Linda E. Wasielewski, P.L.C.

SUCCESSION PLANNING FOR THE FAMILY BUSINESS

The sustainability of the family owned business is governed by succession planning.

Succession planning refers to a comprehensive approach to plan for the transfer of a family business from one generation to the next. Included in this planning are state and federal tax, labor management, business organization and capitalization, family dynamics, financial management and enterprise management considerations.  Few families have individually designed succession plans. Many families do not know how to develop a plan or where to start developing it.

The consequences may be disastrous if a family business is allowed to pass by testamentary or intestate process to heirs who fragment the productive assets through partition among the testamentary or intestate heirs.  If one or more heirs are involved in the business and rely on it as their primary income, that heir may be forced to purchase the shares of other heirs to keep the business operating under her or his control. Incomplete or inadequate family business succession planning often results in heirs who are incapable of running the business, family conflict, prolonged legal battles, and partition of family-owned and operated business assets to satisfy heirs who want to "cash in" their share of the business rather than invest in it.

As the owner of a family owned business, the business succession issues for you and your family are more complicated given that a higher proportion of your overall wealth is tied up in business assets when compared with other people in general.

Succession, in any family business, is a process rather than an event. So, the sooner you start the process, the better your chances of success. In many cases, business owners give thought to a succession plan, but they put off implementation. This can cause serious problems if you leave the business earlier than planned due to death or illness. Your successor will be making his or her first key business decisions during a difficult time and the health of the business could suffer.

General comments about family businesses

As an owner of a family business, chances are you’ve worked hard to build your business and you want your business to continue to thrive after you retire, whether your children succeed you or you sell your business to others. Chances are that your business is your biggest asset, so doing all you can to maximize the value of it when you do exit from it is vitally important to your financial future.

Planning to ensure your family business’s success

As a business owner you are busy. At times you feel there are barely enough hours in the day to keep up with the day-to-day pressures of family and business, and long-term planning can seem like a luxury you just don’t have time for. But, as an experienced businessperson, you also know that without proper planning, businesses (and families) don’t flourish.

This article is intended to help you start thinking more about a number of issues you should consider to plan for your financial future and for your business’ future. This article focuses mainly on succession planning for your business, as well as some business planning strategies you should consider.

Why families don’t retain their businesses

A surprisingly small number of family-owned businesses survive transition to the second generation. There are two common reasons why families don’t retain their businesses. The first reason is straightforward: there is no qualified successor. However, even if your business will not be passed down to the next generation, making sure you take steps to ensure the value of your business survives is just as important and is really just another form of succession planning.

The second major reason is more unfortunate - family businesses fail or are sold off because of a lack of planning. Though most of us are careful to safeguard our personal assets, for example, insuring our homes, many businesspeople do not plan ahead to safeguard the value of their business.

For business owners, their business is their single largest asset in terms of value. But, beyond that, their business also represents a major source of self-esteem and personal worth. In short – for many business owners, their identity is very much wrapped up in their business. So, thinking about how they might exit the business means they must come to grips with personal identity issues. Consequently, many just don't want to think about the day when they retire and are no longer running the business.

In addition to the fear of retirement, the business succession process must invariably deal with the business owner's death. Surveys showing how few of us have prepared a will are clear evidence that death is difficult for most to contemplate.

Finally, for those individuals making it past the first two succession planning hurdles (contemplating retirement and death), there is one more tough issue that is easy to put off: picking one child as your successor while ensuring you are being fair to all your children. In addition, the business may only support one family.

All of these issues are difficult to deal with. Because it takes time to thoughtfully address these issues, planning for your succession is – by necessity – a process rather than an event. Also, given that most of the major decisions to be made are of a personal nature, the process used to manage each family's business succession will vary greatly depending on the nature of the family issues involved. Consequently, there is no one approach that will work for all business owners.

