At its core, business succession planning can be boiled down to two decision-making categories: the expected and the unexpected. In transition planning, the business owner decides how they will exit, whether that entails selling to a third party, to insiders or gifting to family members. It's a plan that contemplates eventual expected events.
By contrast, contingency planning, which is what we'll focus on here, is about trying to solve for unexpected events like death, disability, and divorce. Understanding and executing estate planning documents and buy/sell agreements are crucial in this effort. Indeed, overlooking or not paying enough attention to them can have a devastating impact on the continuity of a business.
Estate plan
Key to a solid contingency plan for a business is ensuring that the owner's estate plan aligns with their goals for the business after they die. In working with business owners over the years, I have found that all too often that owners have not considered how and if their business will be passed to their heirs and, therefore, have not coordinated their wills and/or trusts accordingly.
A common provision in an individual's estate plan directs assets to be divided equally among heirs — usually children. However, this is not always ideal when it comes to the disposition of an established business. Unlike traditional investments like stock, bonds and cash, an operating company has many moving parts, including employees, payroll, clients and day-to-day decisions that need to be made in order to keep the company running. For these reasons, a detailed contingency plan for the business should be intentionally incorporated into the owner's estate plan.
A business can be the largest asset that the owner has, and owners can worry that it would not be "fair" if it wasn't divided equally among their heirs. In such cases, the owner should consider that "fair" is often not the same as "equal." If one heir has worked in the business and helped it to grow, for example, it may make more sense, and be more fair, to have them inherit the business.
There are other ways to effectively make each heir "whole" as it relates to the value of the estate. One is by using life insurance to increase the overall asset pool. Another way is to ensure that control of the business is passed to the desired heir(s) while equity of the business passes more equally. This is done by dividing the business into controlling and non-controlling shares and ensuring that the controlling shares go to the heirs who will be running the business.
Buy/sell agreement
Another commonly overlooked document is the buy/sell agreement, a contract that states what becomes of a partner's share of a business is if that partner dies or, for whatever reason, leaves the business. This document is usually created when the company is formed. Unfortunately, it is then often filed away with the other formation documents and forgotten. Three critical components of a buy/sell agreement are:
Triggering Event: A buy/sell agreement should include a thorough list of triggering events in a business that would activate the provisions of the document. The death of the owner is the one of the most commonly contemplated events but others — like disability, divorce, voluntary and involuntary termination — can have a tremendous impact on a company.
Valuation Method: One of the most overlooked pieces of the buy/sell agreement is the method used to value the business upon a triggering event. Since the buy/sell agreement is often created when the business is formed and its value is small and/or hard to determine, it is common for owners to use a flat dollar amount. This may make sense when the business is young, but over time the value usually falls far below the actual value. It is usually recommended that a third-party appraisal be used as the valuation method.
Funding Mechanism: Life insurance is a common method used to fund a buy/sell agreement. But as with the valuation issues, insurance policies that were put in place when the buy/sell was created are usually not sufficient as the business grows. The funding method should be reviewed annually to ensure that it keeps pace with the growth of the business value.
