When should you start planning your exit strategy from your business? Try yesterday!
From the first day you start your business, you want to make sure your business plan is coordinated with your succession plan. Many business owners are so wrapped up in their business that they don’t even think about a succession plan until a year or two before they want to retire. Yet, preparing for the transition of your business could save you heartache and protect your family from unnecessary financial risk.
Understand your emotional attachment.
Many business owners find succession planning an overwhelming and emotional challenge. “It’s so powerful for people who’ve started their business from scratch,” says Kimberly Rosati, regional manager of estate planning at Fidelity Investments. “It’s their life, their everything. They may not be ready to walk away from the business.”
Triggers of succession
Aside from the personal goals of a succession plan, there are other issues that could trigger the selling or transferring of assets. Potential issues include the disability or death of an owner, clauses in the ownership documents on estrangement and lifetime transfer restrictions, start-up equity options, or loss of a professional license. But when any of these events or any other disruption occurs, it helps if you already have a plan in place.
Step 1: Determine your exit strategy and your desired legacy.
Some questions to ask yourself as a business owner preparing for this transition are:
- What do I envision for my business in the future, and how would my transition impact that vision?
- Do I want to have a clean break from the business or would I prefer to stay involved?
- Have I identified successor executives such as key employees or have I groomed family members to take over?
- If I sell the business and walk away, how will I fill my time?
- Am I really ready for this?
Find out what your business is worth.
If you decide to sell your business or a portion of it, you have to find out how much the business is worth. There are several common methods of business valuation. These include:
- Asset-based valuation: An asset-based valuation is determined by aggregating the value of tangible and intangible assets. The value of these assets can be arrived at through a professional appraiser.
- Earnings multiplier: Calculate your business’ annual earnings, determinate an actual multiplier, and confirm that these measurements are typical for other businesses in your industry or location.
- The use of “comps”: Determine what other similar businesses in your industry and location have sold for recently. You can work with a business broker for information on recent sales.
Step 2: Build your plan for transition.
One common problem in estate planning is that a business owner’s wealth is often largely concentrated in the business. This can expose the owner and his or her family to tremendous financial and business risk in the event of incapacity or death. What would happen if the business were liquidated? There are several ways to minimize this eventuality.
Consider a buy-sell agreement.
To protect against your—and your family’s—exposure to this concentrated asset, particularly in the event of your sudden departure from the business, you could put a buy-sell agreement in place early on and, for example, fund it with life insurance. A buy-sell agreement is a contract that restricts business owners from freely transferring their interests. Generally speaking, a buy-sell agreement provides for the orderly transfer of one owner's interests to either the other owners or back to the corporation upon the occurrence of certain triggering events, including the disability, death, or retirement of an owner. Funding the buy-sell agreement with life insurance provides the policy owners—typically, the company or co-owners—with a death benefit and it provides the deceased owner's heirs with liquidity.
In general, the two common types of buy-sell agreements are cross-purchase agreements (providing for the purchase of one owner's interests by the other owners upon the occurrence of certain specified events) and stock redemption or entity purchase agreements (providing for the company's repurchase of an owner's interests in the company upon the occurrence of certain specified events).
The type of buy-sell agreement you choose depends on numerous factors, including the ownership structure of the business, the financial stability of the business, and the legacy plans of the current owners. Generally, a cross-purchase agreement can be worth more to the remaining shareholders because they would get a step-up in basis once one of the owners dies. On the other hand, if there are more than two or three owners, buying insurance on multiple policies would get costly in a cross-purchase agreement. You should consult with an attorney to see how to structure such an agreement in light of your personal situation.
Work with a team of trusted professionals.
For best results, assemble a group of key professionals who work together on your behalf. You may want to include a CPA, a financial or estate advisor, and a corporate attorney to help create your business plan. Also, you may want to coordinate with an estate planning attorney to make sure assets are transferred tax efficiently.
Groom your internal team.
No matter what your ultimate plans are, you should consider grooming a highly capable team of employees so that any transition is smooth and your business continues to operate as successfully as possible. Ask yourself how well your top managers would be able to cope if you left next week, next month, or next year. The more ready they are, the easier it’ll be for you to walk away when the time is right.
Use smart estate planning techniques to exit tax efficiently.
Taxation is always an important consideration. Discuss with your attorney or tax advisor ways in which you could potentially transition the business in the most tax-friendly manner.
In the case of a family business, you could receive continued income from the business even after transferring ownership to your children. One way is by establishing a grantor retained annuity trust (GRAT), an irrevocable trust that pays a fixed annuity to the grantor for a defined term and pays the remaining interest to an heir; or a grantor retained unitrust (GRUT), which is similar to GRAT except that it pays a fixed percentage of the trust’s assets on a revalued annual basis. If properly structured, any appreciation of the business’ assets held within a GRAT or a GRUT would not be subject to estate taxes.
Consider a family limited partnership.
A family limited partnership or a family limited liability corporation (FLLC) provides two alternative ownership structures for holding a family business. If properly structured, either arrangement provides for centralized management and protection from creditors. Consult with experienced estate planning professionals when setting up these or similar entities.
Step 3: Selling your business
There are three options for selling your business: sell to family members, sell to other employees or co-owners of the business, or sell to a third party. The succession could be slow and gradual, but regardless, proper preparation is essential.
Transfer ownership to family members.
In passing ownership to the next generation, you might consider some of these questions:
- Which child or children should run the business?
- How can you ensure that all the children are treated fairly?
- How will you keep or create family harmony while transferring the family business?
- How can you transfer the business to the children when you still need income from the business?
Read Viewpoints: How to talk about estate planning with your family.
Sell to other employees or owners.
Selling your business to other employees or co-owners could make a lot of sense. After all, no one else knows your business better than your employees. If you decide to sell your business internally, begin by identifying key employees.
One option is to sell to key employees through a type of workout plan in which you provide financing and they repay you in installments out of earnings over a period of years. Discuss your options with your attorney.
Sell to a third party.
A third option is to sell the business to a third party. If you have an emotional attachment to the business and/or are hoping to stay involved, rather than walk away fully, selling externally may have less appeal. However, even in this case, you could arrange to remain involved for a set period of time through a retainer or similar agreement. This would allow for the kind of continuity that you would typically have in a family or employee sale.
If you decide that none of these options would work and that you would be better off closing the business, liquidating the business is always an option.
No matter how far you are from eventually selling your business, it’s never too soon to start planning for a smooth, efficient, and profitable business succession plan. Begin today by arranging a meeting with your team of professionals, which could include your accountant, corporate attorney, and financial consultant, as well as valuation specialists and an estate planning attorney.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917