The succession planning process – an overview

In broad terms, the business succession process involves the following stages:

1. Determine whether succession within the family is a viable alternative

2. Develop your succession plan

3. Monitor the implementation of the plan, and make changes as necessary, and

4. Coordinate your succession plan with personal tax planning for retirement and the distribution of your estate.

Each of these steps is equally important. For example, excellent succession plans can be ineffective if they are not properly implemented and sophisticated estate plans can become ineffective if they are not coordinated with a business owner's plan for succession.

This is a process. The success of the process will depend on a number of factors, including: a desire to make it work, healthy family relationships, and trust, honesty and openness among family members.

Is succession a viable alternative?

Determining whether succession to a family member is good alternative is an obvious first step but doing so is not always straightforward. Many business owners do not carefully consider all the issues when deciding whether succession to a family member is realistic.

Business owners often have a plan in their own mind – take the case where one of the children has been active and effective in the business. In such a situation it may seem obvious to you what's going to happen – that child will succeed you. But the goals of that child may not be in harmony with this plan. Alternatively, some children may be overlooked as a successor because their views and general outlook on business issues differs greatly from that of the founder (due to human nature, we often relate better to people who share the same style and values).

In many cases, problems can arise right at the beginning if you do not deal appropriately with two key questions:

1. Are my children interested in succeeding me?

2. Are my children capable of running the business when I retire?

To deal with these questions fully, both communication and objectivity are important. Have you actually asked your child whether he or she wants to succeed you? And if you have, are you sure he or she was truthful in his or her response (knowing how strongly you feel)? Objectivity in terms of assessing your child’s ability to run the business is also important.

Assessing a child’s interest in the business

It’s important to remember that it is difficult to be objective during this process. You have devoted a great deal of time and resources to developing your business and you should be proud of what you have achieved. Your feelings toward the businees is probably obvious to your family, which creates potential problems:

• Some business owners may find it difficult to accept that a child does not share his or her interest in the business, and

• A child may find it difficult to tell the parent that they are not interested in succeeding them in the business.

For some, a good way of working through these problems is with the help of an outside family business advisor. Family members, especially children of the business owner, may be more willing to share their feelings about the business, both pro and con, with an independent advisor. The role of an advisor at this stage is to help with information gathering within the family, usually by interviewing family members individually and by then facilitating open discussions between the family members.

Assessing a child’s ability

Succession will only work if your business is passed on to a child who has the skill to run it. Where there is one obvious interested candidate, the process is more straightforward – you can focus on evaluating that family member's abilities.

Choosing between interested and capable children complicates this process.  What should you do if more than one child is interested in, and capable of, taking over? The business may be limited by the size and profitability of the operation – could your business support two or more families? This will need to be analyzed if you are considering the shared leadership options.

Having to choose among possible successors is often one of the main reasons many business owners do not deal effectively with the issue of succession. As parents, we try to treat all children fairly, which usually means treating them as equals. However, when it comes to succession, the reality is you will likely have to pick one child to be your successor.

It is possible to pass on control of your business to various children as partners, but the success rate for this sort of arrangement is generally not as good as you might think, and to pull it off, your children will need a strong sense of trust and harmony as a group. In most cases, however, it is best to choose a single leader, and many cases it may be the only option.

This is not an easy process.  Parents can't bear the idea of rating the strengths and weaknesses of their children.  If one of your children uses a management style similar to your own, it may be difficult for you to be objective when comparing that child to another child with a different management style.

Building objectivity into the process may also help your children deal with the succession process. Though the children who are not chosen may still find the decision difficult to accept, the fact that objectivity was brought to the process should help make the choice easier for all to deal with.

Shared Leadership

Choosing a single leader is usually recommended. There are, however, some structures involving the sharing of control that have been successful for some families. There are two basic approaches that have been known to work:

Family “partnerships”

Family partnerships can work if each child is a full partner and the partnership agreement specifies that complete consensus is required for all important decisions (note that we are talking about a decision-making arrangement at this point and not necessarily a legal structure). This alternative works in situations where the children see each other as equals and there is a strong desire among the children for succession of the business within the family. If a single leader is chosen and other children in key positions within the business do not accept the choice, the conflict created could destroy both the family and the business.

