F amily-controlled businesses comprise between 80-90 percent of all business enterprises in North America (Source: J.H. Astrachan and M.C. Shanker, “Family Businesses’ Contribution to the U.S. Economy: A Closer Look,” Family Business Review, September 2003). And while it is estimated that nearly 40 percent of family businesses are passed successfully to a second generation, only a small fraction of them make it to the third generation or beyond.
In fact, many business owners fail to give any meaningful consideration to what will happen if they die suddenly or otherwise become unable to continue looking after their business, or they simply procrastinate in formalizing a succession plan. In situations where there are no family members possessing the expertise and know-how to properly manage the family business after the owner’s death or incapacity, the family may find itself in a position of having to dispose of the business to a third-party for a price below its actual value.
Regardless of whether you intend to pass your family business to the next generation or maximize its value through an orderly sale at the time of retirement or death, business succession planning is vitally important to ensuring a smooth transition. Fortunately, there are many options to consider when structuring a plan that is right for you and your business.
The first step in setting a business succession plan is choosing a successor. This can be a difficult task when you do not have a child or other family member that has demonstrated the requisite skills and interest necessary to maintain and grow your business. In some cases where there is not a readily available heir-apparent, you may consider taking on a new minority partner or hiring a new employee whom you can groom to take the reins. If you are in business with one or more co-owners, you should strongly consider a cross-purchase agreement, which requires each of the owners to purchase the interests of a deceased or incapacitated owner for a specified or determinable price or an entity-purchase agreement, which requires the company itself to purchase the outgoing member’s interest. These arrangements are often funded through life insurance policies taken out on the lives of the participant-owners.
Unless you intend to transfer your business through a bequest under your will, in which case you should consult an estate planner, the final steps to establishing a business succession plan include choosing an appropriate method for calculating the value of your business and selecting a mechanism to fund your successor’s purchase. Some of the more popular methods for establishing the value of a business include: (1) engaging a qualified professional to conduct a business appraisal periodically or at the time of transition, (2) setting a fixed price that is agreed upon between the outgoing and incoming owners, which can be updated periodically to reflect changes in the business and (3) preparing a formula based on objectively determinable metrics, e.g., net earnings, that is agreed upon by both parties.
Finally, the successor owner’s purchase of the business is typically paid either in a lump sum funded by life insurance proceeds from a policy on the outgoing owner’s life (usually only in the case of a minority partner/shareholder as successor) or a loan secured at the time of transition, or in installments that can be paid out of the business’s profits.
By taking the time to solidify a business succession plan now, business owners are able to ensure a smooth transition for their business while maximizing its value and avoiding unnecessary frustrations and potential discord among family members after they die.
» C. Tyler Ball is a tax attorney in the Jackson office of Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C., where he specializes in Business and Estate Planning.