, with an ESOP, the tax benefits represent a deferral of federal taxes and not an outright avoidance of tax. Additionally, it is not prudent to allow tax mitigation alone to drive a decision related to succession. If many of the employees in your company do not see ownership as a major benefit or would shudder at receiving a plan statement with a decline in value for their ownership, this may not be the optimal choice for succession planning.
In recent years, it seems like private equity has entered almost every industry. Additionally, many recent deals show a willingness to pay at a level that is difficult to ignore and has gained the attention of many owners who previously would not have considered this option. There are several important factors to consider when evaluating an opportunity to sell to private equity:
- The after-tax cash in pocket the ownership group ultimately receives
- Careful understanding of any contingent consideration, working capital requirements, and structural details of the deal
- Whether you are interested in rollover equity in a new business
- The owner(s) and current management team’s role in the continued operations
Every aspect of a private equity deal requires careful consideration and understanding before proceeding. Having a sell-side diligence team is important as the structure of the deal will be material in what you ultimately realize in after-tax cash. Additionally, it is not uncommon to have more than one opportunity with private equity and accepting the first offer may be suboptimal. Business owners also must also get comfortable with how the private equity deal reconciles with their vision of the company’s future. If this is important to you, and you do not feel confident in the path, then it might be necessary to consider other alternatives for ownership succession.
The goal of this article is to provide an overview of some of the options with respect to ownership succession. Starting early and with open discussion among all the interested parties is critical to reaching a desirable outcome. Finally, coordinating with your legal and other professional advisors will help to ensure the optimal structure is achieved, and help avoid unwanted surprises.
Our team is here to listen and to help you through this process. Our chief objective is to understand your goals and help you evaluate the most efficient and effective ways to reach them. Contact our team to learn more.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.