A successful small business is rightly a point of pride. It means that plans were made, risks were taken, and sweat equity was liberally invested. When things go right, the resulting enterprise may become the livelihood of the founder and members of his family. After the hope for initial success, the founder’s greatest desire may be for the business to continue after he is out of the picture.
This is easier said than done. Business “succession planning,” as it’s called, can be complicated stuff. But it can also be vital to ensuring that the business continues if something unexpected happens to an owner.
There may be only one owner who simply wants to leave the business to a family member. In this case, the owner should have a Last Will & Testament that includes a specific bequest of the business to the family member in question.
If, however, there are multiple owners and one of them dies, the surviving owners may want to purchase the decedent’s share of the enterprise. If this happens, how will the value of the late owner’s share be determined? And where will the survivors come up with the money to buy it?
A well-thought-out succession plan will address questions like these.
After identifying their shared goals, the owners of the business should prepare a buy-sell agreement. This document ensures that the business will transfer according to an agreed-upon plan. In addition to an owner’s death, the agreement can lay out a strategy for dealing with an owner’s disability, retirement, divorce, or bankruptcy. It should state how the business will be valued and who has the right to purchase the ownership shares that are suddenly available.
With proper planning, a business can continue even after an owner’s death, disability, retirement, divorce, or bankruptcy.
How much the company is worth can be determined though a business valuation clause. This could include a formula for valuing the business, such as “three times annual earnings before interest and taxes.” But a formula devised today may not lead to a fair valuation when it is applied years from now. The better approach may be for the buy-sell agreement to state that a business-valuation expert will recommend the best ways to establish the value of the business.
To anticipate an owner’s possible death, other steps should be taken in addition to preparing a buy-sell agreement. First, each owner should purchase life insurance naming the other owners as beneficiaries. This essential step will provide the liquidity necessary for the surviving owners to buy a deceased owner’s share of the business.
Second, each owner’s will should explicitly mention the buy-sell agreement and authorize the personal representative (executor) of the estate to honor it. This ensures that the company’s surviving owners can purchase the decedent’s share of the business from his or her estate.
A buy-sell agreement makes it clear up front who can buy ownership shares of the business and how the process will work. Like a prenuptial agreement, it also provides an opportunity to consider possible succession scenarios in advance, rather than resolving any disputes through costly court proceedings.
A succession plan is so essential to a business’s long-term continuity that you might think most businesses would have them. But the regrettable truth is that the percentage of business owners who neglect to create a succession plan is about the same as the percentage of people who never prepare a will.
Like estate planning, business succession planning is easy to put off. It means considering some sobering questions and worst-case scenarios. The emotional attachment many business owners have to their enterprises can only complicate matters.
Whether your small business is a sole proprietorship or a corporation with multiple shareholders, calling a lawyer to discuss a succession plan should be a priority. With a well-considered plan in place, you can then focus on growing your business, knowing that you’re ready for whatever lies ahead.
Lee Carpenter is an Estates & Trusts attorney at Saul Ewing Arnstein & Lehr LLP and an Adjunct Professor at the University of Maryland Carey School of Law. This article is intended to provide general information about legal topics and should not be construed as legal advice. For qualified legal counsel contact Lee Carpenter at Lee.Carpenter@saul.com or 410.332.8626.