Five Myths of Business Succession

Few small firms survive past the first generation of owners. That is well-known. Most people assume the business failures are due to the inadequacies and mistakes of the succeeding owners and managers. At least an equal share of blame goes to the founding owners who do not properly develop and implement succession plans. With proper planning, a small business’s probability of survival is increased by putting it in the control of competent managers.

A number of small business owners do not plan for succession because they do not want to face their own mortality?the same factor that keeps many people from developing estate plans. Another important hurdle for small businesses is that their owners typically believe succession planning myths. Shattering these myths is a key if more business owners are to successfully sell their businesses, retire comfortably, and see the businesses thrive under new management.

It’s too soon. Most business owners and even financial advisors believe exit planning can wait until about five years before the owner is ready to leave, according to an article in Wealth Planning for May 2007. In fact, the probability of success is enhanced if the planning begins much earlier. By waiting, the owner forecloses many opportunities to increase the net cash received.

Even a good small business often needs a couple of years to find a buyer willing and able to pay the owner’s price. In addition, the economy has cycles. If the owner decides to retire when the economy is in a recession or interest rates are high, a buyer near the owner’s price might not be available or financing might not be available.

If the owner plans to transfer the business to family members, waiting forecloses valuable options. Long-term gifts of ownership avoid gift and estate taxes. Early planning also would allow the owner to take assets out of the business in tax-advantaged ways, prefunding retirement. The optimum structure of the business for tax purposes also might not be available if the owner waits to plan.

Succession means loss of control. Control is important to many business owners for both financial and emotional reasons. Many do not realize is that a succession plan can shift ownership without giving up control. There are strategies that allow ownership and control to be separated. The owner can begin transferring ownership while running the business and drawing income from it.

The business could be transferred to a family limited partnership. Or a corporation could be recapitalized so that there are voting and non-voting ownership interests. There are other solutions that depend on the type of business and who the eventual owners will be.

The value is in the numbers. An examination of the financial statements is the way to determine the value of many large businesses. With a small business, however, the value often depends on the owner. Relationships with customers, suppliers, and employees might be the key to success. The owner also might be the sole source of innovations and plans for the company. Many times a buyer is willing to pay only based on one year’s income or the market value of the tangible assets.

A business owner can avoid this situation with advance planning. The work force should be bolstered with a strong management team that has long-term incentive compensation. The owner should take care to give responsibilities to employees and establish relationships between key employees and customers and suppliers.

The owner might be able to add more value by making a convincing case that the business has a market niche protected by barriers to entry, patents, trademarks, long-term contracts, or other protections.

While numbers are not everything for a small business, the financial statements can support the argument that the business is financially solid and not entirely dependent on the current owner. A buyer wants to see consistent growth of earnings and cash flow for several years. The buyer will be asking, “What is the value of this business without the owner?”

The contract price is what counts. Many small business owners decide that the business has a certain value or that they need a particular sale price to fund retirement. With small business sales, the details and structure of the sale are more important than the contract price. The key is to structure the transaction to minimize taxes. In a standard sale, the seller pays taxes (usually at capital gains rates) while the buyer pays for the business with after-tax dollars.

Instead of focusing on the contract price, business sellers should work to structure the deal for maximum tax savings for both the seller and the buyer. If the owner begins considering the options well in advance of a sale, the tax planning potential increases.

Buyers are self-funding. It is the business that finances its sale. A buyer will pay in cash (or borrow from a third party) only if he or she expects the business to generate enough cash flow to offer a good return on that cash. Otherwise, a buyer with cash would buy bonds or publicly-traded stock.

An owner often finances the sale of the business. This can be done by taking money out over time, by arranging things so that employees or family members can own the business, or by selling to a third party on terms.

Owners who realize this will start exit planning well in advance of their retirement. They will take money out of the business over time to provide for retirement. Or they will explore how to set up an employee stock ownership plan, leveraged buyout, or other financing strategy. The point is that the seller needs to consider how a purchase of the business will be financed. The money to pay for the sale ultimately must come from the business. The owner can start the planning early and expand the options available or can wait until a buyer with ready cash appears.

An owner spends many years building a business. All that time, an exit strategy should be under consideration. Only a few businesses are able to go public or be sold to larger companies for a multiple of earnings. For most small businesses, the owner must plan well in advance to increase the business’s probability of survival and to maximize the cash received from the business.