Business succession planning should be part of the overall business development strategy of any enterprise. Leaving it until it is too late may have negative consequences to the future of the business. Important considerations and options for successfully transferring ownership and control to new management when the time is right are highlighted in the following “succession planning learning series.”
Balance of Power in a Closely Held Business
In a closely held corporation created for reasons beyond lifestyle, the relationship between a board of directors and shareholders could become tenuous if the goals of the founding shareholders are not aligned with those of the directors. This is especially true when the shareholders elect board members who have unique skills such as financial, accounting or legal, and want them to take actions that are in the best interests of the corporation versus a shareholder or group of shareholders. As a general proposition, the board of directors possess distinct powers and controls that are authorized under state statute or common law. At times, this issue may create a unique tension if the shareholders electing them have a different vision for the enterprise.
The directors of a corporation are principally concerned with the management and operation of the company. The challenge in a corporate setting is how the two bodies; i.e., shareholders or directors, are aligned in terms of vision. A further challenge would occur if one body misuses its powers to the detriment of the other.
The never-ending discussion is who should have control of the company. The power of the shareholders is restricted by the governance documents that were agreed upon during the formation of the enterprise, while the board is vested with management powers which, in many circumstances, would leave the shareholders at the mercy of the directors who they elected.
Throughout the course of history, the evolution of corporate governance principles has tended to tame the powers of the directors. Once strong principles have been implemented, the shareholders are more assured that the directors will act in the best interests of the company and its shareholders without favoring either body.
Business Succession Planning Considerations
Business owners of closely held or family business should routinely consider succession planning options in order to preserve the long-term value of the business enterprise. A comprehensive succession plan becomes the strategy to grow the business, reduce taxes and serve as a retirement strategy. Most importantly, a well-planned and communicated succession plan will preserve harmony in the family especially as it relates to those family members who participate in the day-to-day activities and contribute to its success.
The general considerations in developing a business succession plan include devising a strategy that achieves the personal goals of the founders; choice of entity structure; valuation methodology and how the plan will be financed. During the process of developing a succession plan, it is necessary to evaluate the talent of the next generation so that when there is a transfer of control the likelihood of success is high. It should be noted that statistically the success rate in transferring a business to the second generation is not extremely high and, therefore, it is essential for the founders to develop a mechanism to save the business if they become concerned that the transfer will not achieve the stated financial goals.
Considering the most recent changes to the tax code under the Trump administration, the income and estate tax implications must be reviewed carefully with the tax consultant for the family so that the structure of the transfer takes full advantage of the revamp to the tax code. Balancing business needs and family requirements will be challenging and developing a governance structure that includes the requisite controls for decision making is critical once the founders are no longer in control. Adopting best practices will mitigate risk given the possibility that the next generation will have difficulty meeting the demands of the business after the transfer, which may negatively impact the retirement goals of the founders.
Identifying the “Categories of Concern” in Succession Planning
During the next ten years, we will more than likely witness significant transfers of wealth and business to the next generation. These transfers will involve new business structure, which will depend on careful and diligent planning to achieve success. Succession planning involves multiple disciplines and requires well thought out planning and training of the successor to the founder of the business. Statistically, thirty percent of businesses survive to the next generation and the odds become much worse for the second generation.
Founders of business are motivated to fulfill their vision; however, it is not a given that the next generation will embrace the vision or have the same passion for success. Long term planning and training the next generation are the keys to a successful transition. Preparing a successor for leadership requires discipline and the right balance in terms of holding on and letting go at the right time. The strategy to be implemented for an orderly transition of a family business involves multiple disciplines that focus on maintaining a customer base, quality controls, preservation of company assets and harmony within the family unit.
A comprehensive strategy to transition a business will also include family estate planning techniques designed to minimize estate taxes and preserve the value of the overall estate. The founder must maintain control of the decision-making long enough to become comfortable watching the successors perform and be assured that when the reigns are turned over, the founder’s hard work and retirement will be preserved. The categories of concerns that must be addressed include articulating short- and long-term goals; effective communication; shareholder relationships; compensation models; stock transfer strategy; management; valuation and continuity of the business.
Navigating Key Issues in Succession Planning
The issues confronted in developing a business succession plan range from the simple decision to anoint a family member as the next leader to a comprehensive restructuring of the enterprise to achieve long term goals. Succession planning in the context of a family business is often more challenging due to conflicts in the goals of the founder and successor, which might involve who runs the business or what the business will do in the future.
