Business owners need succession plans for various reasons, including retirement, unexpectedly becoming disabled, and death. Family business succession planning is essential too. As business owners, you may think the family knows what to do when the time comes. Don’t assume this. Develop a legitimate plan.
In this guide, we’ll review what succession planning is, the challenges that come with it, and strategies to consider if you have a family business.
What Is Family Business Succession Planning?
Family-owned business succession planning is when the family business leader makes preparations to pass the business on to the next generation. Succession planning is critical to ensuring the long-term success of your business and that the transition is easy for your family and employees.
According to a PricewaterhouseCoopers (PwC) survey, only 34% of U.S. family businesses have a solid succession plan in place. Succession planning is a process that can take time. Start laying the groundwork early on. Plans can always be adjusted later if necessary.
Family business succession planning can include the following:
- Deciding what events trigger a transition
- Deciding which family members will run the business
- Deciding how to divide owner shares/interests
- Determining the value of the business
- Considering tax and legal implications of transition options
- Planning for inheritance equalization if not all children want a part in the business
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Succession Planning Challenges for Family Businesses
Family businesses have their own unique set of challenges. Challenges may include:
- Not all family members want to be a part of the business
- Family members have different wishes for the business
- Successor is unprepared to take over
It’s possible that all or some of your children may forge their own path and not want to take over the family business. How do you plan for your family business if your family doesn’t want to take over when you no longer can?
Family members may have different visions for the business. Some may want to continue the business for multiple generations, while others prefer to sell and use the funds for other ventures.
In a perfect world, the family business leader would happily retire, and the successor would be willing and ready to take over. But unexpected disability or death can create unforeseen circumstances. If you haven’t planned ahead, your successor may be unprepared to run a business.
Planning and preparing ahead of time is the only way to tackle these challenges.
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Succession Planning Strategies for Family Businesses
When beginning to plan for your succession, your plan should answer these three questions:
- What if I die tomorrow?
- What if I become disabled or mentally incapacitated?
- What if my family doesn’t want to take over the business?
You will need advice and guidance from your accountant and attorney when developing a business succession plan, but let’s discuss these what-ifs to start your planning off on the right foot.
Strategic Planning for the Death of a Business Owner
We all hope to die at an old age in the comfort of our own homes. But this isn’t the case for everyone; we can’t predict our death.
This is why business owners need to discuss plans with family members early on. The current generation of leaders needs to find out which family members are interested in taking over.
Involve the next generation in the business as soon as possible so they’re well prepared and have the necessary experience to take over many years into the future or, if the unexpected should occur, sooner than planned.
Besides preparing the next owner, business owners should create a buy-sell agreement. A buy-sell agreement is a contract between the family business owners to define what happens when specific events occur, such as death.
Things defined in a buy-sell:
- Who will purchase the business owner’s interest
- What events trigger the buy-sell
- How the business will be valued
- What the purchase price will be
- How the transaction will be funded
Using life insurance to fund a buy-sell agreement is one of the most cost-effective methods. A standard setup involves the business owner buying life insurance on themselves and naming the next owner as a beneficiary. Upon the owner’s death, their designated beneficiary uses the death benefit payout to buy the owner’s shares/interests from the estate.
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Using life insurance for collateral assignment when applying for loans is a common practice that almost every life insurance company and lender is equipped to handle
Strategic Planning for the Disability or Incapacity of a Business Owner
First things first, get a durable power of attorney in place. A durable power of attorney (POA) document allows you to appoint a person to manage your financial and personal affairs if you cannot do so. Unlike a simple power of attorney, a durable power of attorney remains valid even if you were to become incapacitated.
A buy-sell agreement can also mitigate a disability risk. In this case, it’s often called a disability buy-out agreement.
Without a disability buy-out agreement in place, an otherwise healthy and prosperous business could head down the road to financial disaster.
If you become disabled, not only will the business need to hire someone to replace the duties you can no longer complete, but if you’re still active in the management of the business because you need the income, your business is paying twice.
Funding a disability buy-out agreement is similar to funding a buy-sell agreement, but instead of life insurance, disability insurance is used. A price is still agreed upon in advance, as is the definition of “disability.”
Strategic Planning for Non-Involved Family Members
There are various reasons your children may not want to inherit the family business. It’s imperative to make a succession plan before your ready to retire.
Consider the following questions to get started.
What happens if no one in the family wants to take over?
If no family members plan to take over, you must start looking externally. Is there a co-owner or key employee eager to lead? Do you need to hire out? Will you be selling to a 3rd party? Will the business be liquidated?
A buy-sell agreement can help if no children plan to take over the business. If someone other than a family member wants to take over the business, such as a co-owner or an employee, they can enter a buy-sell agreement with you.
Once triggered, the new owner pays your family what your share of the business is worth (this dollar amount is determined in the contract already). The family then relinquishes their rights to the business.
What if only some of my children are interested in the family business?
Your business is likely the most significant part of your estate—the estate your children will inherit. But if not all of your children are interested in the business, what do you leave for them? The solution to this issue also involves a buy-sell agreement.
The example below helps explain this scenario:
John Washington owns a successful business. He is married and has two children.
His wife, Martha, has been instrumental in the business’s success, but she does not want to depend on it as her primary source of income after John’s death. Their eldest son, Lincoln, shares his father’s love for the business, but their younger son, Theodore, has an independent career in graphic design.
John and Martha’s goals are to:
- Ensure Martha will be financially secure.
- Leave the business to Lincoln.
- Make the inheritances of the two sons equal.
Without business succession planning, if John is the first to die, Martha inherits all of their assets, including a business she does not want. Furthermore, Lincoln would not own the company that he does want.
The issue of equalization really comes into play when Martha passes away. If Martha leaves the business to Lincoln, there will not be sufficient assets for an inheritance for Theodore. If she divides the estate equally, Lincoln will have a partner who is not interested in the business and, therefore, likely won’t be much help continuing its success.
To complicate the matter further, once the estate passes to children and not a spouse, it may be subject to estate taxes. So, another issue arises. From whose inheritance will these expenses be paid?
If these expenses are paid from the business, there likely would be no business. If they are paid from non-business assets, Theodore would end up with little or no portion of the estate. If the expenses are divided equally between the two of them—which is the likely event—this could cause the ending of the business, the liquidation of family assets, and possibly their home.
To solve this family’s inheritance issues, life insurance can be used.
John Washington should buy enough life insurance to cover at least his interest in the business. The life insurance can fund a buy-sell agreement naming Lincoln the second party to the contract.
Lincoln uses the death benefit upon John’s death to purchase the business from his dad’s estate. Lincoln then owns the company, Martha doesn’t need to rely solely on the business for her standard of living, and the estate has the cash to help equalize the inheritance to Theodore.
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Get Life Insurance to Protect Your Family and Your Business
We shared the basic things you, as a family business owner, should be thinking about. Succession planning strategies can become very complicated. A plan requires careful preparation. Work with your accountant, attorney, and financial planner to ensure everything is set up accurately and can be carried out smoothly.
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Start the process by getting a term life insurance quote today. Window-shop in peace without giving up any contact information, and know that your information will never be sold..