First among equals

One child has more control over most day-to-day decisions, but important, fundamental changes are decided on by the group. In this situation, the boundaries of the leader's responsibilities should be clearly defined and disclosed to all. This option is generally considered where 3 or more children will be involved, and that may not be an option for many business operations.

The success of both arrangements will depend on shared vision and a strong enough bond among the children that will allow for successful teamwork. The children will need to adopt a balanced approach to building consensus, as very few business partners will agree on everything. As one would expect, the family partnership arrangement is the more difficult of the two to successfully implement.

Another approach that some families consider is the idea of rotating control among the children. Though this approach appears to deal with the issue of fairness, it is often a poor business decision. Becoming a leader of a business is a learning process and rotating leadership among a group will more than likely mean the business constantly has a leader in training. In addition, from a customer's point of view, the business can appear to lack clear direction if each successive leader takes the business in new areas.

What happens if you can’t identify a successor?

After working through the process of determining whether any of your children have both the desire and capability of succeeding you, you may decide succession within your family just won't work. You could reach this conclusion for a number of reasons, including, for example:

• None of your children are either interested or capable

• A child has the potential to succeed you, but is not yet ready

• You have children who are equally interested and capable, but you feel selecting one child over others is not worth the risk of disharmony within your family (or your potential successor may not want to take on the job, given the feelings of the other family members).

Alternatives to passing the business on to a family member

If you conclude that passing the business on to a single family member won’t work, there is an option to consider that may fit the bill:

Sell the business – after all the issues are considered, the best option may be to simply sell the business and realize the value of the assets. Once you have decided that a sale is the best alternative, you can make plans about how and when to sell, so that you maximize the value of your business. You can establish an estate plan around the proceeds you will receive from the sale of your business. Remember, passing on a business to new owners is really just another form of business succession.

Succession plan development and implementation

Once you have decided that family succession makes sense, the next phase is to develop a plan, and begin its implementation. Given that the succession plan should be tailored around the unique characteristics of both your family and your business, every succession plan will be different. Consequently, rather than outlining a specific plan you should use, we’ll look at several elements that are common to most successful plans:

• clearly identify your successor and his or her role

• transition your successor aboard

• accept the necessity of a succession plan

• keep the plan as open as possible

• establish a clear timetable for the process

• develop a clear business plan that extends beyond your retirement

• seek outside advice

• retain key non-family employees, if any, and

• realize that fairness and equality are not the same thing

Clearly identifying your successor and his or her role

To be effective, your succession plan should clearly identify who will succeed you and what their role will be. For example, simply transferring your business to a child and allowing him or her to decide how to run it is not a succession plan and doing so often has a poor chance for success. It will be much easier to effectively transfer control if family members fully understand their current and future role in running the business.

Family businesses are successful because of the presence of a strong leader, which means an ability to make important business decisions quickly to capitalize on opportunities as they arise. Consequently, there is a strong bias toward having a clear leader, even though there is potential for disharmony within the family.

Transitioning your successor

Once the successor is named, the goal becomes making sure the successor will be ready to take control when the time comes. There are several ways to meet this goal, including:

• Allow your successor to participate in business decisions – in the beginning, you will have control over major business decisions. You should allow your successor to be involved, passing on more responsibility for important decisions as time passes.

• Meet key contacts – Allow your successor to see how you manage relationships with important customers, suppliers and other key business contacts. Also, this will give them an opportunity to become comfortable with your successor.

• Allow your successor to work in different areas of the business – the best way to learn about the business is to be directly involved in different areas of it. Be careful, however, to select the work experiences so as to ensure the experience gained is a valuable learning tool.

• Gradually allow your successor to assume your duties – once he or she has a good knowledge of your business and has been involved in decision-making, the next step is to gradually pass on your responsibilities.

• Accept the necessity of a succession plan

Remember - a succession plan is a plan for change – therefore, for the plan to be successful, a business owner must accept that there will be major changes as the implementation of the plan proceeds. So, for example, the current leader must consciously accept that, over time, the chosen leader will become responsible for more business decisions and may take the business in new directions.

