Funding a Small Business Succession Plan
The June 2013 issue of the CPA Client Bulletin described the two key elements of a succession plan for a privately held company: putting a value on the business and finding the right successor. Even with those two ingredients, however, a succession plan can’t be considered a success unless you get paid a fair price for your company. A viable small business might be worth $1 million, $10 million, or more; where will the buyer be able to get that much money?
Worst case scenarios
To start considering this issue, you might think of two types of business succession: voluntary and involuntary. The latter could be caused by your death or severe disability. In case of such an involuntary departure from your role as head of the company, you’ll want to have someone lined up to take over right away. You’ll also want your heirs to be compensated for your equity in the company (in the event of your death), or you’ll want some ongoing cash flow in your forced retirement (due to disability).
These risks should be addressed with a buy-sell agreement between you and a business partner, a key employee, or an outsider. Funding can come from insurance. In the event of your death, the policy beneficiary can use life insurance proceeds to buy your stake from your heir; if you are disabled, a disability income policy can provide the cash you’ll receive after you’re no longer able to run the business.
Dollars on departure
A buy-sell agreement may not cover situations where you want to retire or just leave the company for another line of work.
Example: Kay Turner reaches age 66 and decides she has worked enough, building her company to the point where it’s worth $3 million, according to a reliable appraisal. Potential buyers include relatives, employees, other companies in her industry (sometimes known as strategic buyers), and outsiders (often called financial buyers) who hope to eventually sell Kay’s company for more money than they pay her.
It’s possible that the buyer will have $3 million to pay Kay and bid her farewell, but that’s often not the case. In some situations, the buyer will borrow the money. Then the buyer will have to pay off the loan plus interest, probably from the company’s future earnings. In this situation, Kay should see if “clawbacks” are in the contract—will she have to repay money she has already received if the company fails to meet certain future levels of earnings or revenues?
In many cases, the buyer might offer to pay Kay over a period of years, rather than make one upfront $3 million payment. Frequently, an extended payment plan will be structured as an earnout, meaning that Kay will continue to work for the company during a transition period with some financial incentive to maintain revenues or earnings.
Other forms of business succession funding may include the sophisticated use of trusts, often in pursuit of tax advantages. No matter how you intend to sell your business, you should read the contract carefully, evaluating all the devilish details. You also should have professional guidance for such a crucial transaction, and our office can help you determine that you’re really getting a fair deal.