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. Professionals

    How to Protect Elderly Clients from Predators

    Advisors dealing with older clients face a specific set of difficulties. Here's how to help protect them.
  2. Retirement

    Strategies for a Worry-Free Retirement

    Worried about retirement? Here are several strategies to greatly reduce the chance your nest egg will end up depleted.
  3. Professionals

    Small RIAs: How to Level the Playing Field

    In order to compete with larger firms, small RIAs have to get a little creative. Here are a few ways to kickstart growth.
  4. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  5. Professionals

    How to Manage a Client's Return Expectations

    One of the most critical functions of an advisor is to set realistic return expectations for their clients. Here are some ways to achieve this.
  6. Markets

    The 5 Biggest Canadian Insurance Companies

    Learn more about the insurance industry as a whole, how it functions in Canada, and the five largest Canada-based insurance companies.
  7. Entrepreneurship

    Top 5 Startups That Emerged in Denver

    Learn why Denver is one of the hottest markets in America for startups, and identify five of the top startups that are emerging from the Denver market.
  8. Entrepreneurship

    How Does ClassPass Work and Make Money?

    Find out how ClassPass makes money, how the company aims to help both businesses and consumers, and why it has been so successful.
  9. Professionals

    What Kind of Insurance Do RIAs Need?

    Advisors spend a lot of time discussing insurance with clients but they also need to consider their own coverage needs as small-business owners
  10. Entrepreneurship

    Top 5 Startups That Emerged in Detroit

    Learn how startups are changing the face of Detroit, a city long dominated by large corporations, and identify the specific Detroit startups leading the trend.
RELATED TERMS
  1. Venture Capitalist

    An investor who either provides capital to startup ventures or ...
  2. Cost Test

    A standard test applied to a process to determine if the net ...
  3. Enterprise Investment Scheme (EIS)

    A UK program that helps smaller, riskier companies to raise capital ...
  4. Per Transaction Fees

    An expense a business must pay each time it processes a customer’s ...
  5. Operating Cost

    Expenses associated with administering a business on a day to ...
  6. Path To Profitability (P2P)

    A clearly defined route to profitability as described in a business ...
RELATED FAQS
  1. How has Google's operations strayed from its original mission statement?

    Google's (GOOG) mission statement has been the same since its inception in 1998: "Organize the world's information and make ... Read Full Answer >>
  2. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  3. What are the main factors that impact share prices in the insurance sector?

    The main factors that impact share prices in the insurance sector are interest rates, earnings and actuarial risk. In the ... Read Full Answer >>
  4. Why do insurance policies have deductibles?

    Insurance policies have deductibles for behavioral and financial reasons. Moral Hazards Deductibles mitigate the behavioral ... Read Full Answer >>
  5. Can I buy insurance to reduce unlimited liability in a partnership?

    Partnership insurance is actually quite common. Most of the time, partners buy insurance to safeguard against the possibility ... Read Full Answer >>
  6. Which emerging markets are seeing the strongest growth in the insurance sector?

    The emerging market economies seeing the strongest growth for the insurance sector are primarily the main emerging market ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!