You’ve done well.
You have built a successful practice. Now you’re thinking of the next stage—retirement and maybe passing the business on to one of your children. How do you go about it?
The first step is to seek the best advice available. Your own experience in helping people make wise financial choices should underscore the importance of obtaining a detached, expert view. Bart Basi, Ph.D., CPA, president of the Center for Financial, Legal and Tax Planning, Inc., a consulting firm in Marion, Ill., believes that succession planning should begin as early as possible in the life of a business. This is particularly true for service-based organizations, which often depend heavily on the principal parties. Without a succession plan, a company can lose valuable market share while the succession issue is worked out-sometimes under the added stress of the death of the owner. Managing succession is especially important for small firms because they may lack the resources and alliances needed to sustain them during difficult times.
According to Larned S. Whitney, CPA, a sole practitioner in Benicia, Calif., business owners should start thinking of succession the day that they open the doors of the business. But Whitney, who often offers advice on succession as part of his annual tax function, acknowledges that this is not usually the case. “With many people,“ he says, “the business takes over their lives, and then suddenly they’re left with a situation of having not planned adequately for succession.”
Whitney emphasizes to his clients that succession planning is an inescapable issue. He has learned that the more he repeats this message, the harder it is for his clients to ignore it. “Eventually [the owner] is going to leave that business,” Whitney says. “[He’s] either going to walk away from it or be carried away from it.”
In addition, there can be problems for a business owner in his 50s or 60s who has not given any thought to succession issues. “The options become slightly less open,” he says, “because we haven’t got the time to do the planning. We haven’t got the retirement plan in place, especially if the parents are looking at the business as their retirement.”
Valuing the business
Donald J. Jonovic, Ph.D, president of Family Business Management Services in Cleveland, begins succession planning by looking closely at the client’s priorities. “The first thing I do,” he explains, “is talk to the owner to try to get some sense of what his personal goals are in terms of how much, how long and how deeply he wants to be involved in the company.”
The next step is to work out what all of the stakeholders are looking for from the business. Stakeholders would include children and in-laws and even employees. Usually, there is little consensus within this group. Jonovic observes that the potential for conflict “is built into the system.”
Owners must then examine their compensation strategy. “That forces them to look coldly at the organization as a business, not as a lifestyle,” he says. It also separates the owner’s goals from those of the business. Another area to look at is the future of the ownership. How will a transfer be made? Will there be multiple owners? What will the buy-sell agreement look like?
John Marklin, CPA, the owner of Marklin Financial Services in Richmond, Va., also begins succession planning by getting a feel for a client’s priorities. He will then point the client toward obtaining tax and banking advice. Marklin wants to know, for instance, whether the client wants to cash out quickly, or if he is more focused on setting up a child in the business.
Marklin may advise a client to bring in a business broker or appraiser to value the company. Owners of private companies often believe that their firms are worth more than they really are. He may also have to warn owners that their businesses are not attractive to buyers because privately held companies lack the ability to exchange shares easily and do not offer ready access to verifiable information.
Buyers are likely to consider factors like the future demand for a business’ products and services. “You’re not going to pay a high multiple for a mature business,” Marklin says. “You’re going to pay a higher multiple for a growing, thriving business.”
In valuing a business, Basi looks at three years of sales and places greater emphasis on the current year. He also considers factors such as the size and nature of the market, the client profile, the strength of the organization itself and its long-term prospects. With a financial services firm, Basi would look for a client base that includes businesses whose own employees might be developed into clients. He would also be wary of firms that were overly dependent on a few large clients.
Basi has found that gross margins in service industries are averaging around 53 percent of sales. Multiples, he says, have been running from .85 to 1.3 of gross margins. A firm with a gross margin of $1 million, for instance, might sell for $1.3 million. “On the other hand,” Basi says, “we might have to sell it for $800,000.”
Family-owned businesses also need to take note of the increasing complexity of the environment in which they operate. Globalization and the development of technology mean that family-held businesses must be more open to the idea of bringing in skilled executives from the outside. This means sharing equity and status. Whitney, as a CPA, also reminds clients that even the smallest of businesses must be aware of the implications of tax laws and environmental and privacy regulations.
New legislation has made the tax picture more complex. And although those in the insurance industry have the advantage of understanding tax laws better than most of their clients, the complexity is always going to be there. That’s why outside advisors may be needed.
Jonovic regards the succession process as relatively simple, but says that clients are often overwhelmed by its apparent complexity. One way of unraveling this complexity is to assemble an advisory board that includes the firm’s lawyer, accountant, insurance specialists and any other key experts. These advisors are then encouraged to pool their knowledge. “Treat them almost like a board of directors,” he says, “and start addressing all these issues on an ongoing basis.”
One of the most serious mistakes owners make is to leave people out of the process and do things by fiat. Another is to fail to separate the three main issues a business faces: ownership, management and strategy. Jonovic also argues against a culture of secrecy. “Secrecy is pandemic in closely held businesses,” he says.
