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Understanding the Fundamentals of Succession and Transition Planning

Andrew J. Sherman, Partner, Dickstein Shapiro Morin and Oshinsky LLP

The greatest intergenerational transfer of wealth in history will occur in this country over the next decade. An estimated $10 trillion is expected to change hands by 2010, and much of this wealth will be managed by second-generation entrepreneurs in the form of stock ownership. What this means for the nation's 13 million family-controlled businesses remains to be seen. However, one thing is certain: second-generation entrepreneurs will hold the future of the economy in their hands. Second-generation entrepreneurs face a more complicated world than their parents did, when they founded and built their businesses. Technology, competition, and workforces are changing, comprising some of the most difficult challenges for "new" entrepreneurs. Couple these issues with the fact that the founder may still be actively involved, and the job of running a family business becomes monumental for the successor.

According to recent statistics, only 35 percent of family businesses survive past the first generation of ownership. Only 20 percent survive to the third generation. Some of the reasons why family businesses don't successfully pass down the generations are planned, and others are not.

Many entrepreneurs with family-owned or closely held businesses say the most difficult challenges involve deciding who will succeed the current generation and how to preserve and build the company's value by providing for a smooth transition of ownership and management.

Estate and succession planning decisions involve complex questions of law, tax and business planning, including the types of property to own, the form of ownership, and, for small business owners, the organization and operation of the business and steps for passing that business to the next generation. The only way to find the plan that's best for you is to work closely with your lawyer and other specialists who can advise you properly. Tax accountants, appraisers, life insurance agents, bank trust officers, and financial planners provide other important sources of information that you should consider in the planning process. You must make the final decision about the organization and disposition of your business, so it is essential that you be well informed about the choices that are available so that you can make the best decision for you and your family.

A Process, Not an Event

"Succession Planning" is a process, not an event. Even when the formal Succession Plan is in place, it must be a living, breathing and evolving document which is reviewed and updated from time to time to reflect changes in the marketplace, competitive conditions and the health or capabilities of the current leadership. The process forces the current leadership to confront difficult issues, such as:\

  • How do current leaders choose among multiple capable successors?
  • How do current leaders deal with successor apathy? For example, what happens if nobody in the family is interested or capable of taking over? What other exit strategies are available?
  • What if the current leadership is deteriorating, yet unwilling to relinquish authority or ownership?
  • What are the estate and gift tax implications of the proposed plan?
  • What is the impact of the plan on other "stakeholders" who are non-family member owners, such as loyal key employees, vendors or customers?
  • If the business will not or cannot be kept in the family, who are the likely buyers? Employees? Strategic buyers, such as competitors or companies in parallel lines of business? Financial buyers, such as those interested purely in the profits or financial potential of the business?
  • How do intra-family feuds and normal family pettiness affect changes to the Succession Plan, if at all?
  • Who should be included in the planning process? How will family advisory councils and boards of directors - which should include some competent and objective outsiders - influence the final decision or changes to the plan over time? To be successful, the development of the Succession Plan must be a team effort with team-wide buy-in of the goals and objectives. If the affected parties fail to embrace the details of the Plan, then implementation will lead to more feuding and eventually litigation.

Family business owners are often too focused on day-to-day challenges and fail to plan for the eventual transfer of the fruits of their labor. In other words, they neglect succession and estate planning. In doing so, they jeopardize the future of their companies as well as the financial security of their families. Effective succession and estate planning establishes who will run the business after the owner or a co-founder retires or dies and how ownership will be transferred. The plan should include details about how the owner will pass on the wealth accumulated and held in the company to surviving family members. Once developed, the Succession Plan should be reviewed annually and modified periodically as circumstances change.

The Succession Plan should also seek to minimize estate and gift taxes. At the same time, it must provide liquidity to pay these taxes and support the surviving spouse and dependents. Life insurance products are often used to cover the funding of these obligations; the plan takes advantage of wealth transfer strategies, such as gifts, trusts, and family partnerships, which can be used during the owner's lifetime to transfer wealth to the family.

From a leadership perspective, the family business founder must be prepared to "relinquish the helm" without reluctance or regret. A strong message must be sent to the next generation, the employees and the customers that this is a decision the founder made without duress or shame. The outgoing founder may or may not want to have some continuing role in the management of the business in an advisory capacity. Sometimes it is better to make a "clean break" and get the founder refocused on either a relaxing retirement or some commitment to community or charitable activities to stay active and vibrant. The successful transition plan usually involves the founder choosing a fixed departure date (and really sticking to it), having a strong and independent team of advisors in place to support the new generation of leadership, resisting the temptation to meddle or interfere, having a alternative exit strategy if, after a reasonable period of time, the new leadership fails, and having activities to pursue after the departure which are rewarding and challenging.

