For many small business owners, maintaining positive cash flow and a stable balance sheet can be an ongoing battle that consumes virtually all of their time. Even retirement often seems like a distant speck on the horizon, let alone plans to hand over the business. However, establishing a sound business succession plan is beneficial for most business owners and can be absolutely necessary for some.

Tutorial: How To Write A Business Plan

For business owners that are at or near retirement, the issue of succession cannot be ignored. This article will take you through the steps you'll need to take to create a successful succession. (To learn about other retirement considerations, see Managing Income During Retirement and Life After Retirement.)

Picking a Successor Isn't Easy
Many factors determine whether a succession plan is necessary, and sometimes the logical and easy choice will be to simply sell the business lock, stock and barrel. However, many owners prefer the thought of their businesses continuing on even after they're gone.

Choosing a successor can be as easy as appointing a family member or assistant to take the owner's place. However, there may be several partners or family members from which the owner will have to choose, each with various strengths and weaknesses to be weighed and evaluated. In this case, lasting resentment by some or all of those not chosen may result, no matter what choice is ultimately made. Partners who do not need or want a successor may simply sell their portion of the business to their partners in a buy-sell agreement.

How much is the business worth?
When business owners decide to cash out (or death makes the decision for them), the first task is establishing a set dollar value for the business, or their share of it. This can be done via appraisal by a certified public accountant (CPA) or by an arbitrary agreement between all partners involved. If the portion of the company consists solely of shares of publicly traded stock, then valuation of the owner's interest will be determined by the stock's current market value.

Life Insurance: The Standard Transfer Vehicle
Once a set dollar value has been determined, life insurance is purchased on all partners in the business. Then, in the event that a partner passes on before ending his relationship with his partners, the death benefit proceeds will be used to buy out the deceased partner's share of the business and distribute it equally among the remaining partners.

There are two basic arrangements used for this. They are known as "cross-purchase agreements" and "entity-purchase agreements". While both ultimately serve the same purpose, they are used in different situations.

Methods of Transferring a Business
Cross-Purchase Agreements
These agreements are structured so that each partner buys and owns a policy on each of the other partners in the business. Each partner functions as both owner and beneficiary on the same policy, with each other partner being the insured; therefore, when one partner dies, the face value of each policy on the deceased partner is paid out to the remaining partners, who will then use the policy proceeds to buy the deceased partner's share of the business at a previously agreed-upon price.

Example: How a Cross-Purchase Agreement Works

Imagine that there are three partners who each own equal shares of a business worth $3 million, so each partner\'s share is valued at $1 million. The partners want to ensure that the business is passed on smoothly if one of them dies, so they enter into a cross-purchase agreement. The agreement requires that each partner take out a $500,000 policy on each of the other two partners. This way, when one of the partners dies, the other two partners will each be paid $500,000, which they must use to buy out the deceased partner\'s share of the business.

The obvious limitation here is that, for a business with a large number of partners (five to 10 partners or more), it becomes impractical for each partner to maintain separate policies on each of the others. There can also be substantial inequity between partners in terms of underwriting and, as a result, the cost of each policy. There can be problems even if there are only two partners. Let's say one partner is 35 years old and the other is 60 years old; there will be a huge disparity between the respective costs of the policies. In this instance, an entity-purchase agreement is often used instead.

Entity-Purchase Agreements
The entity-purchase arrangement is much less complicated. In this type of agreement, the business itself purchases a single policy on each partner and becomes both the policy owner and beneficiary. Upon the death of any partner or owner, the business will use the policy proceeds to purchase the deceased person's share of the business accordingly. The cost of each policy is generally deductible for the business, and the business also "eats" all costs and underwrites the equity between partners.

3 Reasons to Have a Business Succession Plan
Creating and implementing a sound succession plan will provide several benefits to owners and partners:

  • It ensures an agreeable price for a partner's share of the business and eliminates the need for valuation upon death because the insured agreed to the price beforehand.
  • The policy benefits will be immediately available to pay for the deceased's share of the business, with no liquidity or time constraints. This effectively prevents the possibility of an external takeover due to cash flow problems or the need to sell business or other assets to cover the cost of the deceased's interest.
  • A succession plan can greatly aid in allowing for timely settlement of the deceased's estate.

The Bottom Line
Proper business succession planning requires sound preparation. Business owners seeking a smooth and equitable transition of their interests should seek a competent, experienced advisor to assist them in this matter.

Business succession is just one retirement consideration; for more, see Getting Started On Your Estate Plan.

Related Articles
  1. Entrepreneurship

    10 Characteristics Of Successful Entrepreneurs

    Do you have the qualities of a successful entrepreneur? Those who do tend to share these 10 traits.
  2. Investing

    5 Up and Coming Social Media Startups

    Although the days of Facebook's dominance aren't close to being over, here are some new creative platforms gaining traction on the worldwide web.
  3. Your Practice

    Advisors: $240B in Fees Up for Grabs by 2030

    Advisors have an opportunity to win generational assets over the next 15 years. Here are some tips on how to cater to different demographics.
  4. Products and Investments

    Cash Value vs Term Life Insurance: Which is Best?

    The debate between cash value life insurance and term insurance plus an investment plan is an ongoing one. Here's a look at both sides of the argument.
  5. Your Clients

    How Advisors Can Make the Most Out of Volatility

    Advisors can use market volatility as an opportunity to enhance their value to their clients and grow their practice. Here's how.
  6. Personal Wealth & Private Banking

    What People Hate About Financial Advisors

    Advisors need to make a living too, but doing so by cutting corners at a client's expense isn't right. Here are the top complaints against advisors.
  7. Entrepreneurship

    Are You Really an Entrepeneur? A Reality Check

    If you are going to be an entrepreneur, and you’re doing it on a shoestring, you’ll need more than a good idea. Here are some skills to master.
  8. Your Practice

    Top Insights Into Winning More Wealthy Clients

    The upcoming young and wealthy client class is like none other when it comes to wealth advising preferences. Here are some hints to what these folks want.
  9. Entrepreneurship

    Digital Nomads in the Modern Economy

    Digital nomads compose a growing portion of the modern economy.
  10. Career Education & Resources

    Laws & Regulations To Know Before Changing the Name of Your Business

    Discover some of the most important steps you need to take after making a decision to change your legally established business name.
RELATED FAQS
  1. Do working capital funds expire?

    While working capital funds do not expire, the working capital figure does change over time. This is because it is calculated ... Read Full Answer >>
  2. How does escheatment impact a company?

    In recent years, state governments have become increasingly aggressive in enforcing escheatment laws. As a result, many businesses ... Read Full Answer >>
  3. How much working capital does a small business need?

    The amount of working capital a small business needs to run smoothly depends largely on the type of business, its operating ... Read Full Answer >>
  4. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
  5. Do beneficiaries pay taxes on life insurance?

    Generally speaking, when the beneficiary of a life insurance policy receives the death benefit, this money is not counted ... Read Full Answer >>
  6. Can I borrow from my annuity to put a down payment on a house?

    You can borrow from your annuity to put a down payment on a house, but be prepared to pay an assortment of fees and penalties. ... Read Full Answer >>
Trading Center