Texas Business Dispute Blog

Monday, October 24, 2016

Succession Planning Part 3: Ownership Transition – Passing on the Keys to the Kingdom

By: Ladd Hirsch 

“If you don’t know where you are going any road will take you there.”  -The Cheshire Cat

As the wily feline wisely suggested to Alice, knowing where you are going is the key to knowing how to get there. At no time is this more true than when a business owner is working on their succession plan.  In our previous posts on succession planning, we stressed the importance of creating two different succession plans – an emergency plan and a long-term plan, and how to implement the management changes necessary for both of these plans to succeed. In this post, we will focus on transition planning to prepare for a change in the ownership of the business.

Determining The Majority Owner’s Exit Strategy

When a business owner decides to transfer ownership in the company, there are two fundamental exit strategies to consider.  The owner can sell the company to a third party or transition the ownership to one or more key employees. In a third party sale, this often involves a cash out in which the majority owner sells his or her interest in the business leaving future decisions regarding the company to the new buyer.  In a sale to insiders, the owner is attempting to transition the ownership of the company to insiders, who share the majority owner’s vision for the business.

The key decision for the majority owner is to decide what he or she wants to achieve when exiting the business. This requires the business owner to engage in some self-reflection, and be prepared to take an objective look at the business.  

Is the owner focused primarily on maximizing the value of his or her ownership interest?  Or, is the owner concerned about crafting a legacy and preserving the business for the next generation or for long-term employees of the company. This is purely a personal choice, but if the owner wants the business to continue along the same track, it is critical to engage in long-range succession planning.

In preparing for an exit, the majority owner is not required to decide between selling the business or giving it away. The owner who wants to secure a cash payment at the time of departing, but who also wants to preserve his or her vision for the future of the business is not without options. Long-term succession planning can permit the owner to receive a cash payment upon exiting while successfully handing off ownership to a new party in a best of both worlds business scenario.

Beyond thinking about the financial aspects of the deal itself, owners must also consider the personal cash flow and tax implications and prepare for them. This is particularly important if ownership is being transitioned to a family member in a way that could be taxed as a gift.

Reviewing Financing Options

Once an owner decides on plans for exiting the business, both for themselves and also for the business, the planning process can begin in earnest.  If the owner’s goal is to sell his or her interest in the business, the next step is to determine the best way to maximize value for the sale.  Most often, that will require that the owner retain a broker, investment banker or some other type of financial advisor to promote and assist in securing a sales transaction.

If the owner decides to sell his or her interest in the company to insiders, this can take a number of different financing paths that include all of the following:

  • Leveraged buy-outs where the business itself takes on bank debt to cash out the owner.
  • Structured buy-outs where the owner is paid over time for his or her ownership interest.  This can also involve some bank debt, although a small amount would be involved.
  • Bringing in a new minority equity owner who provides a capital infusion and knowledge capital, but with insiders receiving the majority ownership over time.
  • Selling to new majority owner, but with key employees also receiving a minority stake.

The goal of these various financial options are to facilitate the continuity of the company, often under existing management.  

When an owner sells out to company insiders, negotiating a workable financing plan is just one key part of the process.  It is equally important, if not more so, for the owner to develop and implement a long-term management succession plan, which we discussed in our previous post.  For a management and ownership transition to be successful, all of the parties involved have to understand and buy in to the plan for the business. If the succession plan is not successful, the new owners may not be able to meet their financial obligations to the bank and may also default on their payments to the owner preventing them from completing their purchase.

Conclusion

Another favorite line from Alice’s Adventures in Wonderland is: “Which way you ought to go depends on where you want to get to…”  And so it is that business owners need to decide at the outset where they are trying go when they begin to plan their exit from the business.

Making the transition from majority to minority owner, or to former owner, however, is not a path that most business owners are equipped to handle without outside expert advice.  The sale of a company, or a majority business interest, involves a number of complex business, legal and tax issues on which accountants, estate planners and business attorneys can provide invaluable guidance.  These advisors can also be of considerable help in the succession planning process.  Tax advisors, in particular, can save the business owner and the business sizable amounts just from the way that the sale of the business (or ownership interest) is structured. 

As a final note, one part of succession planning that is often overlooked is the crucial role that life insurance can serve for the company and the owner.  Life insurance proceeds could be a vital source of funds for the business in the event of the owner’s accidental death.  The locked in cash value of the policy can provide other benefits, as well, that can also be helpful in the succession planning process.  An experienced life insurance broker is therefore another advisor to be consulted at an early stage once succession begins in earnest.


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