Fundamentals of Succession Planning

Only 3 in 10 family businesses survive the transition from the first to the second generation. Only 1 in 10 of these businesses survive the transition to the third generation. These statistics point out how difficult it is to pass the family business from one generation to the next.

Succession in a public business consists of a change in management and is accomplished, at least in theory, by the board of directors choosing the most qualified person to lead the corporation. In a family business, succession is more complex because it involves the transfer of both ownership and management of the business as well as balancing the needs of both the business and the family.

It is very important that all affected parties participate in the planning process. The succession of a family business impacts more than just shareholders and management. For example, spouses of shareholders can have a significant affect on the success or failure of a succession plan, even if they are not employed by the business. The entire "family" must decide if the business should continue, how its leaders will arise, how ownership will be transferred and what the business will look like in the future.

1. A Family Decision

It is important to determine if the family members want to continue the business as a family business. At the outset of the planning process the controlling owner/entrepreneur who has worked a lifetime building the business will likely respond with a very strong "yes"! But what about members of the next generation who neither work in the business nor receive any dividends? They may be more interested in selling the business and receiving the proceeds. The answer to this question can form the foundation of a succession plan or lead the family business owner to conclude that the best approach is to sell the business.

2. Future Leaders

Second, if the family decides to continue the business as a family business, a plan to transfer the leadership of the business must be developed. This includes preparing the next generation for leadership by setting standards for entering the business, including education and outside work experience, setting objective standards to measure performance and compensation, and allowing the next generation the opportunity to test their leadership skills — giving them the chance to succeed or fail. Another aspect of the plan to transfer leadership is an objective formula or time frame for when leadership will be passed to the next generation. This may be difficult for the owner/entrepreneur who many never want to retire, but the next generation of leaders may not want to wait until they are in their 60s to get a chance to run the business.

3. Transferring Ownership

The third component of the succession plan should address the transfer of the ownership of the business. The transfer of ownership raises three issues: (a) who gets to be an owner, (b) how do they pay the new owners for their interest, and (c) what are the governance mechanisms to allow the new owners to work together?

With regard to the first issue, the family must answer questions such as:

(a.) Will the stock be passed on pro-rata to the next generation without differentiating between those who work in the business and those who do not? If so, it will be important to set up a mechanism to balance the desires of the working shareholders who are receiving a salary and may want to use excess capital to grow the business with the desires of the non-working shareholders who may want the excess capital to be used for dividends.

(b.) Creating the method for paying for the stock in the family business can be difficult. As a practical matter, the only source of funds for purchasing the senior generation's stock is the assets or earnings of the business itself. If the senior generation is paid cash it may leave the business without sufficient capital to operate. On the other hand, if the senior generation leaves their capital in the business they may be less willing to let go of control. Therefore, advance planning for the financial needs of both the business and the senior generation is essential for a successful transition.

(c.) Transferring ownership from one generation to the next usually results in an increase in the number of shareholders. Decision making by a single owner, or consensus decision making between sibling partners will probably not work when there is a large group of owners. This is especially true when there are some owners working in the business and others who are not. The common values that worked to hold the family business together may not exist with the new generation of owners. Therefore, procedures and mechanisms are needed to promote collaboration among the new owners and educate them regarding their responsibilities to the business and each other.

Conclusion

Succession planning is not an easy process and it is not done overnight. The fundamental questions that are raised in the planning process are not easily answered. Once the issues are identified it requires developing a structure — both within the family and within the business — that will allow the next generation to continue the family business.

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should consult with competent counsel with regard to specific situations.

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