The Show Must Go On: The Importance of Business Succession Planning

Business.com / Strategy / Last Modified: February 22, 2017

Every small business owner dedicates most of his time to growing the business, but what happens when they retire?

Every small business owner dedicates most of his or her time to growing the business, but often many owners do not consider what will happen to the business if they choose to retire, become incapacitated or die. However, it is essential to have a business succession plan before it's too late.

There are a number of underlying factors that can determine whether a business succession plan is necessary. In some cases, the path of least resistance is to sell the business entirely. However, there may be other partners involved and there is always the possibility that some owners may want the business to continue operating after they are no longer involved.

What Are the Essentials of a Business Succession Plan?

A business owner needs to be objective in determining what the future prospects of the business are, particularly if and when he or she is no longer at the helm. After determining if the business has the potential for long-term viability, the key considerations in a succession plan include choosing a successor, ascertaining the value of the business, obtaining life insurance and determining the best method of transfer.

Choosing a Successor

In some cases, a small business owner may appoint a family member to take his or her place. This is not to say, however, that these individuals will have the skills or experience to carry on and ensure that the business will continue to prosper. Business owners should not assume that their children will have the desire to continue the family business. Moreover, there may be other business partners or key employees who are better positioned to take over. 

Related Article: How Does Succession Planning Apply to Parental Leave?

Nonetheless, it is critical to select and train successors in all phases of the business. There must be clear guidelines for running the business -- the role of the successors must be articulated and a method for resolving disputes must also be put in place. Once these matters are resolved, a business owner needs to be able to step aside and allow the successors to gradually implement the transition.

What Is the Valuation of the Business?

Generally, there are three ways to determine the value of a business: the asset approach, the income approach and the market approach: 

Asset approach -- The value of a business can be determined by evaluating the stated assets and subtracting the liabilities. This is a bottom line look at the balance sheet that does not consider market conditions or good will.

Income approach -- The analysis of business income requires looking at past earnings, projecting future earnings and factoring future cash flow and capitalization in order to determine a present or future value of the business.

Market approach -- The market approach is basically a comprehensive analysis of comparable companies that have been sold in your industry. This approach takes into account differences in the size, duration and market risk of the business.
In order to objectively evaluate the present or future value of your business, it is necessary to engage the services of a business valuation expert such as a Certified Public Accountant.

Related Article: Don't Wait Until It's Too Late: 4 Ways to Avoid the Pitfalls of Piecemeal Planning

The Importance of Life Insurance in a Business Succession Plan

The death of an owner, partner or key employee can be devastating to the sustainability of the business.

If the valuation of the business has been established, life insurance can be purchased that will provide proceeds to buy out the owner's interest or deceased partner's share in the business.

How to Transfer a Business

Generally, there are two methods that allow for the transfer of a business, cross purchase agreements and entity purchase agreements, depending on the exigencies of your business.

A cross-purchase agreement is an arrangement in which each partner buys and owns an insurance policy on the other business partner's share and each partner is also the beneficiary of the policy he or she owns. In the event one partner dies, the face value of the policy is paid to the remaining partners and used to purchase the deceased partner's interest. However, there are limitations to these arrangements, including disparities in ownership interests and the insurability of each partner.

An entity purchase agreement is more straight forward. This arrangement allows for the business to purchase a single policy on each partner and the business is also the beneficiary. In the event of a partner's death, the business uses the proceeds to buy out the deceased individual's share.

What Are the Benefits of a Business Succession Plan?

By establishing and implementing a carefully designed succession plan, business owners, partners and minority investors can derive a number of benefits. First, by establishing the value of the business, the need for valuation in the event of death is eliminated and the price for a partner's share will be agreed to beforehand. Further, if there is life insurance in place, the benefits will be readily available to cover the deceased's share of the business. This will prevent the need to sell any assets or the business in its entirety. Finally, a succession plan, when coupled with a comprehensive estate plan, can expedite the settlement of an estate in the event the owner dies.

First, by establishing the value of the business, the need for valuation in the event of death is eliminated and the price for a partner's share will be agreed to beforehand. Further, if there is life insurance in place, the benefits will be readily available to cover the deceased's share of the business. This will prevent the need to sell any assets or the business in its entirety. Finally, a succession plan, when coupled with a comprehensive estate plan, can expedite the settlement of an estate in the event the owner dies.

In the final analysis, a well-designed business will allow for the fair and equitable transition of the business. To achieve this objective, an owner should rely on the expertise of a team of professionals including accountants, tax advisors and estate planning attorneys.

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