If the current leader keeps a tight rein on decisions or exhibits an unwillingness to change, these are sure signs that the founder has not totally embraced the idea of succession. This can create a great deal of frustration for both the founder and the successor and could ultimately cause the successor to move on to other pursuits.

Keeping the succession plan as open as possible

As with any important plan, this plan will have a better chance of success if everyone involved has a clear understanding of the plan in general and of each person's role in particular.

The plan must be written and made available to all those directly involved in the succession process. The succession plan should be discussed with all who will be affected by it. This means disclosure should go beyond your family – key non-family employees, key customers, suppliers, lenders, and other key business contacts should be aware of your plans.

During discussions with those directly involved, consider going beyond the details of the plan itself. For example, rather than just telling those involved what decisions have been made, it may be useful to explain why certain decisions have been made.

Always keep in mind that the way you communicate is important, especially with respect to discussions within the family. Plan meetings specifically to discuss the succession plan and other issues facing the business. This allows family members to focus their attention on the issues facing the business.

Establishing a clear timetable for the process

Establish a clear timetable so those involved know exactly what will be expected of them and when. Vague time references should be avoided. For example, if your plan merely states that it is your intention to continue working until the day-to-day responsibilities become too much to handle, your successor will be left uncomfortably waiting for the inevitable – your illness or death. At a minimum, definite dates should be set for the following events:

• retirement of the business owner

• transfer of ownership, and

• transfer of voting control (if the business is corporately-owned)

Many business owners will want to retain overall control and ownership until death, though they are comfortable giving up day-to-day control before then. The key is to make sure everyone involved is aware of your intentions and the time frame.

Once you have set a specific timetable you should stick to it. If the timetable is not followed, the credibility of the entire plan will suffer greatly in the eyes of all involved.

Developing a clear business plan that extends beyond your retirement

A clear plan and direction for the business will greatly benefit your successor- one that extends beyond your retirement. Involve your successor in the development of the plan - it will be a valuable learning experience for him or her. Though your successor may take the business in a different direction in the future, a detailed business plan will get him or her off to a good start.

If you have non-family employees who are key to the business, keep these employees during the succession process - it will be important. The first issue is to ensure that these employees are fairly remunerated.  Keep in mind that key employees may feel they are working for you rather than for the business - as a result, it is important they are informed of the succession plan, its progress and its affect on them.

Also, it is important that key employees have respect for your intended successor. This respect will have to be earned over time but it can actually be won or lost before the succession process begins. The application of a few simple rules can pay dividends down the road:

• Encourage your children to work outside of your business before joining – it will  enhance the credibility of your children in the eyes of non-family employees. Also, the child may develop a higher level of self-confidence and may be in a position to bring new views and ideas to the business.

• Avoid premature promotions of family members – If it appears to employees that a child has been promoted before his or her time, then both you and the child will lose credibility. Even if the child later proves capable, the loss of credibility will be difficult to recover from.

• Try to treat family and non-family employees equally – your employees know that family members do enjoy a special status as employees of the business. However, making an effort to treat all employees equitably will benefit you and your successor in the future in terms of things like productivity and loyalty. So, it’s a good idea to: pay reasonable salaries to all employees based on work performed, carry out performance reviews for both family and non-family employees, and involve both family and non-family members in key decisions, where appropriate.

Realize that fairness is not synonymous with equality

When developing a succession plan, treating your children fairly does not necessarily mean your children should be treated equally. It is generally a good idea to choose one leader because having the business run by your children as equals often does not work.

Where there will be children active in business and others who will not, one option that can help is an agreement on how the proceeds from the business will be divided if it is sold.

Due to these issues, there is no better tool than asset diversification – those business families that can build-up non-business assets will be ahead of the game in terms of dealing with disharmony within the family when it is time to transfer the business to the next generation. One powerful tool for this purpose is life insurance.

Other business planning strategies to consider

Shareholder agreements for Family Business Corporations

If you are transferring ownership of your business, either directly to family members as part of your estate plan, a shareholder agreement is an important tool you should consider. A shareholder agreement is an agreement that governs the conduct of the shareholders and it should address all areas of possible concern. With such a broad mandate, the possible contents of a shareholder agreement are endless.