Keeping it in the family
Succession involving family members can be fraught with difficulties and can often stir up deep emotional issues. If the owner is handing the business over to a son or daughter, the owner must make it clear that the offspring should be treated as an employee instead of as the offspring of the owner.
Basi relates the story of how he fired his own son. While working for the business during his summer vacation from college, he began reminding people in the office that he was the boss’ son. This conduct was so disruptive that the other employees offered to match the son’s salary if he would just stay away from the office. Basi blamed himself for failing to establish the right tone from the outset.
Apart from the normal tensions of family life, there may be multiple siblings with different life goals. Also, individual relationships within families are constantly evolving. A father who has always made the decisions, and announced them in no uncertain terms, may now be confronted with a child with a brand new MBA and lots of new ideas about how to run the business.
Delving into these situations, Whitney says, is like peeling an onion and always finding new layers. “I have gone to any number of presentations and seminars by everybody, from marriage and family counselors all the way through to financial planners,” Whitney says, “and I have yet to hear anybody say there’s an easy way to do it.”
Basi says that it is easy from a legal and tax standpoint to transfer ownership to the next generation. He uses a technique called a stock redemption program. This involves giving the owner’s child one share of stock, which represents 100 percent of the company. The parent gets a note from the company and receives payments that are taxable at the flat rate of 20 percent rather than the 35 percent to 40 percent rate that is likely to apply to salary.
“We effectively cut taxes in half,” Basi says. If repayments are missed, the former business owner can quickly reassert control. Insurance is also available against default. For a stock redemption program to work, however, the parent must be willing to give up control.
Marklin does not advise owners to sell the business to their children in exchange for a note. This would effectively make the parents the banker. Instead of relieving them from the stresses of the business, it would immerse them further. There are also tax rules that disallow favorable capital gains treatment within a family sale. Further, banks may be wary of intra-family succession deals because of the young age of the buyers and the departure of the person who knows the business best-the former owner. The bank’s caution may be reflected in a higher interest rate and down payment.
Proceed with caution
Principals who are looking toward succession should learn to act as mentors, gradually delegating increasing responsibility to others and allowing them to make their own mistakes. They should also reduce their own client contact and focus more on bringing in business. Business owners need to make themselves dispensable, but often find such advice difficult to accept. Ceding control to anyone is not part of their nature but is necessary to ensure the future of the company.
This method of making a gradual transition works well with families. Rather than selling a business to an inexperienced 22-year-old, a parent can bring the son or daughter into the operation and, over a period of five years or so, give the child a variety of jobs with increasing responsibility and remuneration. During this time, the owner can gradually transfer stock in the form of tax-exempt gifts. At the end of the five years, the child will be a 27-year-old chief executive officer with, perhaps, 20 percent of the company in his or her name.
During this long transition period, the parent can gradually spend less time with the business. Meanwhile, there would have been no change in ownership from a tax standpoint. In such circumstances, a bank is likely to look favorably on a request for a loan to finance the sale of the remainder of the business.
Marklin cautions against giving away too much too soon. He once warned a client: “Your children are children. You turn your keys over to your children, and the business may not be here in five years.”
Business owners must also realize that their offspring may not be the best option for succession and the continued health of their company. Basi, for example, has found it necessary at times to advise a client in the strongest terms against turning a business over to a child. The son or daughter may either not want the business, or may not be capable of running it.
He recalls one case in which two sons were eager to stay with the family firm but lacked the financial skills necessary for the company’s continued survival. The solution was to give the sons long-term employment contracts and then sell the business to a buyer who recognized the importance of the sons to the success of the enterprise.
Basi sometimes finds himself dealing with a client who insists, against the best advice, on turning a business over to a child who has no interest in it. He argues that an owner who goes ahead with such a transfer might be faced with one of two unpleasant surprises: The child might run the business into the ground, or he might turn around and sell it, pocketing a large sum of money and leaving the father with nothing.
Before offering his advice, Basi reviews the state of a business and makes a one-day site visit, talking to the principal parties. Then he returns to his own office and develops draft recommendations for discussion with the principals and their advisors. “We fine-tune them,” he says, “and once the set of recommendations is ready, we start implementing.”
The implementation typically takes about six months. He recalls one case that took only 30 days, while another was a “horror story” that lasted for more than two years. “Every time I came up with something,” he recalls, “somebody threw a monkey wrench into it.”
Skilled financial advisors can often find themselves with the same succession-related difficulties that other business people have. Many fail to apply their expertise to their own situations. Jonovic says, “It’s like doctors who study the human body but still smoke, eat too much and don’t get any exercise.”
When it comes to planning for succession, advisors who have built successful, independent practices should listen to the advice they give to their clients every day: It’s never too late to begin planning. And, for the best results, the planning should begin right now.
Robert O’Connor is a London-based freelance writer and a frequent contributor to Advisor Today.