When it comes to succession planning for closely held business owners, there are two distinct concepts at play. The first deals with the identification and cultivation of the future internal management of the business. The second, and most frequently discussed aspect, addresses the ownership change of the business. A truly effective business transition addresses both the management structure as well as the impending ownership change in unison.
Internal management ≠ ownership
The owner(s) of many closely held businesses often act as internal management due to the fact that the business is the result of an entrepreneurial effort of the founder. But, as the company grows, most successful entrepreneurs learn that it’s neither effective nor efficient to continue performing all management functions, so they hire managers and/or key employees. It’s important that your succession plan identifies and places qualified people in the top management positions to prepare internal management to eventually lead the business. It’s also advisable to secure employment agreements with the managers because it adds value to the business.
Entrepreneurs frequently want their business to stay within their family. One of the top mistakes made in succession planning is not realizing that the next generation of family members may not be interested or capable of running the business. Just as dangerous is placing non-family members in key management roles for which they are not qualified. The ultimate test is to take an unbiased look at the management team and answer the question, “Are they able to continue the business down its current path?”
Ensure the board of directors are visionaries
Just as the day-to-day management of the business needs a structured plan, so does the visionary aspect of the business. The owner, board of directors or internal management can all be the visionaries. Therefore, a succession plan for the visionary leaders must be in place. This is especially important when the board of directors consists of the ownership’s family members. The visionary leadership of the company is just as important as the day-to-day management. Often, a business survives to the second generation only to find the entrepreneurial vision of that generation is lacking and the result leads to stagnation.
The old horse and buggy versus automobile analogy comes to mind. Companies with foresight for the future will adapt and grow, while those who lack vision will stagnate or die. Visionaries for your business may be found in many different places. They may be your family or friends, internal business management, or even your competitors. When you’ve identified a person with vision, the board of directors may be a good place for them. They may also be a good candidate for ownership.
Define exit strategy in conjunction with management planning
The owners of a business drive the direction in which it will travel. That’s why it’s important to consider the future intentions for both management and the board of directors in the ownership transition. It’s much more than simply gifting ownership in your company to your children; it’s also understanding whether the family heirs are equipped to thrive in a leadership role and determining if they have a desire to do so.
If the answer to either of those points is no, then passing the business to your heirs may not be the best alternative. Detailed management planning helps identify the best exit strategy. If planning identifies that there are others better equipped to lead the company, then familial heirs may simply become passive owners. If that’s the case, then it’s helpful to detail how leaders and future owners will work together.
How does selling to a third-party impact internal management?
Selling to a third-party may be a sound option to transfer ownership if the familial heirs do not have the ability or desire to fill the leadership role. While bringing in a completely new ownership team often adds fresh business perspectives and ideas, it can also mean new challenges for the internal management team. Even though this option to transfer ownership can be the most lucrative, it can also be the riskiest. It may prove to be the end of employment for some employees, the end of the company you built or both.
Transition ownership to employees
Another viable, yet not widely considered succession option, is to sell to an employee stock ownership plan (ESOP). The leadership of internal management, as well as visionaries, are very important for a successful ESOP. And, in some cases, the exiting owner is able to maintain a role in the management and vision of the business, further enabling the grooming of the successors.
An ESOP is a qualified retirement plan where the employees benefit from the business’ success via participation in the ESOP retirement plan. Direct ownership of the stock is with the ESOP trust. Employees benefit because the value of the stock in the ESOP is paid in the form of retirement benefits. Employee-owned companies have proven to be more efficient and effective than their non-employee-owned peers. What better way to reward your employees than making them all owners and stockholders?
Without a plan, the business simply ceases operation
Finally, if there’s no plan in place or something happens to the owner before there’s a solid plan, the business may be forced to shut its doors and close forever. This leaves the internal management team and all employees without a job, and the family receives no benefits, as the company no longer has any potential worth. The stark reality is that 70 percent of family-held businesses don’t make it to the second-generation. Sadly, this statistic shows what happens when business owners ultimately fail to adequately plan for the future of their business.