Over the years, one of the biggest challenges for small businesses is finding ways to transfer the value embedded in the business to the next generation. With the busy-ness of everyday operations demanding constant attention, business succession planning often remains on the back burner.
Studies have shown a few things:
- Only 30% of small, family-owned businesses survive to the 2nd generation
- Only 13% survive to the 3rd generation
Now sometimes it may make sense to sell the business, and the value of the small business is reflected in a sales price leading to cash for the family.
Unfortunately, many times the small business does not get to transfer the embedded value because there is not sufficient planning in place, or they started planning way too late.
Why Small Business Owners Fail to Plan
The old saying about the owner being too busy to work on the business is certainly true with small businesses. “Keeping the lights on” has real meaning for many small business owners.
Small business owners usually need help planning for the transfer of a business, but it is very difficult to get the small business owner to prioritize the time for the succession plan of their business.
If the business owner waits too long for this succession planning, they often find the business value declining for multiple reasons.
So, what makes succession planning so difficult for business owners?
- Finding time
- Identifying a potential successor
In addition to the practical reason of just finding time to plan, the small business owner needs to have a successor identified.
The dream of passing the business to a family owner often doesn’t happen because a family member may not be available, or interested, in the business.
Key employees can often be a potential successor, but not every key employee wants to be a business owner. Sometimes they just want to be a well-paid key employee.
Many times a potential successor could be a competitor interested in growing their own business.
Finding an interested successor is often the biggest challenge, and the small business owner that has options for future owners is better positioned to transfer value from their business.
The Small Business Owner With an Internal Buyer — Buy-Sell Agreement
If there is an internal buyer for the business, one of the more common methods used by many businesses is the traditional Buy-Sell Agreement coupled with a purchase agreement over time.
The Buy-Sell Agreement is usually paired with a life insurance component, or other financing options. At a very high level, the Buy-Sell Agreement defines how a business owner’s share of the business transfers to a future owner with the death of the business owner and payout of life insurance.
The comprehensive agreement will also include a transfer process of how the future owner will purchase the business over time. The life insurance component can provide liquidity for the future owner to purchase the business from the family-owned shares of the business.
Variables to Consider in a Buy-Sell Agreement
Now the Buy-Sell Agreement can have variations that are usually governed by unique variables for that specific business. The variables can include:
- The number of business owners involved
- The age difference (and insurability) of the business owners who are involved
- Income tax considerations
- The overall interest of the parties involved
However, all of the above variables pale in comparison to the key question:
What is the value of the business?
This can be the most challenging part of succession. It is rare to meet a business owner that undervalues their business. And the selling party and the buying party are always interested in meeting their own financial objectives. So, it can be hard to come to an agreement.
These normal challenges all create additional complexities for the business owner’s succession planning, but the business owner must stay focused on the long-term objective of recognizing a value for her/his business.
When the business represents a large percentage of the family’s overall wealth, then it is absolutely critical to find ways to recognize this value for the retirement needs of the business owner.
What Other Options Are Available for the Small Business Owner?
The other options usually depend on whether there is an internal buyer, or we need to find an external buyer.
If there is an internal buyer (a family member or a key employee), then a purchase arrangement over time coupled with a Buy-Sell Agreement is most common.
What if there is a group of employees wanting to buy the business?
Variations of an Employee Stock Ownership Plan (ESOP) may fit well with this situation. Another option may be to hire a manager to run the business, and then this manager turns into a potential buyer over time. This delicate balance takes time, and perhaps an incentive for the potential buyer, but sometimes the business owner needs to develop a future buyer.
Other transfers that may provide more value for the business owner include:
- a merger with another company
- an alliance to enhance the value of the business (with the goal of leading to a future buyer)
- selling to a 3rd party
If there is no internal buyer, then unfortunately, many times this can lead to a fire sale or liquidation to a 3rd party.
Clearly, this does not adequately recognize the true value of the business, but when the list of options becomes very short, this one may become the best choice.
The Challenges of Selling to a 3rd Party
Selling to a 3rd Party is always an option, but finding a buyer will highly depend on market conditions and the attractiveness of the business.
Professionals, commonly known as business brokers, can be very valuable for the business owner who is looking for external buyers. The business brokers’ experience and business relationships can help in many of these options, but they also come at a cost for the business transaction.
The business owner needs to think through their options long before they are knocking on retirement’s door. And they need to make sure all of this planning is integrated with their own personal estate planning, financial planning, and insurance planning.
How The Bell Law Firm Can Help
We’ve enjoyed working with many business owners over the years. Their needs can be very complex, so their planning will certainly not take care of itself. It definitely pays off for them to have a trusted guide to help them through the maze of decisions that need to be made.
Often overlooked in the process (and mentioned above, but worth mentioning AGAIN), is the need to integrate their business plan with their own personal estate planning. We really can’t emphasize this aspect enough.
Once business owners take the time to put a plan in place, then they also need to recalibrate with their advisors. If they do this, it should result in a higher value being transferred to their family over time.
- 4 Important Reasons Small Business Owners Need to Plan
- When Does My LLC Need an Operating Agreement?
We look forward to a chance to help business owners with their succession planning, so they can have peace of mind knowing they are on track to recognize the value of all their hard work. If we can help you in any way, feel free to call us at (913) 345-2323.