When Should Succession Planning Begin?

 

There is no definitive answer. For some it begins before children are born. For others it is a last minute thing. For more still, it never happens. Does it matter? Likely. Because, there will be a succession of every business. No one has yet lived forever. Not everyone wants to run a business forever. Some businesses just evaporate.

 

Excluding evaporation, which can be a valid choice, there are several possible successions. Selling to strangers is usually the easiest. All of it or merely part? Small part or controlling part? The ideas and methods surrounding selling to strangers are immensely different from the ones where the transition is to a family member. Selling to an employee or employee group is different again.

 

Good planning will enhance value in a sale to strangers. Good planning will improve security in a sale in the family. Good planning provides for ways to deal with implicit conflicts and it avoids the creation of new conflicts.

 

For any moderately complicated business, the time required to optimize value, train the people who will provide the security and deal with conflicting views and conditions is about five years. The question is when to begin?

 

The answer to that is obvious. Begin now.

 

For example, why would you not begin to optimize value now. Structure matters. An operating business with real estate assets is worth less than the same business without the real estate assets but with a solid long-term lease and perhaps an option to buy. In the beginning the scare resource is capital. People do not want to use that for assets that are earning 8% or so. A holding company helps. It helps in more ways than just value of the operating business.

 

Developing customers, avoiding the dominant customer problem, developing worthy suppliers and building brands all add value but may not be part of the day-to-day firefighting.

 

Similarly, training people cannot provide bad value.

 

Be especially careful to plan for a method to transfer your special skills and unique knowledge. You know people and their idiosyncrasies better than anyone else in the business. Someday the new owners will need to know those things too and they will have to learn from scratch unless you provide a way. I had a client write down the name of anyone he met with, telephoned, emailed, or texted in respect to the business. Name, contact information, why he was important or useful, what particular personal data was relevant. In less than a year there was more than 700 pages. According to the son who was taking the business over, and who had worked there for several years, “I had no idea about at least half of those people.”

 

Internal family issues will arise but you can allay many of the fears with good communication and a long enough time.

 

If you leave it too long, nothing good will come of it. The death of an unprepared founder will drop the business value by a large percentage. Urgency of sale has never produced an increase in value. Anyone who has the money to buy, the expertise to operate and the inclination to act quickly, is too smart to pay full price.

 

Estate sale means bargain.

 

The last easy preparation is to own adequate life insurance. It will cushion the blow of a premature death and it will provide valuable estate options when the succession plan works out as you had hoped.

 

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

 

The Law of Non-Reciprocal Meaning

When people do a deal, each expects to get what they want from the arrangement.  Sometimes that leads to unnecessary and fruitless conflict.  In the end, neither gets what they want.  In lawyer talk, it is a good deal because they are equally unhappy.

Sometimes there is a way to get what everyone wants.  Maybe more.  Instead of looking at what the deal is, look at what the deal means.  You will find that it means different things to each party and the deal is how they will get those things.  When you start from meaning, new alternatives become apparent.

What follows is a highly simplified example and is not intended to be advice of any kind.  It is intended to be the basis for discussions with knowledgeable advisers aware of your specific resources and desires.

Parent

Father (age 62) wants to sell the family business to one of three children.  It is worth $4,000,000 ($600,000 in taxes due.)  He owns other assets worth another $2,000,000 after taxes have been paid on them.  The other two children are not involved in the business.  He wants all three to be treated equally.  Each will get $1,800,000 from his estate.

He wants to invest the after tax proceeds from the sale and spend about $9,000 per month from the income.  He will need to earn about 6% to achieve that

Father’s meaning – An estate for the children of $1,800,000 each, and $9,000 per month to spend.

Child

Wants to buy and $4,000,000 is a fair price.

Child’s meaning.  Own the business with no debt after 20 years, Pay about $28,000 per month for 20 years at 6%.  (Assumed to a bank, but parent might do it too with slight variations.)

Here’s where it gets interesting.

Over 20 years, the child will pay $6.7 million of which $2.7 is tax deductible interest and the rest is capital.  To pay that much you need $10,100,000 of corporate pretax income and you get what exactly?

  • An estate of $5.4 million.  $1.8 million for each child.
  • Looking from the buying child’s viewing point, it means $3.6 million to the siblings.  Of that $2,000,000 is made up of other assets, so only $800,000 each will necessarily come from the business sale.

Question.  Does it make sense to use $10,100,000 of pretax income to pay someone $9,000 a month of spending money when they are alive, pay two siblings each $800,000 (they split the other $2 million) when the parent dies and get an  inheritance of $1,800,000 cash?  That is $500,000 per year that cannot be used in the business.

Revising the question to address meaning.  If we assume there is no commercial risk to the business, how much pretax income would it cost to supply $9,000 per month after taxes, guarantee two payments on death of $800,000 each, and pay $600,000 of income taxes.

Using a freeze instead of a sale.  $9,000 per month paid as a dividend  requires about $205,000 per year of corporate pretax income.  The $2.2 million due at death is satisfied  with guaranteed life insurance for about $90,000 of corporate pretax income.  Total about $300,000.  A lot less than $500,000.

From the buying child’s place, either way, the result is that the business is paid for, taxes due are remitted and each sibling gets $1.8 million.  Only the cost to acquire the result is different. It is 40% lower, but you give up the $1.8 million cash inheritance.  If you want that, bump the insurance to $4,000,000 and pay an additional $75,000 or so of earnings toward the premium.  That would still leave it around 25% less costly.

There are two points of interest.

  1. Addressing the meaning of the transaction exposes alternatives.
  2. Use pretax income to compare the cost of the alternatives because that is where all the money will come from.

Freezing a corporation is a well known and straightforward tactic.  The insurance assumes a 62 year old male nonsmoker in standard health.

As with all transactions, there are many other details and alternatives and some may be important.  Like some cash up front, like an Individual Pension Plan and a lower rate on the dividend, or some other salary/dividend mix format for  father.  Most can be worked out as long as the parties are addressing the meaning of the deal.

Meaning matters.  Do not get stuck on the form of the deal or a particular number.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.  don.s@protectorsgroup.com