Business Succession Planning: Everything You Need to Know
Choosing a successor from within the family might look like a logical choice, but also presents difficulties. 3 min read
What is Business Succession Planning?
Business succession planning is necessary for any business owner, especially to those close to retiring. In the U.S., more the 50 percent of small-business owners are 50 years old and above, which means a great number of business owners should already be thinking about transitioning their businesses.
While selling the business would be the simplest way, most owners would prefer if their business would continue on after retirement. Choosing a successor from within the family might look like a logical choice, but also presents difficulties. The process of selecting a suitable successor, scrutinizing strengths and weakness, might eventually affect relationships between family members.
A great percentage of small-business owners expect to sell their businesses in preparation of their retirement, but fewer than 30 percent have an actual drafted succession plan.
In a sole proprietorship or partnership, the company's assets cannot be distinguished from the owner's personal assets. Therefore, should the owner of a business with the same structure decide to have a successor, it would be in their best interest to form a corporation.
The first step in a business succession is to determine how much it the business is worth. Determining a business' worth can be handled by a Certified Public Accountant, or settled by all partners involved within the business. In the case of stocks, market value will dictate the worth of the business owner's portion.
Methods of Transferring a Business
During a Cross-Purchase Agreement, each associate buys and owns a policy on the other partners and acts as owner and beneficiary on the same policy. In this type of agreement, if one partner passes on, the original cost of each policy on the deceased partner is distributed to the remaining partners, which should be used to buy out the deceased associate's share at a previously arranged amount.
For example, if three partners own equal shares worth $1 million for a $3 million-worth business, they can consider entering into a Cross-Purchase Agreement. Within the agreement, it is required for a partner to take out a policy at half the price of their shares for the two other associates, so when one of them passes on, each partner will be paid that amount with they a required to use to buy out the deceased partner's share in the business.
With a business that has a sizeable number of associates, counting five partners or more, it would become highly unsuitable for each member to maintain separate policies for the other members. The determined underwriting can affect the cost of each policy, causing inequity among partners.
In addition, a Cross-Purchase Agreement may not work for business with only two partners, especially if it causes imbalance in the costs of the policies. In the event that a Cross-Purchase Agreement would not work, an Entity-Purchase Agreement is used instead.
Entity-Purchase Agreements are much simpler. In an Entity-Purchase Agreement, the business purchases a single policy on each associate and becomes both the policy owner and the beneficiary. After the death of a partner, an Entity-Purchase Agreement allows the business to use the amount paid out from the policy to purchase the deceased partner's share. The cost of each policy can be deducted from the business, and the business can absorb the costs and equity between partners.
Reasons to Have a Business Succession Plan
A feasible succession plan will greatly benefit all owners and partners of a business. Having a succession plan allows for an agreeable price for a partner's share of the business, and because the value of a partner's share is settled previously, it does away with the need to do it upon the death of a member.
Because policy benefits are readily made available, they can be used immediately to pay for a deceased partner's share of the business without the fear of fluctuating values or time limitations, effectively obstructing an external takeover or having to sell the business to compensate for the cost of a deceased partner's interest. A business succession plan can also assist in timely settling of a deceased partner's property.
Detailed preparation is needed for proper business succession planning, and should business owners work towards a seamless and fair changeover for their interests, they should look for a capable and skilled advisor to work with them.
If you need help planning your business’s succession, you can post your legal need on UpCounsel’s marketplace.