When you read the numbers, you can’t help but admire small business owners. A March 2014 FAQ issued by the Small Business Administration (sba.gov) finds that almost one-half of private-sector employment and economic output comes from firms with 500 employees or less. Further, small businesses create almost two-thirds of new private-sector jobs.
Notwithstanding their robust contributions to the US economy, small businesses are risky ventures. For 2011, the US Bureau of Labor Statistics reported that 24% of businesses failed in their first year of operation, and 48% didn’t make it past the second year. Small business ownership is not a fast track to guaranteed financial stability; success usually requires a lot of persistence and sacrifice. And anyone who has survived to thrive in a small business should certainly be well-compensated for their efforts.
Unfortunately, after devoting great time and energy to building a profitable enterprise, many small business owners neglect to prepare for their eventual departure from the company. After working so hard to succeed, the long-term rewards from their labors are diminished by the absence of a succession plan.
The numbers suggest this is a very real issue for small business owners. A 2007 Family Business Institute report found that only about 30% of family-owned businesses survive into the second generation. And while some businesses may not transfer to the next generation because the owner simply decides to close the business when he/she stops working in it, there are plenty of others who want to transfer their businesses, but don’t. In a business column for the January 11, 2015, Arizona Republic, management consultant Gary Miller writes: “Currently, 80% of business owners of small and middle market companies who put their businesses up for sale never close the transaction.” Miller sees this dilemma growing: “With the impending Baby Boomer tsunami, more businesses will be for sale than at any other point in history, creating a buyer’s market.”
Exit Plans should be Established at the Beginning (or Shortly Thereafter)
To maximize the lifetime value from building a successful business, owners should probably begin considering their departure from it as soon as it appears the business will be profitable. This is not to say owners should leave the business as soon as possible. But once it has been established as a going concern, the creator(s) should consider how to preserve its current value and maximize future benefits. A succession plan will not be a one-time set-it-and-forget-it event. Rather, owners should see it as an ongoing project, one that will require regular adjustments and likely involve a variety of legal and financial arrangements, with ongoing reviews by legal, financial, and tax professionals. But for all the complexity, most succession issues fall into two categories: ownership and funding.
The essential ownership question is: When the original owner departs, who will assume control of the business? This question usually spreads out into specific ownership issues. Some examples:
- In the event of an early death, do surviving family members have an interest (or aptitude) to run the business? Business owners reflexively think of the next generation, but the first family member to be considered is a spouse. This issue is particularly challenging for partnerships, because a surviving owner may not be excited about working with an ex-partner’s spouse.
- How many family members are interested in the business? It is understandable that business owners would want to transfer ownership to interested heirs. But if some children have no desire to work in the business, the challenge is how to equitably pass on the company’s wealth, given their unequal participation.
- Can “outsiders” become owners? If an owner wants to retire or leave the business, do the remaining owners or heirs have the right to restrict the sale? Or must a departing interest be purchased by surviving owners?
These ownership issues can be addressed in various ways. For example: Buy-sell agreements preemptively address an untimely death by designating a pattern for ownership succession. Issuance of voting and non-voting stock allows active heirs to manage the business, while permitting non-participating heirs to realize an appropriate percentage of future profits.
Transfer-of-ownership issues multiply if there are several owners with varying percentages of interest, or if there are several generations involved prior to the transfer of the business. Because ownership is a legal construct, getting the terms of ownership correct is a must. Improper titling not only risks court battles, but may cause estate and tax headaches as well.
In most business transfers, the transaction is effected with cash – the buyer/successor pays the departing owner. If the departure is an untimely death, a typical cash source is life insurance. For a retiring owner who wants to sell the business to provide a stream of income, sources for cashing out can vary. Some owners might be content with an agreement that has the successor send them (or their heirs) a monthly check for a specified period. But many sellers may not want to rely on a new owner’s promises to keep paying them. They want the certainty of cashing out, and receiving their business’s present value in full. In these instances, the sale of a business will often require financing. One of the keys to a successful succession plan is facilitating the funding. Because small businesses are often a unique mix of an owner’s sweat equity, hard assets and debt, they can be difficult to value and harder to sell, even to family members. Prospective investors or lenders will want credible documentation of the business’s viability – particularly without the current owner – in order to participate. In the Arizona Republic article, consultant Miller says the two primary reasons small businesses aren’t transferred are poor planning and overvaluation. Accurate assessments from good data give both buyers and sellers the best opportunity to complete the transaction.
Life Insurance: A Succession Cornerstone
As a business’s life progresses, things will change, and what once seemed like a viable succession plan will no longer fit. A future-oriented owner will constantly reassess the ownership and funding issues, and adjust. But in the midst of almost-certain change, life insurance can be a constant succession plan asset.
In fact, life insurance may be a critical business transition asset. Because of its unique now-and-later characteristics, attorney Andrew Sherman, in an article for entrepreneurship.org, says: “A life insurance policy is often the cornerstone of a business’s succession plan.” As circumstances change, life insurance can be repositioned to meet new financial objectives.
- In the event of an owner’s untimely death, a life insurance benefit can settle creditor claims and provide survivors with financial resources to either maintain the business or afford to liquidate it.
- Longer-term, cash value accumulations from the same policy, which may not be guaranteed, could be a supplemental source for retirement income.
- Life insurance can be the primary funding vehicle in a buysell agreement; the death benefit can purchase a deceased partner’s share of the business from the estate, and cash values can facilitate a buy-out if one partner wants to leave.
- In one-way buy-sell agreements, such as a child succeeding a parent, cash values may be a source of funding or collateral for financing the purchase at the owner’s eventual retirement.
Just like ownership stipulations in succession documents, the proper assignment of life insurance ownership and beneficiaries is critical to effective use in a succession plan. After a lengthy section detailing life insurance use in Volume 1 of Pepperdine University’s 2014 Graziadio Business Review, author Otis Baskin concludes, “If this sounds complicated, it is.” Succession planning is not a do-it-yourself project. Many business owners may be self-made, but it is almost impossible to self-succeed. Professional assistance is not only recommended, but necessary.