1. Advanced Planning
June 2013
Wealth
Planning Insights
Contents
You can't take it with you: Succession
planning for small businesses Pages 1 – 3
Business succession planning is the process
of selecting and preparing successors to a
company's current managers and owners.
The goal is to allow an organization to
continue to conduct business even in the
event of a key individual's unexpected
departure.
Buy-sell agreements can provide clarity
in a time of transition Pages 3 – 5
Do you know what would happen to your
company if you were to retire or pass away?
Are you certain that your partners would
agree with what you think?
Disclosures Page 6
You can’t take it with you:
Succession planning for small businesses
As the principal of a small business, you have a unique role in the
company. Your efforts have produced a thriving enterprise, and created
value for your family. However, there may come a time when you are
ready to take a reduced role within the company or step down entirely.
Even the most ardent business owners must plan for how their death
could impact operations. Advanced planning helps to ensure that new
management is prepared and that a departing owner (or his or her
estate) receives proper compensation for the business. This month,
Wealth Management Consultants Bill Shad and Lance Cholet
share the benefit of their experiences with these issues.
What is business succession planning?
Bill: Business succession planning is the process of selecting and
preparing successors to a company's current managers and owners.
The goal is to allow an organization to continue to conduct business
even in the event of a key individual's unexpected departure. Business
succession planning is critical to the survival and stability of any
organization.
Are there particular issues when it is a family-owned business?
Bill: In my experience, there are two distinct types of small businesses
in the US: family-owned and all others. Planning for either type of
business can vary in complexity, but planning for a family-owned
business has an additional emotional overlay that has to be taken into
account. For example, the next generation of owners may not agree on:
who should be in charge
what each family member's roles and responsibilities should be
equity ownership
overall compensation.
2. Wealth Planning Insights June 2013 Page 2
The main things to
think about are who
will run the business,
and how the
ownership interest
will be transferred.
It may be advisable
for you to plan for a
gradual step-down of
responsibilities.
Some family members may want to be active owners, deeply integrated
in day-to-day operations. Others may want to receive their share of the
profits, possibly pursue an unrelated profession or just relax on the
beach. Then there could also be that family member who is incapable
of working for the business but wants to be actively involved.
What are some ways to treat differing family members fairly?
Lance: You could structure the agreement to allow you to sell shares
and control of the business to children who are active in the business
and use the proceeds from the sale to provide for children who are
not. If you wish to hold the shares until death, you could bequeath
them to family members active in the business, but also purchase life
insurance in a trust benefitting other family members, so that the
ultimate value passing to each of your family members is equal.
Does a business succession plan need to be memorialized?
Bill: Ideally, yes. A properly drafted business succession plan will help
lay out the terms of engagement for each family member. For
example, you could decide whether upon the death of an owner,
there is an automatic buy-out of his or her interest, or if the deceased
partner’s family members can remain as owners.
What are the critical components of a good business
succession plan?
Lance: The main things to think about are who will run the business,
and how the ownership interest will be transferred. These are two
different issues, but they are intertwined.
Bill: Particularly if the business is a sole proprietorship, it is very
important to think early about who will succeed you as leader. It is
important to have time to pass on all of the lessons you have learned
in your years in the business. Also, who do you want to own the
business? It does not necessarily have to be the successor manager.
For multi-person businesses, you have to decide if the remaining
partners will continue on by themselves, or if they will want to bring in
a replacement for you.
Lance: Your ownership interest can be transferred by gift/bequest or by
sale. Therefore, an important part of many business succession plans is a
buy-sell agreement, which could govern either of these situations.
How can I take care of my income needs once I have
transitioned the business?
Bill: It may be advisable for you to plan for a gradual step-down of
responsibilities. Allowing for plenty of transition time can create a two-
fold benefit—there is more time for you to pass your knowledge and
expertise, and avoid suddenly stopping your main income stream. You
could also structure any payments made under a buy-sell agreement to
be made over a period of years. Keep in mind that whether you are
3. Wealth Planning Insights June 2013 Page 3
A buy-sell agreement
(also known as a
buyout agreement)
spells out what
would happen to an
owner’s equity in the
company if he or she
were to become
disabled, retire, die
or want to sell.
earning a salary for services, as opposed to a payment for an equity
interest, will have different income tax consequences. This is another
reason to make sure to seek legal counsel regarding these matters.
Any final thoughts?
Lance: A well-drafted business succession plan, aligned with a proper
buy-sell agreement (see companion article), can allow a business to
continue to operate during times when ownership changes occur.
Ideally, business management can transfer smoothly, remaining
owners do not have to worry about being partners with the departing
owner’s designees, and the departing owner is fairly compensated for
his or her equity in the business.
Bill: This is definitely an area where the advisor can add value. Many
business owners may not have thought about these issues before.
From my experience, discussing succession planning also leads to
conversations about the owner's personal net worth and the planning
that can be done in that arena as well.
Buy-sell agreements can provide clarity
in a time of transition
Do you know what would happen to your company if you were to
retire or pass away? Are you certain that your partners would agree
with what you think?