Estate Versus Succession Planning

Estate planning consists, in part, of determining how property should be distributed at death. Succession planning focuses on decisions about the form of ownership and the organization and operation of the business, including the eventual transfer of the business on to the next generation, third-party buyer or group of employees. Both estate and succession planning decisions involve complex questions of law, tax, and business planning. The only way to find the plan that is best for you is to work closely with your lawyer and other specialists who can advise you properly. Tax accountants, appraisers, life insurance agents, bank trust officers, and financial planners provide other important sources of information that you might consider in the planning process. Because you must make the final decision about the organization and disposition of your business, it is essential that you be well informed about the choices available so that you can make the best decision for you and your family. Most importantly, don't confuse the role and value of a Will with the importance of effective succession planning. A Will is not an effective substitute for a Succession Plan.

Another critical distinction is the difference between ownership succession and management succession. These two concepts can be separated for the purposes of succession and transition planning. Agreements can be put in place that separate how the stock or assets of the business will be owned, which is different from how the stock or assets will be managed. Ownership involves the property rights inherent in being an equity holder in the business, such as voting on major decisions and a pro rata share of dividends and distribution. However, day-to-day operations, control and accountability for the management of the business can be delegated by contract to those most capable of understanding and running the business.

What follows are tips for effective Succession Planning:

  • Have a firm grasp on the fact that life will not last forever and that, if properly managed, your business may outlive you. Nobody enjoys discussing his or her mortality, but an effective succession plan establishes the ground rules for what will happen when you are no longer around or no longer capable of managing the company's affairs.
  • Be prepared to appoint members to your company's Board of Directors who are objective and outside the family ownership circle.
  • Have regular strategic planning meetings that include both family members - particularly those who will succeed you - and key employees who aren't family members.
  • Select and regularly communicate with a team of outside advisors, including lawyers and accountants who have experience with closely held businesses, complex corporate matters and estate planning. These advisors can also be a source of insight, continuity and strength during an unexpected family crisis.
  • Be honest with yourself when analyzing the strengths and weaknesses of various family members when considering successors. Try to separate issues of love and fairness from issues of business acumen and strategic management.
  • Be prepared for the unexpected. Most closely held family businesses experience a "sudden loss" of leadership due to death or disability, leaving behind children or spouses who are too young or too inexperienced to manage the business effectively. What would be your plan for the "following Monday morning?" Who would run the company?
  • Invest the time and money to train and educate the "next generation" of leadership - whether the successor is your spouse, children or another family members. If your succession plan calls for a full or partial sale of your business to some or all of your staff, do the same for the employees who will take over.

How to Plan Ahead

Some family-business owners believe it's easier to go day-to-day with the mystery, confusion and ambiguity of not knowing how or when the next generation of leadership will be designated. However, avoiding the issue allows the rumor mill to run rampant, which causes more ruffled feathers and frustration than no communication at all. Remember that apathy or silence won't prevent family members, key employees or even your competitors from reaching their own conclusions as to how the pie should be divided from a management, control, compensation and ownership perspective, or about what the future might bring for the company. A carefully structured, well-researched, written strategy that is communicated to all affected parties well before the proverbial "eleventh hour" will stop the rumors in their tracks. That, in turn, will allow the company and its leadership to focus on what is really important-serving the needs of customers and building market share, profitability and value.

The best way to capture this overall strategy is through the preparation of a Family Business Continuity Plan, or "FBCP," which is a written document that establishes a primary plan as well as a series of fallback plans for ensuring that the business is continued. In this context, "continued" means that the business continues to operate in some capacity, servicing customers and creating revenues and profits for your estate and successors long after you retire, die, are disabled or otherwise leave the business.

The planning prior to the actual preparation of the FBCP is an important exercise that considers all possible exit strategies, including:

  • Transferring the business to your children or other family members.
  • Selling the business, or your portion of the ownership, to co-owners, where applicable, or to some or all of the employees.
  • Selling the business to a third party
  • Selling a significant portion of the company to the general public via a public offering or other creative exit strategy.

Major factors and long-term objectives to consider in the pre-planning process include the following:

  • Your financial needs and goals.
  • The future of the business.
  • The valuation of the company.
  • The availability of qualified family successors.
  • Trends within your industry.
  • The degree of risk you are willing to assume and the control you wish to exercise over the company after the transfer or exit strategy has been implemented.

It is important to understand that each strategy will have a different impact on risk/control analysis that you and your advisors should weigh carefully to rank the various exit strategies and select your primary strategy.

