Small Business Saturday is a great reminder of the importance of small businesses to the health of our economy, but I think it’s also a good time for us to think about the health of our small businesses. To me, the biggest long-term challenge facing small businesses today is succession planning. What happens when an owner dies, becomes disabled, or decides to leave the business? A poorly planned succession has the potential to destroy a business.
There are several strategies that small business owners can take to ensure a smooth transition, and life insurance can play a pivotal role in making it possible.
Estate Planning is Not Succession Planning
For closely held family businesses, studies show that each time there is a transition from one generation to the next, the chances of keeping the family involved and successfully sustaining the business get smaller and smaller. There is only a 30 percent success rate moving to the second generation, dropping to 12 percent for the third and only 3 percent for the fourth. S. C. Johnson & Son, having been a family company for five generations, is indeed a rarity.
One of the big challenges is addressing the needs of both active and inactive children. Some children work in the business, some don’t. Should all the children be treated equally, or should they be treated equitably? I’ve seen many situations where the succession defaults to the owner’s estate plan, which usually calls for the estate (including the business) to be divided equally among all children. Estate plans are not business succession plans.
I’ll give you an example of how complicated this can be. A friend’s family owns a business and there are two sons – one is active in the business, and the other is not. The active son, John, has really built up the business, spending considerable time and effort to grow it. Dad stepped aside many years ago, although Dad still owns 55 percent of the business. The balance is owned 20 percent by John and 15 percent by his brother Mark.
John feels that he should get the business. He’s been identified as the heir apparent. In fact, the estate plan says that the business passes to John and all other assets are divided 50/50. Well, that’s not fair to Mark. His inheritance isn’t the same as his brother’s, which upsets his mother, who wants everything equal across the board.
Succession plans for family businesses can become fraught with all the emotional interplay that is found in families. It really comes down to having the family understand the difference between equal versus equitable.
What a family business should do is hold a family meeting, moderated by trusted financial professionals, including their financial professional, CPA and/or business attorney. Sit down offsite — not at home, not at the business, somewhere neutral — and really talk through the issues and the roles and responsibilities and commit to a plan, whether it’s part of the estate plan, or a buy/sell arrangement whereby the active child or children buys the business interest.
Non-Family Businesses Need Succession Plans, Even More
For those businesses where the co-owners are not related, a good succession plan is a must. Anytime you enter into business with other people, you have to always consider what would happen if an owner died or was disabled. For example, if one of the co-owners is responsible for 70 percent of the fees generated, then, if something were to happen to her, that would negatively impact the revenue of the business. Likewise, a death of a co-owner may mean the other owners are suddenly in business with a spouse, who may have little interest or understanding of the business other than being accustomed to having a certain amount of income from the business.
My basic warning is: If you’re in business and you don’t have an up-to-date succession plan in place, you should be concerned.
It’s important to get these issues worked out as early in the life of the business as possible, as there are a lot of “moving parts” to such agreements that will take time to figure out. Buy/sell agreements are the most common approach, but you have to consider whether it’s a cross-purchase (where the remaining owners buy the shares) or a redemption (the shares are bought back by the company). Should the agreement be triggered at death, or should it also cover disability? What happens if someone retires? These are questions your financial professional, together with your personal tax and legal advisors can help you explore.
The Role of Life Insurance in Small Business Succession Planning
Since the number one triggering event is death, life insurance can obviously play an important role as the main funding vehicle for the succession. The death benefit that I own on my business partner (and she on me) will help pay family members for the value of the business when one of us passes away. If I own a permanent life insurance policy, I might have cash value that I can access for an installment purchase of the business in case she retires or moves on.
The key is to make sure that you have adequate coverage, determined by a formal valuation of the business, and that the coverage is updated periodically to keep pace with the growth of the business. If the insurance I have on my co-owner has a $250,000 death benefit, but the business has grown so that her share of the firm is now $500,000, then I will not have enough to buy her heirs out in a lump sum.
A well-drafted agreement should also allow me to buy my policy back from my co-owner if we sell the business to a third party or if we dissolve the arrangement, because there’s no reason for her to benefit economically from the death benefit should I pass away, and I might have insurability issues at that point in time and need or want to own my own policy for those purposes.
For a closely held family business, life insurance might be used to fund the buy/sell arrangement for the active children, or serve as a wealth replacement vehicle if the business is not being passed on to the inactive children.
Succession planning is a big topic, and we’ve barely scratched the surface on many issues, but I hope I have explained the importance of putting a plan in place as a key part of being in business. Letting the estate plan dictate how a business is passed on may cause issues, and there are numerous stories of prominent business empires that have been significantly impacted by the lack of a well-designed succession plan.
This post is for informational purposes only and should not be considered as specific financial, legal or tax advice. Depending on your individual circumstances, the strategies discussed in this presentation may not be appropriate for your situation. The information in this material is not intended as tax or legal advice. Always consult your legal or tax professionals for specific information regarding your individual situation.