Successful transitions from the first to the second or third generations in family-owned businesses come from identifying the family member who is capable of running the business and then structuring the transition as a business transaction, says Christopher Hirschfeld, Vice President and Managing Director, Goelzer Investment Banking, according to insideindianbusiness.com.
The business owner may assume that a child wants to run the business and is capable, but “this assumption needs to be validated well before the owner steps aside,” Hirschfeld says. And where more than one sibling will inherit shares of the business, it is possible to plan for one clear decision maker while providing for economic equality, he says.
Other factors in succession planning that will lead to a successful outcome are, according to Hirschfeld:
- The family treats the succession like an arm’s length transaction. A “sale” of the business to the heir will require a valuation of the company, best conducted by an independent business appraiser. The heir should have sufficient liquidity to buy the business.
- The transaction should have the support of parties beyond the seller and buyer. Board members, employees, clients and customers should support the plan. Continuing cash flow is critical during the transition.
- Important tax and estate documents should be prepared to accompany the sale, including employment agreements, non-solicitation and non-competes, buy/sell agreements and shareholder agreements.
Business owners planning to turn over the business to their children must think about the potential burdens of gift taxes and estate taxes which can eat up as much as 60 percent of the value of the company, according to the Small Business Administration’s (SBA) publication, “Succession Planning – Passing the Mantle” from their Business Development Success Series.
Financial tools the SBA recommends for small business owners are:
- Insurance policies that can provide the heir with money to purchase the business.
- “Gifting”, the annual exclusion gift, which in 2006 allows husband and wife business owners to each hand over $12,000 to their child, tax free, and allows entrepreneurs to manage succession. Donors may also give $12,000 to the spouse of their heir and each grandchild, tax free. The business owner and spouse may each give away $2,000,000of the value of the business, for a total of $4 million during their lifetimes.
- Insurance for surviving partners in a partnership so that they can assume the shares when the partnership agreement does not automatically transfer shares to an heir.
- Provisions for closely held corporations that allow shareholders to purchase stock from heirs. Buy-sell agreements are appropriate to closely-held businesses.
Sole proprietorships often do not have the legal blueprints in place to manage succession and the SBA recommends that they identify “trigger dates”, including:
- Ownership transfer will begin
- Control is shifted, i.e., more than 51 percent of ownership of voting interests
- Transfer is complete
- All responsibility for day-to-day operations rests with successor
- Founder retires.
The time to plan for succession is between the ages of 55 and 65. Some experts recommend a three to five-year transition period; others suggest five to ten. The more time given to planning, the better the outcome, the SBA says.