I was recently on a trip to South America with a few clients. During one particularly long hiking day in Patagonia, the conversation turned to a client’s business. The client has a small, but highly profitable professional service business.
He’s run the company for 40 years and would like to retire in the next five to 10 years. A few years ago he brought his son, who is in his mid 20s, into the business. The son has flourished in the position—exceeding expectations.
On the trail, my client wanted to brainstorm ideas on the best way to transition the company. He specifically focused on what kind of payout would be appropriate, valuation, timing and tax implications.
There is no doubt these are critical considerations that need to be analyzed and addressed. However, I suggested we think about things a little differently.
Focus on long-term succesS
Whenever you think about business succession planning, there are two tracks you should consider. The first is the mechanics of the deal. These are the things my client focused on, such as valuation and tax implications. The second, and more important track, at least initially, is to focus on ensuring the long-term success of the transition.
What does this mean? It means making sure that whoever you transition the company to will be in a position to lead and effectively run the company. Seems obvious, but surprisingly I often see more time and energy spent on the mechanics of the transition than on making sure the people who are going to run the company have the skills and confidence needed to run the company.
This is less concerning for those who have a larger company and are receiving 100% of the purchase price on the date of sale. However, this is also rare. Most often the purchaser will pay a smaller percentage in cash at closing and then, over time, will pay an earn-out based on the success of the company.
In that case, or in the case of my client transitioning to a younger family member, there may be very little cash received at the time of the sale. When this occurs, the majority of the purchase price is paid for over time from the company’s profits.
Educate and Empower the New Owners
This is why the long-term success of the company is so important. You can hire the best legal and tax team available to work on the mechanics of the transition, but if you don’t educate and empower the new owners, the company will flounder and the expected transition proceeds will never materialize.
The biggest risk isn’t a low valuation or missing a tax loophole. The biggest risk is the future success of the company because all, or most, of the buyout occurs after the sale is completed. This is why it is critical to spend time, energy, money and resources doing whatever is necessary to ensure your succession team is confident, skilled and ready to guide and grow the company.
On the flight home, my client and I worked on a five-year empowerment plan. We identified all the critical areas of the business and scored his son’s knowledge and confidence in each area on a scale between 1 and 10. In several categories his son scored 9s and 10s, but in a few received 1s and 2s.
This simple process provided a snapshot of where his son excelled and where he needed help. We then created a calendar over the next three years of where my client should focus his efforts.
If you own a business and are considering a transition to a family member, think about all the areas that are critical for the success of your business. Now think about your team. Can they take over? If not, you know where you need to focus.
Spend your time and resources here rather than the mechanics of the transition. Once your team is ready to take over, then shift your focus to the deal.
For additional assistance developing the succession plan for your business, reach out to a CFP® professional today.