Buy-sell basics
A buy-sell agreement (also known as a buyout agreement) spells out
what would happen to an owner’s equity in the company if he or she
were to become disabled, retire, die or want to sell. Ideally, the
agreement would (1) describe how the owner's interest would be
disposed of (e.g., who would be permitted to or required to buy it,
terms of sale, and more), and (2) ensure that the owner, or the estate,
is fairly compensated.
These matters may also be governed by an operating or shareholder's
agreement. Such documents often have loosely written language
about who can buy shares and when. However, an operating or
shareholders' agreement likely is missing two of the most critical
components of the buy-sell agreement: the method of valuation for
the business and a plan to ensure that the remaining owners have
adequate liquidity to buy the departing owner's stake.
A buy-sell agreement provides certainty about what will happen after
an owner leaves the business. Without an agreement, co-owners may
be forced into partnership with the former owner's transferees or
heirs. This may not be the desired result.
4. Wealth Planning Insights June 2013 Page 4
You can also build in
transfer restrictions
by prohibiting the
sale or transfer of
shares to unwanted
third parties (i.e.,
non-family members
or spouses).
Provisions typically found in a buy-sell agreement
A well-drafted buy-sell agreement will state clearly, and in detail, what
happens if a co-owner exits the business (whether by choice or due to
death or disability). Specifically, how does the ownership interest pass?
The transfer needs to be orderly, and mutually beneficial to the exiting
co-owner and the remaining co-owners. Also, the transfer of ownership
should not disrupt the ongoing operation of the business.
Ask yourself a simple question. If one of your partners suddenly died,
would you want to be partners with his or her spouse? Even if he or
she merely wanted to retire, would you want to do business with
someone of his or her choosing, or someone you selected? Perhaps you
would rather buy the interest yourself—increasing your voting share.
Let's discuss the typical scenario for a three partner company.1 Each
partner has a one-third equity ownership interest in the business.
The business started in 2000. In 2013, the book value of the business
is estimated at $10 million. If one of the co-owners would like to exit
the business, how does one proceed? A multitude of questions come to
mind immediately. But two of the most important are—what is the real
value of the business? And how do the remaining co-owners come up
with the funds necessary to buy the first out?
A buy-sell agreement may discuss a number of issues:
who has the first right (or obligation) to purchase a departing
owner's shares (i.e., the other owners or the company)
what type of event will trigger a buyout—for example, death,
disability, termination of employment, or an offer by an outside
party to purchase the owner's interest
the valuation method that will be used to determine price
the source of funding for a buyout.
Agreeing on these issues in advance will save time and energy later on.
You can also build in transfer restrictions by prohibiting the sale or
transfer of shares to unwanted third parties (i.e., non-family members
or spouses). You may wish to provide exceptions to allow transfers of
interests for estate planning purposes or pledges of interests as
collateral for outside credit (perhaps with the consent of the other
owners).
Funding the purchase
It is important to ensure that a party who has guaranteed to buy
an equity interest actually has the liquid funds to do so. A buy-sell
agreement is designed to deal with unexpected events—if a
prospective purchaser's main asset is his or her own interest in the
same company, then he or she may have trouble raising capital to
complete the purchase. Therefore, while a business line of credit or
1
This is a hypothetical example for illustrative purposes only.
5. Wealth Planning Insights June 2013 Page 5
Many times business
owners want to save
on the cost of a
properly drafted buy-
sell agreement, but
an attorney can
anticipate issues that
you might never
think of on your own.
the personal wealth of the co-owners will sometimes be sufficient to
facilitate and fund the buy-sell agreement, it is important to analyze
your individual circumstances to determine if additional funds might
be needed.
In cases where liquidity is an issue, life insurance is a common
strategy—each owner purchases life insurance on the other(s). Should
an owner die, the remaining owners may receive the life insurance
proceeds estate and income tax-free. They would be obligated to use
these funds to purchase the deceased owner's shares from the estate.
This would convert an illiquid asset (the business interest) to a liquid
one, which might be welcomed by an otherwise-illiquid estate. For
buyouts that may be triggered upon the disability of an owner,
disability insurance may be used to fund the purchase.
If you draft a buy-sell agreement and fund it with insurance, make sure
the insurance is actually purchased. There have been many unfortunate
cases where the buy-sell was completed, but it was discovered too late
that the owners never purchased the agreed-upon insurance.
Two common mistakes to avoid
It is almost never helpful to use a fixed valuation clause in a buy-sell
agreement. Business values change drastically from year to year based
on gross revenues, changes in the tax code, profit margins and
geopolitical landscapes. Consider a method based on an earnings
multiple or profit margin to determine the valuation of the business.
Finally but most importantly, use an attorney to draft the contract.
Many times business owners want to save on the cost of a properly
drafted buy-sell agreement, but an attorney can anticipate issues that
you might never think of on your own.
–Lance Cholet
Wealth Management Consultant
–William Shad
Wealth Management Consultant
Wealth Planning Insights features the intellectual capital of UBS in
financial planning, estate planning, and philanthropy. Articles are
written by specialists in the UBS Wealth Planning and Advanced
Planning Groups. These groups consist of professionals with
advanced degrees, extensive planning experience and subject
matter expertise, who provide a wide range of planning advice
and education to UBS clients.
