What are the essentials of a business succession plan?
In launching a new business, entrepreneurs need to consider what the best business structure will be and how to arrange for funding, as well the how to bring their products to the market. What many startups fail to recognize is the need for business succession planning. If the future prospects of the business are strong, the owner needs to ensure business continuity when he or she is no longer at the helm. This requires choosing a successor, establishing the value of the business, obtaining life insurance and determining the best method of transfer.
Who should be the successor?
Many small business owners choose to appoint a family member to take their place. If they do so, it is essential that the designated individuals have the needed skills, experience and desire to take the reins. Furthermore, there may be other business partners or key employees who are better suited to take over or who will be required to work with successor family members. In any event, a business succession plan should specify guidelines for running the business, the role of the successors, and a method for resolving disputes.
What is the valuation of the business?
There are three ways to determine the value of a business: the asset approach, the income approach and the market approach:
Asset approach
The asset approach evaluates the stated assets and subtracts the liabilities. This is a fundamental analysis of the business’ balance sheet that does not factor in market conditions or reputation (good will).
Income approach
This method is an analysis of past earnings, as well as a projection of future earnings, which entails evaluating future cash flow and capitalization. The goal is to determine the present or future value of the business.
Market approach
The market approach involves a comprehensive analysis of similar companies in the industry that have been sold. Such an approach must take into account differences between the company being evaluated and the companies it is being compared to, in terms of size, duration and market risk of the business.
Obtaining Life Insurance
In the event that an owner, partner or key employee dies, it is essential to have life insurance on such an individual to ensure the sustainability of the business. Life insurance can provide the funds to buy out the owner’s interest or deceased partners’ share in the business.
Transferring the Business
Generally there are two methods for transferring a business: cross purchase agreements and entity purchase agreements, depending on the exigencies of the type of business. In a cross purchase agreement, each partner buys and owns an insurance policy on the others. If one partner dies, the face value of the policy is paid to the remaining partners who use the proceeds to purchase the deceased partner’s interest. In an entity purchase agreement, the business purchases a single policy on each partner and the business is also the beneficiary. In the event of a partner’s death, the business uses the proceeds to buy out the deceased individual’s share.
The best time to devise a business succession plan is when the company is being created. This will minimize the potential of conflicts among family members, partners and minority investors. In the end, a business succession plan should be part of a comprehensive estate plan and a small business owner should consult with an estate planning attorney to explore all the options.