Each business will have different concerns, and the importance of the issues will vary. But, in general, a shareholder agreement for a family business usually deals with the following key issues in addition to more general business concerns:

Share ownership rules

For many family businesses, the rules that govern who can own shares are the most important part of the shareholder agreement. Specific areas that should be addressed include:

• Who will be allowed to hold shares of the business? In most cases, ownership will be restricted to family members. For example, many shareholder agreements prohibit in-laws from becoming owners.

• What happens in the case of marital breakdown? Where the shares of a family business constitute a large proportion of a couple's property, there is a chance that some shares can become property of the soon to be ex in-law. There are several ways a shareholder agreement can deal with this. For example, the agreement could require that, as a condition of becoming a shareholder, each family member must have a premarital or post-nuptial agreement that specifically carves out the shares from the category of family property. Or, the agreement can provide that the shares must be immediately offered for sale to the rest of the family on marriage breakdown.

Buy/sell rules

A shareholder agreement should also include rules regarding when and how shares can be transferred. For example:

• Can shares be transferred to non-family members? There are two basic scenarios that should be addressed: a sale of shares by one family member and a sale of the entire business by all family members. For a sale by an individual family member, the agreement can be restrictive – for example, it could state that all shares must be owned by the family, so only transfers between family members will be allowed. Another option would be to allow for a sale of shares to non-family members, but would require that the shares must be offered to the rest of the family first. For a sale of the entire business, you may also want some special rules. For example, for the approval of such a sale, will a simple majority be sufficient or should a higher threshold be set?

• How will the shares be valued? As most agreements will allow share transfers at least within the family, the agreement should set out rules for valuing the shares. Note that the valuation method chosen must be reasonable to avoid potential tax problems.

• New shareholders must be a party to the agreement – Where share transfers are allowed, the agreement should also require that the new shareholder must sign on to the shareholder agreement as a prerequisite for share ownership.

Disability of a shareholder

The agreement should address the procedures to be followed when a shareholder becomes disabled, especially where that shareholder is an employee. In particular, the agreement may provide for disability payments, and perhaps a requirement that the shares be sold to other family members in the case of prolonged disability.

Death of a shareholder

Finally, the agreement should set procedures to follow on the death of a shareholder, including consideration of the following:

• Can shares be transferred to the shareholder's heirs on death? Depending on the succession plan for the family business, the family may want to restrict who, if anyone, can inherit shares on death. If there is a requirement that the shares must be sold or redeemed, insurance can be used to provide the funds required.

• Use of proceeds from corporate-owned life insurance – Where the corporation holds the life insurance on the business owner, the shareholder agreement should set out how this insurance is to be used. For example, the insurance proceeds could be used to redeem the deceased's shares or can be paid to other family members to buy shares from the deceased's estate.

This is by no means a complete list of issues you should address in a shareholder agreement. The agreement should also provide rules that will help you deal with any other issues you think might arise. By setting out the ground rules in advance in a shareholder agreement, the potential for family conflict will be lessened in the future when these issues arise.

Retirement planning and estate planning considerations

Retirement planning and estate planning go hand-in-hand with succession planning – and should be considered at the same time – because all three relate to planning for your future and your family’s future. Retirement planning is especially important for business owners because they often pour money earned through the business back into the business rather than taking out enough (in salary, bonuses or dividends) to save for their own retirement. Indeed, the founder’s financial needs in retirement are often a critical factor driving other succession plan issues, such as timing of the founder’s exit from the business and the structuring of business ownership. Succession will likely fail if funding the founder’s retirement puts too great a strain on the business, so retirement planning should start as early as possible.

Estate planning, on the other hand, is usually aimed at maximizing the value of your assets (including the preservation and protection of property during your lifetime) and minimizing and/or deferring tax and other costs arising on your death. As well, estate planning is meant to provide for an orderly transition of assets to your beneficiaries and usually includes providing for your dependants. Once you have set your succession plan you should ensure your estate planning goals are coordinated with this plan.