A PLANNING HORIZON OF 10 YEARS — OR MORE — CAN HELP REACH GOALS
Key Takeaways:
- A successful business transition takes at least 10 years of planning — not just one.
- Open communication, clear successor plans and a solid valuation are key to preserving your business’s legacy.
- Failing to plan for taxes, relevance and family dynamics can cost you more than just money — it can cost your company’s future.
Preparing to transition a family business to the next owner — whether it be a family member or third-party buyer — is a process that requires taking the long view. The business owner who decides to retire one year from now without having made any preparations is about 10 years too late. The owner will be able to sell, but may have to make concessions on price, deal structure and tax consequences that would not have been necessary if the proper long-range planning had been done.
While every business is different, it is also true that every business is the same. That is, every business owner needs to look at the distant horizon, questioning basic assumptions about the business, assessing the talents and wishes of family members who may someday become owners, and innovating in ways that keep the company at the top of its game in order to maximize value. All of this takes time and careful planning, preferably with the help of trusted advisors along the way.
Business owners and family farm owners who follow certain steps in planning for exit are more likely to reach the goals they set for a successful transition.
Step 1 — Clarify your Goals
When it comes to setting goals for a business transition, your first thought may be, “Well, my goal is to sell the business.” But there’s so much more to think about.
Are there family members who may want to own the business, or whom you have been grooming to take over? Or are there key employees whom you have trained and entrusted with the company’s growth and operations over the years? You may think of them as family, too, and they may be candidates for ownership.
Additionally, you should consider what you are going to do in retirement. You may want to step away from the business altogether, or keep a hand in it as a consultant for a few years. Either way, you probably expect some type of retirement cash flow stream.
If you haven’t thought about your post-transition role, now is the time to think about it. And if you are not going to continue being active in the business, what will you do with your time? It’s important to envision your retirement life before you get there. Retirement isn’t just about selling your business and handing over the keys. It’s about having a life afterward, and if you are confident in what that life will look like, it will make it easier for you to do the planning and preparation that your business deserves.
Step 2 — Identifying your Successor
For owners of family businesses and farms, this can be the most emotional factor in transition planning. Perhaps the farm has been in your family for three generations, it is a thriving entity and your son or daughter is eager to take it over. Congratulations — you’re golden. But for many owners, the succession picture is more complicated.
Maybe you are now 60 years old and you have decided you’ll work till age 70, which gives you 10 years for planning and preparation to transition your company or farm. But when you reach age 70, your children will likely be at least in their mid-40s. If they aren’t already working with you in the business or farm, they may have established careers elsewhere and will be in their prime earning years when you’re ready for them to take over.
This reality adds another wrinkle to the planning picture for family business and farm owners. If your long-range goal is for the next generation of your family to take over the business, planning must start while they are fairly young — high school is not too early — so they can gain a college education and work experience that will benefit them and prepare them for ownership.
Communication is one of the most critical factors in preparing for transition of a family entity. If you want and expect your children to take over the family business, it must be discussed at a time when the children can decide whether they want to succeed you and, if so, plan how to prepare themselves. Among family farms, the majority of transitions involve succession to family members, and it is more common for the younger generation to be involved in the business and to have gotten the education and training needed to run the farm.
In some families, the parents are reluctant to share much information with their children even when the children reach adulthood. But you can’t expect an adult to plan his or her life around taking over a family business if they aren’t privy to critical information that can help them decide, particularly if it could involve taking on a substantial debt. Business transactions can unravel over poor communication, even among family members. When that happens, the owner should have a Plan B, such as selling to a key employee or finding an outside buyer.
Another key point of communication is educating the successor as to the roles you have filled in the operation. Have you, like many owners, acted as the CEO, COO, CMO and HR director? When you transition the business, the next owner — whether it’s a family member or outside buyer — needs to understand all the roles involved and have job descriptions that will guide the hiring of new managers to help run the operation.
Step 3 — Determine your Company’s Value
Often, business owners have an idea of what they think their business is worth, but it’s based more on emotion than hard data. Once planning for a transition starts, obtaining an independent business valuation is an essential step to set a benchmark.
Typically, the initial valuation is not used to determine an asking price, since the actual transaction is still years in the future. But the report from an independent valuation professional will reveal the value drivers in your business and help formulate a multi-year improvement plan that will increase the value. This is particularly important if the entity will be sold to an outside buyer or private equity group.
The value of a business helps determine the path toward transition. A $50 million business requires different transition strategies and tax planning than a $5 million business does. If partial gifting of an entity to a family member is part of the plan, the value of the business helps determine the size of the gifted portion, as well as financing and tax planning strategies for the rest.
Step 4 — Consider Buy-Sell Agreements
Buy-sell agreements are essential for any business that has more than one owner. This includes unrelated owners as well as extended family members who own a family business together. A buy-sell agreement stipulates how an owner’s share of a business may be transferred upon their death or departure. Often, these agreements are structured to prevent outsiders from gaining control of part of the business and provide a way to determine the value of each owner’s interest.
Once transition planning has begun in a company, it’s important to review the buy-sell agreement if there is one in place. If there is no buy-sell agreement, now is the time to put one in place. If there is a buy-sell agreement but it is outdated, it should be updated at this time. (Generally, buy-sell agreements should be reviewed every two to three years to ensure they are current.)
If there is more than one owner, the transition plans — even if exit is years away — will be coordinated according to the buy-sell agreement.
But agreements on paper are only part of the process. It’s important early in the transition planning to get all owners together for a group meeting to discuss the health of the business and the transition plans. After that, individual meetings with each owner can flesh out additional information that wouldn’t be brought up in a group setting, but which provides important insights into any concerns. Trusted advisors are key facilitators for these meetings, often bridging the communication gaps and helping participants work through hard messages.
Step 5 — Focus on Tax Strategy
Taking into account the value of the business, the proportion held by the seller and other factors, the deal structure is generally designed to be as tax efficient as possible. Some of the factors considered are:
- Which entity type will be the most advantageous, a C corporation, S corporation, partnership, LLC or other structure.
- Whether an asset sale or a stock sale is most beneficial.
- If the deal will include partial gifting, a leveraged gift structure that works for the owner may be considered.
- Moving assets into some type of trust so when the assets are liquidated, such as land and machinery in the case of a farm, it is done on a tax-free basis.
Once the tax strategy is worked out and the deal structure is clear, everyone is on the same page and it’s time to start drafting the legal documents. At that point, the business transition starts to feel real.
Relevance
One of the most important steps in planning for a business exit may also be one of the most difficult for many owners.
Ask yourself, “Will my business still be relevant five or ten years from now?”
Businesses need to adjust to changing times to stay relevant and to grow their value. Just because you envision retiring in five or ten years does not mean you can stop innovating in your company. Indeed, this is the time to step up innovations and improvements that will increase the value and marketability of the entity.
Is there a new technology that is driving innovation in your industry? Have you invested in artificial intelligence (AI) technology to help keep your business ahead of the curve?
Most importantly, what is the long-term outlook for your industry? Markets change, technologies change and customer needs change, and failure to adapt and capitalize on changing conditions will render your business irrelevant and lower its value.
Questions?
This is a lot to think about, but fortunately you have time — IF you are starting the transition process early enough. Moreover, you have a roadmap with clear steps to take.
If you would like to start the long-range process of family business planning succession, contact an Adams Brown advisor.