A major challenge in developing an effective succession plan relates to how the business enterprise is valued and understanding the costs involved in making the transition. The founder’s goal generally relates to slowing down and receiving a return on his or her investment. If the successor does not have an appreciation of either the value of the business or the costs that will be involved in the transition, it is unlikely that there will be a mutually beneficial process.
The major goals in planning the succession of a business is appreciating its value, developing strategies to preserve and grow it, while at the same time establishing a plan that will be successfully implemented by the successor. Deciding upon a form of entity will be critical in addressing corporate and personal and estate tax implications, which may be different depending upon whether the business structure is a partnership, limited liability company, S Corporation or C Corporation. Whether the founder intends to continue participating in decision-making following the transition will influence the type of structure to be adopted.
Choosing the Entity for Succession Planning
The choice of entity for a closely held business is an important decision for both tax and non-tax reasons. It is especially important in developing a strategy for succession planning purposes that will achieve the long-term goals of the founders of the business. Tax implications and liability will always be a consideration in deciding upon a corporate structure, as well as how the structure may be integrated with an estate plan.
Operating a business as a general partnership is relatively uncomplicated; however, this structure exposes the general partners to unlimited liability and could ultimately jeopardize personal assets. Using a limited partnership structure reduces the personal liability; however, the limited partners must be very disciplined in remaining passive regarding operational and the decision-making function. If the family business has been operated as a general partnership, it is prudent to consider alternative structures that reduce the risk to the owners while at the same time enjoys a favorable tax treatment, which may be possible by converting to a limited liability company that provides the protection against creditors and at the same time allows the owners to be treated as a corporation or partnership for tax purposes.
Using the S corporation structure provides for the business to be operated as a separate legal entity while taking advantage of pass through taxation such that the shareholders pay the tax at their personal income tax rate. Converting to an S corporation is often more complicated than converting to a limited liability company in that there exist specific criteria for converting and operating the enterprise after selecting S status. The effect of the pass-through structure may impact an eventual succession plan as it relates to tax efficiency and achieving shareholder goals.
In a C corporation structure, the enterprise is considered a legal entity separate from its owners or shareholders, which provides significant protection to the shareholders from liability. The downside is a two-tier tax at the corporate and personal level. This structure is often the choice when the desired outcome is to pursue equity financing or going public.
In all the scenarios outlined above, the choice of entity structure may change the strategy implemented in developing a succession plan. The ultimate goal will be to adapt a strategy that allows the company’s value to grow, achieve long-term goals and align with the succession planning strategy.
Succession Planning and Employee Morale
Developing an effective succession plan in a business setting requires diligence and execution. In our practice we have often recommended non-family members to become part of the process when children or relatives do not possess the requisite skills to effectively operate the business. Overlooking key employees could lead to morale issues and diminishing productivity or unexpected departures by those who believed they were next in line.
Communicating a comprehensive succession strategy to key employees will serve to motivate those who have been significant contributors to the business success even if they are not relatives. Multiple studies in this area have demonstrated that organizations with succession management practices extending to employees who make valuable contributions results in high engagement and retention. It is therefore important for founders to provide performance feedback to key employees and make it known that there are potential future opportunities within the organization. This principle will apply regardless of the industry because key employees are generally motivated to make certain the business succeeds after a transition.
A few critical elements of developing a successful succession plan include:
- Identifying critical positions that must be filled to assure a smooth transition.
- Identifying talent for critical positions.
- Train successors early and often.
- Make it clear to the rank and file that the founder believes in those he or she has chosen to be their successor.
- Communicating regularly with employees about the succession management process and its importance to their careers and the company.
As a best practice, maintaining some level of transparency in this process provides the employee with a clear understanding of the quality and milestones expected of them and others, which will inspire them to work toward specific goals and will reduce resentment when others are promoted. Regardless of the type of business, employees are always looking for a ladder for opportunity and overlooking key employees leads to lower morale and productivity. A well-developed and executed succession plan that is understood by the employees increases the possibility of success when a transition is finally implemented.
Disclaimer: This blog post is for informational purposes only. This blog is not legal advice and you should not use or rely on it as such. By reading this blog or our website, no attorney-client relationship is created. We do not provide legal advice to anyone except clients of the firm who have formally engaged us in writing to do so. This blog post may be considered attorney advertising in certain jurisdictions. The jurisdictions in which we practice license lawyers in the general practice of law, but do not license or certify any lawyer as an expert or specialist in any field of practice.