A Case Study: Why Succession Planning is Important
Partner's Perspective
by Cindy S. Johnson, CPA, CIT, partner
John, the owner and founder of a successful manufacturing firm, is about ready to sell his company and reap the rewards of a lifetime of hard work: a comfortable, financially secure retirement with his wife in their cabin in the Catskill Mountains.
There’s just one problem. John doesn’t know how he’ll exit the business. He always thought that one of his two sons, who have been working in the business with him for years, would eventually take over when he was ready to retire.
But lately, it has become clear that this isn’t going to happen. His oldest son has lost interest in the business and has begun searching for a new career, and his youngest son simply doesn’t have the desire or skills to run the company. As a result, since John has decided he doesn’t want to retain the business without family involvement in management, his options are to sell the company to an inside group of management employees who have expressed interest in buying the business from him, or sell it to an outside buyer.
Factors to Consider
Whether selling the business or transferring it to family members, there are a number of factors John should consider as he looks at his options:
What are his objectives? The answer to this question will lay the groundwork for all the decisions John must make. For example, if his primary goal is to get the most money possible in order to maximize his retirement income, this could make it difficult to sell to insiders, who may require more flexibility in the price and payment terms.
Conversely, if successful continuation of the business as a legacy and ongoing security and contentment of his employees are most important to John, he might be willing to accept less money and longer (perhaps riskier) payment terms from insiders in order to make the sale to them possible.
How strong is the existing management team? Obviously, this would be a key consideration if selling to insiders, because John must have confidence in their ability to run the company after he’s gone. But outside buyers will likely have a keen interest in the strength of management as well.
It’s important to note the difference between management succession and ownership succession. John should identify and train a strong successor management team as soon as possible, as well as prepare to transition his key business relationships (with customers, vendors, suppliers, etc.) to the successor owners. A buy-sell agreement should be a key part of the ownership succession process.
How much demand is there in the marketplace? John should begin gauging the potential demand for his business among the three primary types of outside buyers:
- Complementary buyer: This would be another business in a niche or industry that complements John’s business. Candidates would be companies that could strengthen themselves and/or open new doors of opportunity by adding John’s company.
- Strategic buyer: This would likely be a competitor that can bring enhancements to John’s company’s products and services by merging, and thus strengthening both operations. John must be very careful with this strategy; cultural clashes are one of the biggest causes of failure for business mergers.
- Private equity investor: These may be venture capitalists or “angel” investors whose goal is to invest money into and grow the business in order to sell it at a profit later. Such investors are generally in search of companies with strong management teams in place and clear growth opportunities.
A business broker or mergers and acquisitions consultant can help John gauge the potential demand for his business and serve as a go-between with interested parties.
Is he willing to assume any kind of post-sale role in the business? It’s not uncommon for buyers to expect the owner to stay on board for a period of time after the sale to help ensure a smooth transition. John could do this as a paid employee, consultant or board member. This arrangement can be negotiated as part of the sale terms.
What are John’s liquidity needs? These will help dictate how the purchase is financed. Since John will use proceeds of the sale to finance his lifestyle during retirement, he needs to ensure a consistent stream of income for the rest of his life. If he collects the entire purchase price at closing, he can deposit or invest it and then make regular monthly withdrawals to meet his living expenses.
If he agrees to finance the purchase himself through a structured buyout, he could structure the payout to assure similar regular monthly payments. The benefit is that he could charge interest on outstanding amounts. The drawback, however, is that John is assuming some risk if the business fails before he has received the entire purchase price.
If John doesn’t need the liquidity for retirement income, considering an employee stock ownership plan (ESOP) transaction might allow him the opportunity to defer income tax on the gain on his sale transaction.
What is the business’s value? John should have a formal business valuation conducted by an unbiased, outside professional to establish a baseline from which price negotiations can begin. There are a number of things he can still do to position the company most favorably for sale and maximize the potential price, such as paying down excessive debt, filling key open positions, making sure all legal documents and contracts are current, and documenting the business’s financial controls.
Start Planning Now
The process of succession planning is crucial in helping ensure that owners reap rewards from the years of hard work they put into growing their companies.
Don’t end up in a situation like John’s — ready to exit your business and retire, but without a plan in place to make it happen. Had he started the process earlier, there’s a chance he could have successfully groomed one of his sons as a successor.
Start thinking right now about your exit strategy and begin laying the foundation for a solid succession plan that will meet your objectives and ensure the successful continuation of your business.
Please call or email me at cjohnson@bobermarkey.com for help in creating a succession plan and devising exit strategies for your company.
Reducing Taxes on the Sale
There are myriad and complicated tax issues involved in selling a business, so our hypothetical business owner John should work closely with his accounting professional to implement tax reduction strategies. Together, they should establish and implement legal and tax structures at least one year prior to selling to help reduce John’s potential tax liability. Here are two thoughts to consider:
- In general, sellers can reduce their tax liability by structuring the sale of their business as a stock transaction. Buyers, however, generally prefer to purchase the assets of the business in order to benefit from immediate write-offs. This will likely be a key point of negotiation between John and any potential buyer.
- If John is going to finance the purchase himself, he can defer some of the taxable income and help cushion the tax hit by extending the terms over several years. However, this must be balanced with his liquidity needs and the additional risk he might be assuming.
For more information, contact Cindy Johnson, partner, at 330.255.22437 or by email.