Succession Planning: Be Prepared for Ownership Transitions

Succession Planning: Be Prepared for Ownership Transitions

April 18, 2023

Succession planning is one of the hallmarks of building a business that can last. Both buy-sell agreements and formal succession plans play a vital role in maintaining a business’s continuity following an ownership exit, and valuations inform the practical financials of creating a strategy that works.

When to Begin Planning?

While there is no set timeframe on when a business owner should begin the succession planning process, generally, planning should start at least five years prior to the owner’s anticipated exit. And even if there is no expectation for a near-term exit from the business, many advisors still recommend having a buy-sell agreement in place.

Buy-Sell Agreements

Buy-sell agreements provide a mechanism for establishing a transaction price and providing for the funding and payment terms of a buyout upon certain triggering events, which can include a shareholder’s death, divorce, or departure from the business. They may also contain other governance provisions that provide an orderly transfer of ownership with restrictions on the transfer of shares to prevent ownership from falling on unrelated parties.

As such, buy-sell agreements are an important tool to ensuring continuation of the business by providing an orderly transfer of ownership. Effective buy-sell agreements can also present options that allow for changing facts and circumstances associated with the company and its shareholders. Regarding the provisions related to purchase price, when practical, the price should be determined based on an independent third-party valuation as of the date of the triggering event. An independent valuation would be the most accurate measure of fair market value (compared to alternative methods, such as a static formula approach) and would also serve to mitigate unintended valuation and tax-related consequences.

The Ideal Succession Plan

A succession plan provides a roadmap to achieve a successful exit. Doing so forces the owner to focus on the execution of the overall strategic plan of the business and to implement value creation strategies to enhance the value of the business over the owner’s remaining time with the company.

An ideal succession plan both makes sense from a financial point of view and gives the owner greater control over the timing and method of an exit. Further, a successful succession plan allows for greater multi-generational wealth creation, provides greater options that align with the owner’s long-term goals for the business (e.g., keeping the company as a family-owned business), and reduces stress and uncertainty among family members and employees.

Proper succession planning should also consider the use of revocable or irrevocable trusts, generation skipping trusts (GSTs), grantor retained annuity trusts (GRATs), or other legal structures to minimize tax liabilities during the wealth transfer process. The business owner should work closely with an estate and trust attorney to plan accordingly based on the objectives and timeframe of the owner. When the intent is to transition the business to family members, there are also important tax considerations that can greatly increase the after-tax net proceeds.

Similar to buy-sell agreements, an independent valuation is important in the context of succession plans since the valuation will determine how much wealth transfers. An independent valuation also satisfies IRS adequate disclosure requirements when filing a gift tax return.

Quality Third-Party Valuations

According to a 2022 Business Owner Perspectives study,1 61% of business owners believe it is important to know the value of their business. However, only 21% of respondents considered a valuation for purposes of estate planning. An even lower percentage of business owners considered a valuation for purposes of establishing a buy-sell agreement between partners.

Ultimately, a quality valuation plays a vital role as ownership plans for the continuity of the business following an owner’s exit.

1. “2022 Business Owner Perspectives Study: Insights from America’s Economic Engine,” MassMutual, 2022.