Five Mistakes to Avoid when Succession Planning
By Sam Brownell, CFA
In our work with independent business owners across the country, we often witness common mistakes that create problems for the owner, their family, and their business. As the owner of a business, the day-to-day responsibilities can sometimes be overwhelming. Providing high-quality service to customers, overseeing corporate strategy, developing and retaining high-quality employees, and keeping up with a myriad of economic challenges, e.g., inflation and supply chain, are just some of the essential daily tasks that can take a business owner’s attention away from thinking about the future. However, ignoring the importance of succession planning can impact the net worth you and your family have built and lead to issues in retirement.
Sam Brownell
For most independent business owners, their business is their largest asset. Unfortunately, it is also a highly illiquid asset. Therefore, monetizing the value of your business requires at least two-to-three years of planning. Putting work into increasing the value and marketability of your business during the succession planning and implementation period is critical to creating sustainable value for the key stakeholders – you and your family, the incoming owner(s), and your loyal employees and customers.
We believe that being proactive with your succession planning is much better than reacting to an unexpected event, e.g., death or disability, and can set up the owner for a successful retirement. Here are the five most common mistakes we see in our succession planning work with independent business owners.
1. Not Knowing the Value of Your Business: Most business owners think their business is worth more than it is to an objective, third-party observer. Because the business is oftentimes the owner's largest asset, not having a clear picture of what the business is worth makes planning for a secure retirement almost impossible. Our best advice for business owners is to get an independent third-party valuation of the business at least 3-5 years before they would ideally retire. Knowing the current value of the business allows owners to calculate whether the value of the business plus their other assets will be enough to sustain their post-ownership standard of living. Further, knowing the value of the business years before a planned exit allows the owners to implement strategies for increasing the value of their business and making it more marketable to internal and external buyers.
2. Not Diversifying Wealth: Most business owners are planning for the sale of their business to fund their retirement goals. This makes sense since owners typically reinvest most of their profits to grow the business, and that reinvestment should earn a strong return if growth is properly managed. However, in practice, a privately held business is an illiquid asset that can take many months (if not years) to sell. Therefore, prior to and throughout the succession planning process, a business owner should diversify their net worth by using more liquid retirement planning options such as company 401(k)s and cash balance plans to maximize the amount they are shielding from taxes while they work on preparing their business for sale.
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3. Not Reviewing Legal Documents: Most legal documents cover death but oftentimes miss one or more of the following trigger events: disability, divorce, personal bankruptcy, termination, and retirement. Business owners need to review their legal documents with their advisers every two-to-three years or when a material event occurs, e.g., a spouse diagnosed with dementia. These ongoing reviews enable the owner(s) to make updates that reflect their current and retirement goals as well as those of their family and their business. This is true for both professional documents, e.g., Operating Agreements, Stock Purchase Agreements, etc., and personal documents, e.g., wills, trusts, etc. These documents never seem that critical until they are, and at that point they become paramount to the protection of the owner's retirement planning, family, and legacy.
4. Not Considering Every Ownership Transfer Option: A key piece of every succession plan is how the sale of the business is structured. Therefore, it is critical that an owner considers every option available to create a market for their shares or ownership interest. Most owners have thought about a sale to a family member or to a strategic competitor, but what about to their employees through an Employee Stock Ownership Plan (ESOP) or Worker-Owned Cooperative (Co-op)? It might surprise owners to know that, if properly structured, a sale to your workers could allow you to defer paying capital gains tax on the sale and provide attractive tax mitigation options for the business post-sale. For example, a C Corporation could defer taxation on the sale by selling at least 30% of its shares to an ESOP or Co-op in the first year of the ownership transition and then investing the proceeds in individual stocks and/or bonds of U.S. companies. Knowing all your options allows a business owner to consider the best avenue for bolstering their retirement assets while leaving their business with the best possible ownership for long-term success.
5. Not Planning for Taxes: Every business owner would enjoy getting a check for millions of dollars, but if they haven't planned for the tax consequences, they could end up paying 40% or more of the gross sale value in taxes. Paying $4 million in taxes on a $10 million sale of the business is enough to leave anyone feeling sour. Assembling a team of qualified professionals who know the owner's business and industry, the owner's goals, and the tax consequences of each ownership transition option can help the owner keep more of the value they have created over their lifetime. We encourage all owners to remember that the net value you receive once all taxes and fees have been paid is what matters to your retirement planning and your family’s net worth.
In our experience, many business owners don’t start the succession planning process because it adds another complicated task to an already overwhelming list. However, starting too late can prove extremely costly to your retirement and legacy planning efforts. Most business owners will only sell their business once, so it’s important that you make the most of it in order to secure your post-ownership goals.
About the author: Sam Brownell
Sam Brownell, CVA, CFA, is the owner and founder of Stratus Wealth Advisors, a wealth management firm specializing in financial planning, succession planning, and business valuation for independent business owners.
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