Based on SBA and other industry sources, CB Insights reported that 31,929,000 small businesses (0-49 employees) employed one-third of the U.S. labor force in 2015. The number of such small businesses was estimated at 41,580,000 for 2019. Although family businesses comprise a significant portion of these small businesses, studies estimate that only 30% of family businesses survive the second generation and only 10% survive the third generation. Reasons for this high failure rate include the lack of adequate succession planning by most family businesses and insufficient planning to minimize transfer taxes across generations. If properly conducted, family business succession planning improves the value and transferability of the business for the benefit of current and future owners. Part 1 of this series offers an overview of family business succession planning and of buy-sell agreements, a critical component of the plan. Part 2 of this series focuses on selling the family business to third parties, family members or employees.
Planning Overview
Broadly speaking, business succession planning consists of transferring ownership and control of the business while minimizing income, gift and estate taxes. Within these broad conceptual categories are a virtually infinite array of combinations that should be customized for each business and family. For a family business, succession planning must also address the emotional issues and dynamics of the family. After the requirements to protect and continue the business are established, the business succession plan must be coordinated with estate planning to minimize taxes.
Areas of Focus
Business succession planning issues may be grouped into three broad categories of management, ownership, and tax issues. Adequate planning requires a multi-disciplinary team of professionals including an accountant, attorney, financial/insurance advisor, business appraiser and, for more complex cases, family business consultant.
This overview focuses on non-tax legal issues frequently encountered. It is not a substitute for legal advice applied to the facts of a particular family business.
I. Succession Planning Overview
A. Basic Outcomes
- sale to third parties, employees or active family members – see Part III below
- gifts to family members – see Part IV below
- liquidation
B. Basic Components of a Succession Plan
- Identify primary objective
- Legacy – preserve the legacy family business to (i) infuse future generations with business ambition, family values, relationships and long-term wealth-building goals, and (ii) provide security for valued employees
- Wealth Management – the business is sold (to family members desiring to own/operate the business or to non-family) and the sales proceeds are distributed to family members for investment in other businesses or passive investments
- Business Analysis
- Valuation/Appraisal
- Mission and strategic plan
- SWOT (strengths, weaknesses, opportunities and threats) Analysis
- Cash flow and capital needs of business
- Liquidity demands arising on owner’s death
- Effect of owner’s death on customer, creditor and employee relationships
- Recommended reading – “The E Myth” by Michael E. Gerber
- Management Issues
- “Family-first” vs “business first” focus – how should business decisions by the next generation be prioritized between needs of the business and needs of the family?
- Is a leader available in the next generation who possesses the passion and competence to implement a shared vision for the business?
- Should non-family run the company?
- What kinds of incentives are necessary to attract and retain top employees?
- Ownership Models
- Owner-Employee – first generation owners frequently work in the business and derive “ownership benefits” from compensation and other deductible perks.
- Hybrid Ownership – sibling- or cousin-owned companies (typically second- and third-generation) use a hybrid ownership model with some owners active in daily operations and other owners having varying governance/oversight roles.
- Owner-Investor – ownership held in family entities such as limited liability companies (LLCs), limited partnerships, corporations or trusts with governance/oversight policies established by an active board.
- Personal Family Issues
- Fairness/equalization issues between active and inactive children
- Financial needs of the senior generation
- Emotional and family dynamics (including spouses)
- When does senior generation step-down?
- Implementation Schedule
- Begin now to avoid “damage control” succession from disability or unexpected death.
- Planning takes time to properly analyze issues, obtain consensus and commitment of stakeholders (family, employees and business associates), groom successors and implement planning team recommendations.
- Establish schedule with milestones for review and accountability.
- Conduct periodic reviews to adjust succession plan as changes occur.
II. Buy-Sell Agreement
A. Critical for Multi-Owner Businesses
The purpose of a Buy-Sell Agreement is to provide business and ownership continuity while minimizing disputes. The Buy-Sell Agreement must integrate with the succession plan. New owners should be required to execute the Buy-Sell Agreement as a condition to receiving ownership.
B. The Business Pre-Nuptial Agreement
Sometimes referred to as a business “pre-nuptial” agreement, a Buy-Sell Agreement is an agreement among the owners of the business to establish:
- restrictions against undesired ownership transfers
- procedures for permitted ownership transfers
- representation on the board or other governing body of the business
- rights and obligations of owners with respect to a future sale of the business
- vesting and repurchase rights of a withdrawing employee’s ownership interest
- confidentiality and noncompetition obligations
- approval requirements for major transactions dispute resolution procedures
- dispute resolution procedures
C. Sample Events Addressed
- The following events typically trigger a redistribution of ownership:
- death
- disability
- termination of employment (voluntary or involuntary)
- retirement
- proposed transfers to third parties
- involuntary transfers (i.e., bankruptcy or divorce)
- management impasse or disputes
- supermajority vote to sell the company (drag-along rights)
- permitted joinder by other owners in an owner’s sale (tag-along or participation rights)
- Price and Payment Terms
- The method(s) for determining the price of ownership interests purchased under the Buy-Sell Agreement should be specified, together with the payment terms (cash or installment payments) and any collateral requirements for deferred payments.
- Insurance funding of purchases by the company and/or the other owners is frequently specified.
- Tax Distributions
- Mandatory minimum cash distributions for owners to pay income taxes on undistributed S corporation, LLC or limited partnership income.
See Part 2 of this series for considerations in selling the family business to third parties, family members or employees.
This blog does not establish an attorney-client relationship and does not constitute legal advice. Legal outcomes are based on the particular facts of a situation and the application of the law to those facts. Anyone with issues described in this blog should hire an attorney for legal advice based on the relevant facts. The firm has no obligation to maintain the confidentiality of any information received by email or comments.