Business Succession Planning – The Basics

What is a Business Succession Plan?

We’re a nation of planners.  We plan our days, weeks, vacations, weddings and paying for our children’s college education many years ahead of time.  Unfortunately, many of us fall short in planning for the one sure thing in life.  It’s long been said the only guarantees are death and taxes.  While we can avoid paying taxes and face unpleasant consequences, there’s no avoiding death.

That’s why virtually everyone with a minimal amount of assets and loved ones should create an estate plan.  It’s a byproduct of human nature that a barrier for many people without an estate plan is the avoidance factor.  Death is obviously an unpleasant thing to contemplate and we often avoid planning for a long time.  Frequently, a near-death experience or the sudden passing of someone in our life creates the motivation to plan.  This holds true with respect to both personal and business planning.

For entrepreneurs and small business owners, there are important considerations flowing from the inevitability of death.  Just as parents of minor children should provide for their care and maintenance through tools such as wills and trusts, entrepreneurs need to provide for the care of another needy legacy—the business they worked so hard to build.  That’s where a business succession plan (BSP) comes into play.  Business owners use a BSP to protect the interests of the following stakeholders following the owner’s passing: the surviving partner(s), the deceased owner’s loved ones and the employees of the business.

An Estate Plan for your Business

Simply put, the BSP is an estate plan for your business.  It lays out the mechanism for the transfer of a business owner’s interest in the company to designated successors.  Your BSP can take a variety of forms depending on the circumstances, but I’ll describe a very common and simple framework here.

How Does it Work?

The buy-sell agreement is a contract among business people.  The participants may include corporate shareholders, partners, members of an LLC, key employees of a business and other players.   The main purpose of the buy-sell agreement is to ensure the smooth transfer of the business interests of a deceased or disabled person in a pre-determined, mutually-agreed upon way that guarantees a market for their sale.

Here is a common scenario illustrating how the buy-sell agreement may work.  The business owners agree on a fair market value for the business.  This contract obligates the business to purchase from the estate (heirs) of the deceased owner that person’s share of the company.  There are several ways to fund this buyout, but the most common method is through the proceeds of a life insurance policy for each of the business owners.  The death benefits are based on the value of the business.  Of course, the cost of the insurance premiums will vary according to many factors, including the health of the respective owners.  Whatever the costs, the insurance policy may be viewed as a sound form of protection for all involved.

Risks of Not Having a Business Succession Plan in Place

Without a buy-sell agreement funded by a life insurance policy or some other means, unintended and very unpleasant consequences may arise.  Without this framework of protection, the deceased owner’s interests would most likely be passed according to the terms of a last will and testament.  Worse, if there is no will, the interests would pass according to a legal hierarchy known as “intestate succession.”  Surviving partners might thus suddenly find themselves being partners with a surviving spouse, children, a trust or some other heir without the ability and/or interest in running the business.

Other forms of BSP include the use of buy-sell agreements between a corporation and its shareholders.  It may also take the form of a cross-purchase buy-sell plan between individual business owners.  The survivor would buy the deceased owner’s business share from the estate.  Any BSP can be tailored to fit the individual needs of a given business and its ownership.

As small business owners and entrepreneurs, failing to plan for the inevitable can tarnish our legacies in terrible ways.  Now let’s clear that avoidance hurdle and address a necessary and important part of life planning.