Major Steps in the Pre-Planning Process

The steps leading up to the preparation of the FBCP include goal-setting, consensus-building and financial analysis exercises, which will help ensure that your FBCP meets the objectives set forth above. These steps include:

  • 1 - Determining Your Life Plan and Timetable. Naturally, your age, health, retirement horizon and whether you view this business as your "last hurrah" dictate the strategies to be selected in your FBCP. In today's era of the "career entrepreneur," many business owners seek exit strategies, not only for their investors, but also for themselves. These "career entrepreneurs" are essentially in the business of starting, building and exiting businesses and may not necessarily view their current venture as their last venture.
  • 2 - Determining the Current and Future Value of What You Have Built. Again, the number of options available to you will be driven in part by what your business is currently worth or what it may be worth to future family and non-family owners. The ultimate value will also be a key factor in the analysis in the following step.
  • 3- Determining Your Retirement and Estate Planning Needs. The strategies underlying the preparation of your Family Business Continuity Plan will also be driven by your personal financial goals and needs. For example, if you've accumulated all the wealth you will need to retire and provide for your estate, then money may not be as important to you as keeping the business in the family. If, like most small business owners, your company is still your primary asset on your personal balance sheet, then your FBCP will need to provide the assets and income that you will need to retire (and provide for your estate) as your exit from the business approaches. Such a need may preclude traditional "gifting" to the next generation, since you will need to derive income from the transfer of the ownership of the business, unless the gifting is coupled with employment contracts, consulting services agreements or other ways to generate an income flow.
  • 4 - Legal Audit. In a legal audit, the company's management team meets with corporate counsel in order to discuss strategic plans and objectives, review key documents and records, and identify and analyze current and projected legal needs of the company. The legal audit also lays the groundwork for the establishment of an ongoing legal compliance and prevention program in order to ensure that the company's goals, structure and ongoing operations are consistent with the latest developments in business and corporate law. Finally, the legal audit helps managers identify the legal issues triggered by changes in strategies, goals, or objectives and allows the planning for the legal tasks that must be accomplished as a result of the issues identified.
  • 5- Corporate Structuring and Reorganization. In addition to all of the other benefits of a legal audit discussed above, the legal audit process should also focus on how your current ownership structure will affect the strategies available under the FBCP. For example, does the current ownership structure inhibit or restrict, either by contract or by charter, the options that would otherwise be available? Unless there is a valid legal, tax, or financial reason to do so, you may want to consider restructuring to allow for maximum flexibility. On a related issue, does the current ownership structure provide for "creative" solutions to the implementation of the FBCP? For example, if your children have different talents and interests-or, worse yet, are feuding-does the current ownership structure give you the option to transfer different components of the business to different siblings? Let's say one of your two sons has an engineering background and the other is in sales and marketing; despite the different backgrounds, there is a potential for conflict in the event of co-ownership. Perhaps you could restructure the company now to set up separate ownership of the manufacturing and distribution functions of the business, which allows these separate business units to evolve even before your exit.
  • 6- Gathering Data and Building Consensus. The process of preparing an effective FBCP should not be done in a vacuum. The current ownership needs to seek input from its advisory team, such as lawyers, accountants, and consultants, the parties targeted to be the next generation of ownership, and affected stakeholders to assure that the FBCP will be well-received and smoothly implemented. You may be surprised to learn how people really feel and how they will react to the primary strategy that you have selected in the draft of the FBCP. Naturally, you can't please all the affected parties all the time. However, you don't want to make the mistake of pleasing no one and drafting a FBCP that is based on a series of flawed or simply incorrect assumptions. You're the only one who'll decide whether these affected family members and stakeholders will have a vote or merely a voice. While some business owners want to retain the final veto, others are open to a more democratic process (though, depending on the players, not all votes need to count equally). The key is to make all affected parties feel as if they were part of the process, which is hard to do if the FBCP is merely presented to them in final form. If your exit is due to a voluntary and gradual retirement, you are likely to have fewer sleepless nights for having allowed affected family members to participate in the process and voice their views and concerns.

The Family Business Continuity Plan should include the following:

  • A vision for the business and the family.
  • A family mission statement.
  • A strategic summary of the company's position in the marketplace that delineates its strengths, weaknesses, opportunities and threats.
  • A set of projected revenues, earnings and net worth for the next three to five years.
  • A plan for the transition of ownership and control to designated family members, which includes a clearly defined timetable, statements of responsibility and authority, and an organizational structure.
  • The preparation of the plan may involve the input of an advisory board or the formation of a succession planning task force. Gathering all the details appropriate for the FBCP is emotionally hard work. Much dialogue and documentation, and sometimes even the consent of third parties, such as lenders, major customers or suppliers (to the extent that the success of your business is dependent upon these relationships) are required. So begin early, allow several years for the total design and implementation and make it a living document, updating it as people and

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