Different Structures for Successful Succession Planning – Understanding Your Options
As a small business owner, you have certainly met and overcome many challenges throughout the course of your leadership. The weight of responsibility never lessens, even as you come to the end of your time as CEO. Deciding on and securing a successor is one of the most important decisions you will make for the long-term success of your business or organization.
Succession planning is both a financial and legal matter, but the process often also holds personal importance — and the right attorney will be able to speak to all three of these considerations. This article explores the different succession planning structures available to you and your organization, provides guidance on making an appropriate decision, and lists essential materials to have on deck as you begin to prepare for the future.
Identifying your successor.
With a quality attorney, you’ll be able to create a detailed and legally-binding succession plan. Before delving into the features of the plan itself, the first (and oftentimes most important) step in this process involves identifying and selecting your successor. A list of the common successors typically identified by small business owners is as follows:
- A relative: Passing on the family business to the “next in line” is a centuries-old practice, and it continues to be the most common type of succession. If you plan to have a child or other relative take charge after your leadership duties are over, communication with your entire family about the intended heir’s future responsibilities is key. There are also specific legal requirements applicable to family-based succession plans that will need to be discussed with your attorney to avoid any unintended tax consequences associated with intra-family transfers of ownership.
- Co-owners and key employees: Whether you intend to pass on your business to a co-owner or another essential player in your organization, these options can be a great way to ensure the team stays in the capable hands of someone well-versed in your industry.
- Outside third parties: Finally, you may decide that the best course of action is to transfer responsibility to someone who was not previously involved in your organization. Usually, the selected third-party buyer is someone experienced in managerial tasks — such as an investor, a management firm, or even an industry competitor. Although this option will occasionally result in significant changes to the structure of your business following the transfer, sales to an unrelated third-party can be a great way to make a profit as you move forward.
Understanding the wide range of succession planning structures.
Once you have accomplished the most important step — deciding on a qualified successor — you’re ready to seek legal counsel to plan for the future. As part of this process, an experienced attorney will be able to provide you with the information needed to identify the structure which works best for your situation. Oftentimes, the overall structure of the succession plan will depend on the identity of the successor. A summary of the common structures, along with the situations in which such structures are typically used, is as follows:
- Gifts and bequests: Transferring ownership of a business as a gift (during lifetime) or bequest (upon death) is the most common way for families to transfer ownership between generations. That said, such intrafamilial transfers require careful consideration of: (a) the timing as to when such successor(s) should receive ownership; (b) the number of potential successors and amounts to be transferred to each party; and (c) the value of any transferred interest to ensure no adverse estate and/or gift tax issues.
- Unilateral Buy-Sell: A unilateral buy-sell arrangement typically provides either a key employee or family member the ability to purchase your interest upon the occurrence of your death or disability. Unilateral arrangements are typically funded with life insurance to ensure the buyer has the liquidity needed to fund their purchase.
- Redemption Agreement: With this technique, an entity buys the entirety of any interest held by a departing owner (or their estate). Redemptions are typically utilized by companies: (i) which purchase and maintain life insurance policies on their owners to fund any future buyout; or (ii) operating as C-Corporations with substantial retained earnings so as to minimize the amount of tax which would otherwise be payable upon the distribution of such earnings to the respective stockholders.
- Cross-Purchase Agreement: Cross-purchase arrangements are standard for business with multiple owners and provide the remaining owner(s) the option (or requirement) to purchase any interest held by a departing owner. The specifics of such cross-purchase arrangements (e.g. amount of purchase price, timing of payment) will depend upon the situation and will require complete agreement amongst the respective owners.
- Hybrid Approach: The hybrid model combines key aspects of both the redemption and cross-purchase structures by allowing both the business and remaining owners the ability to acquire the interests held by a departing owner.
- Outright sale: An outright sale of an individual’s ownership interest, or alternatively of an underlying company’s assets, is the structure most common for unrelated third-party transactions. The overall structure of any such sale will ultimately depend on the company to be sold and the sophistication of the parties involved, though sellers typically prefer stock sales whereas buyers generally prefer asset sales for many different reasons (which any competent attorney should be able to explain).
- Liquidation/dissolution: Finally, if after all deliberations, no successor can be named — or if the owner does not want their business to continue once they make their exit — a business can be officially dissolved. While the terms liquidation and dissolution are typically used interchangeably, liquidation applies to businesses that are in financial distress and want to sell their assets to pay creditors, whereas dissolution refers to the voluntary legal closure of a business.
Prepare for a succession plan with key documents.
Regardless of the type of succession plan you decide to pursue, a competent attorney will typically recommend you consider each of the following documents as part of the planning process:
- Internal Organizational Documents: The major decision makers in your company need to be in agreement about how the company should be owned and operated throughout the company’s life cycle. Such agreements are often memorialized in Operating Agreements (for LLCs and partnerships) or Bylaws and Stockholders Agreements (for corporations).
- Business Continuity Plan: A business continuity plan lists the crucial steps to follow in case of an unexpected event (such as the current owner’s passing). A continuity plan is both an essential part of risk management and important to succession planning, especially in closely held businesses owned and operated by one individual.
- Estate planning documents: Finally, each business owner should always ensure they have the appropriate estate planning documents in place so as to avoid any confusion as to how important decisions should be made in the event they are unable to provide guidance. At a minimum, we typically recommend each business owner consider preparing a last will and testament (to set forth how your assets should be distributed upon your passing), an advance medical directive (discussing how certain health care decisions shall be made during your lifetime), and general power of attorney (discussing how certain financial decisions shall be made during your lifetime).
Gain comprehensive succession planning support.
Finding quality legal counsel is one of the best ways to ensure a smooth succession planning process. Chesapeake Growth Network is a comprehensive financial services provider for small businesses in the mid-Atlantic area. Jon Watson, Esq. and the rest of his team at Bagely & Rhody, P.C. are prepared to meet you where you are in the succession planning process and to find the best plan solution for your business.
Contact Chesapeake Growth Network today to gain access to a premier educational and strategic partnership for small businesses in the Chesapeake Corridor. In our next article, we’ll explore the difference between an LLC and an S-Corp to help you choose the business structure that makes the most sense for your organization’s goals.