A business with no succession plan for the owner is set for self-destruction, or at least major problems. Matthew Hourn and Jonathan Karlovsky explore the important issues and how succession plans can be tailored to suit particular circumstances.
What will happen to your business when you are no longer there? It may be something you prefer not to think about but you know that day will come, eventually.
The best way to illustrate the importance of succession planning is by example:
Andrew and Jason are partners in a successful cleaning business they established 10 years ago. Andrew is responsible for marketing and client liaison and Jason is the manager taking care of the day-to-day running of the business. Andrew is married with three children and Jason is also married with one child. The two families are inseparable and share a comfortable lifestyle.
One weekend, while away with the family, Jason is involved in a serious car accident, and is hospitalised for three months before he tragically passes away. During Jason’s hospitalisation, Andrew was left to control the business and quickly discovered he lacked the skill, knowledge or time, to manage it. While in hospital, Jason was taking a salary and the business was unable to afford to appoint a replacement manager. The business started to decline almost immediately. When Jason died, he left all of his assets to his wife, Alison.
However, Alison does not have the skills to manage the business and wants nothing to do it following Jason’s death. Andrew wants to buy Alison’s interest in the business, but there was no agreement in place to ascertain the company’s worth or ensure a mechanism for the transferring of shares. Further, upon the death of Jason, the bank wanted the mortgage on the company property repaid in full.
Andrew is left with no alternative but to re-finance his family home and pay Alison for her interest in the company. He enters into a new arrangement with the bank for the company mortgage and employs a manager full-time on a substantial salary, but the damage is done, and the business fails to make up for the loss sustained. The business goes from bad to worse, and finally, less than 18 months after Jason’s death, goes into liquidation. Andrew loses his family home and goes bankrupt, all within a two-year period.
Preparing for Succession
Whether you start a new business or run a well-established family business, succession planning is essential to ensure the survival of your business long after you leave it. Succession planning is essentially the transition of the management and leadership of the business to other people. Many successful business owners we advise are too busy with the day-to-day demands of running a business to worry about an exit strategy or a succession plan.
Business owners spend their life achieving enormous success in their business, with the hope of one day leaving it to their family or selling when they are close to retirement. Life is not always so kind. Circumstances change due to death, divorce, financial changes or a business owner’s sudden lack of interest. Without a succession plan in place, a lot of businesses will fail or their value will be substantially reduced.
In our experience, business owners avoid discussing exit strategies, as it is sometimes too painful for the business owner to think of their business without them. Often, discussing exit strategies seems pessimistic to them, but it is reality. We do not live forever, and why spend your life creating a successful business to see it crumble when you leave it.
Dealing with family-owned businesses can be very complicated. You’re faced with issues such as sibling rivalries and other emotional issues which can play a major role, often threatening the business. It is essential when dealing with family businesses that a succession plan is developed as soon as possible, to ensure there is mutual understanding and expectation about each individual’s entitlements.
From a legal and financial perspective, exit strategies for an owner/manager or a succession plan for a family business requires detailed planning. It’s not wise to wait until you are close to retirement; that day may never come. In our experience, by avoiding succession planning you gambling with the business’s very existence.
If you currently own and run your business ask yourself who is going to do your work if you retire or decide that you would rather improve your golf handicap than work in the business. The key to the success of a number of businesses is the founder. This is why it is essential to ensure that you identify a successor and agree on a succession plan.
If you ask yourself whether the business will survive without you and the answer is no, then you leave your business open to self-destruction. A succession plan will give your business every chance of survival when you are gone or your partner suffers long-term illness; ensure your family will receive the true value of your interest in the business; and assist in the transition of ownership to remaining partners or family members, rather than selling at a substantial reduction.
Crucial Questions
Before considering an exit strategy or succession plan, you need to ask the following questions:
• What are my future income needs?
• How long do I want to remain active in the business?
• Does anyone in the business have the management skills to run it in the future?
• Do I need to leave the equity to my children?
• Can my children effectively run the business?
• How will the sale of my shares in the business affect any minority shareholdings?
• Will key personnel feel secure if I sell?
• How do I secure key personnel in the event of a sale?
• Will the business lose sale appeal without the key people?
Every plan must be based on your own personal circumstances. No two situations are the same, but there are factors that need to be considered in every plan. Such as, if your family will be retaining and running the business or whether you plan on continuing to own the business or retain outside management. And if selling, will you sell to current management or competitors; and what stake will you sell—all or only a share of the business.
If you are not going to pass the business on to your children, you should look at the best way to sell it. Structure your affairs to reduce unnecessary capital gains. This may include selling the shares rather than the business (as this may be more tax effective); or rolling the sale proceeds into superannuation to avoid paying capital gains tax (where allowable).
The question you need to ask is not only how much you get for the sale of your business, but what is the most effective way to sell it to achieve the best possible outcome.
Insurance Options
When dealing with business partners, if it’s your intention to ensure an exiting business partner’s family is not involved in the business, an exit strategy must be considered when drafting the Shareholders Agreement. It is essential for the remaining business partners to consider how they will pay out the deceased partner’s interest.
When a key shareholder exits a business for whatever reason, it can have a detrimental effect on the business almost immediately. The safest and usually the most economical strategy is to ensure that the company has the relevant insurance. The three most popular are life insurance, total and permanent disability insurance, and key-person insurance.
Recently, a client wanted to finalise a Shareholders Agreement and assist in selecting business insurances. The company was a business with three hands-on shareholders who were involved in the business since its inception
. The shareholders’ families were entitled to their shareholding if they were to die or suffer serious illness. However, all shareholders agreed they did not want the shares to be held by the family members, as they had little or no interest in the business and would prefer a monetary solution. In this situation, we recommended each shareholder gave a direction to their Executor to sell their shareholding back to the company, for the amount of the insurance benefit we suggested be arranged.
Basically, the company had taken out life insurance/equity insurance on the shareholder that would provide the company with a certain amount of money. On the death or permanent impairment of the shareholder, the company would then purchase the shares from the shareholder’s estate at the same amount of the insurance payout figure. This ensures only the shareholders with the experience in the business remain shareholders.
Succession Planning Process
It’s never too early or too late to start succession planning. A simple succession plan should include a choice in a successor, whether a family member, a current employer or possibly an outsider; and how you plan to ‘groom’ your heir—it may be appropriate to employ the heir to shadow you and learn from your daily activities, attend meetings and assist in fulfilling your current duties.
In a perfect world, long-term planning is the key, but it’s never too late. Set a time when you, as owner, will step aside and allow the heir to fill your shoes.
It is also important to seek professional advice on strategies on succession planning. Your lawyer and accountant can help you face these challenges. They can help define what you and other key shareholders want in the future, and identify the most appropriate method to realise the business’s wealth. Our experience enables us to evaluate and test your succession planning goals and to ensure they are feasible and tax effective. We recommend developing a written plan for the transfer of ownership and leadership.
You, as the business owner, have dedicated your life to building the business, often from nothing. Your courage, determination, and optimism should not go unrewarded by simply not turning your mind to what will happen after you retire or exit the business.
* Matthew Hourn is a business law partner with Clinch Neville Long Lawyers. Jonathan Karlovsky is a partner of PKF Chartered Accountants and Business Advisors. For information about their ‘Creating and Retaining Wealth’ seminars, August 4 and August 11, contact Matthew on 9279 4888; or Jonathan on 9248 9793.
