Succession planning

In short

A friend of mine spent thirty years building a plumbing shop and never once wrote down who would run it next. If you own a small business, you have probably felt that same quiet worry. Start by naming the people who could take over, whether family, staff, a partner, or an outside buyer. Then ask each one, gently, if they want the job. Get a fair value on the business and put it on paper. Write a buy sell agreement, which is a contract that sets the price and terms for a future sale. Meet with a lawyer and a tax professional before you sign anything. You are not being gloomy by planning. You are being kind to everyone who depends on you.

The whole of it

What it is

I once watched a neighbor's hardware store close its doors within a year of his passing. The shelves were full and the customers were loyal. What was missing was a plan. Succession planning is the work of deciding who will own and run your business after you step back, and how that handoff will happen. You may step back by retiring, by falling ill, or by simply wanting a change. The plan covers three questions. Who takes over the daily work? Who takes over the ownership? How does the money change hands?

You have probably noticed that these are three different questions. A daughter may love the shop and have no cash to buy it. A loyal manager may run the place well and never want to own it. Good planning lets you match the right person to each piece. It also protects your family if something happens fast. A business with no plan can lose most of its value in a hurry, because customers, lenders, and staff all get nervous at once.

How it works

A woman I know sold her bakery to two longtime employees, and it went smoothly because she began five years early. Time is the friend of every good handoff. The work moves in stages. First you choose a path. The common paths are passing the business to family, selling to employees, selling to a partner, or selling to an outsider. Each path has its own tax rules and its own feel.

Second, you get the business valued. A valuation is a professional estimate of what your company is worth. Owners often guess too high or too low, and both mistakes cause trouble. Third, you put the terms in writing. A buy sell agreement names who may buy, when they may buy, and how the price is set. Many owners pair it with life insurance or disability insurance on the owner, so the buyer has cash ready if the worst happens. Insurance here is a funding tool. It is not a recommendation to buy any particular policy.

Fourth, you train your successor. If you are holding the only key to every customer relationship, your successor will need years to earn that trust. Introduce them slowly. Let them make small calls, then bigger ones. Fifth, you plan the tax side. Selling a business, giving it away, and leaving it in a will are taxed in different ways. The Internal Revenue Service explains the basics of gift tax, estate tax, and capital gains on its website at irs.gov. The rules change, so a tax professional should check them against your own facts.

If you sell to your employees, one route is an employee stock ownership plan, often called an ESOP. It is a retirement plan that buys shares of the company for the workers. The Department of Labor and the IRS both publish guidance on how these plans must be run. It takes real paperwork, so it suits some firms and not others.

The numbers, and where to find yours

You have probably wondered what the tax bill might look like. It depends on the path you pick. Three figures matter most, and the law sets them, so we do not print them here as fixed facts. The first is the yearly amount you can give to one person without filing a gift tax return, which is the current figure, which the official source publishes each year. The second is the lifetime amount you can pass on before federal estate and gift tax applies, which is the current figure, which the official source publishes each year. The third is the long term capital gains rate that may apply when you sell a business you held more than a year, which is the current figure, which the official source publishes each year.

You can find your own numbers in a few places. The IRS publishes its gift and estate tax pages and its capital gains guidance at irs.gov. Your business tax returns show your basis, which is roughly what you have put into the company. Your accountant can pull your ownership percentage from your corporate or partnership records. The Small Business Administration, at sba.gov, has free guides on selling or transferring a business. If your state has its own estate or inheritance tax, your state revenue department posts those rules too. Gather these before you meet your advisers. It saves you money and time.

A worked example

A friend of mine named Ruth owns a small print shop. She is 62. She wants to retire at 67 and hand the shop to her manager, Daniel. Here is how her plan might run, with plain figures we chose for the story.

Ruth hires a valuation firm, and it says the shop is worth 400,000 dollars. Daniel cannot pay that all at once. Ruth and Daniel agree that he will buy the shop over ten years. He pays 20 percent down at the closing. Twenty percent of 400,000 dollars is 80,000 dollars. That leaves 320,000 dollars to be paid over time.

They agree on a simple schedule. The 320,000 dollars is split into ten equal yearly payments, before any interest. Dividing 320,000 by 10 gives 32,000 dollars a year. Ruth also charges Daniel simple interest of 5 percent on the balance he still owes. In the first year he owes the full 320,000 dollars. Five percent of 320,000 is 16,000 dollars. So his first year payment is 32,000 plus 16,000, which is 48,000 dollars.

In the second year he owes 288,000 dollars, because he paid down 32,000. Five percent of 288,000 is 14,400 dollars. His second year payment is 32,000 plus 14,400, which is 46,400 dollars. The payments shrink each year as the balance falls.

Ruth also buys a life insurance policy on herself, sized to cover what Daniel still owes if she dies early. That way her family is not left holding a shop they cannot run. She writes all of this into a buy sell agreement. Her lawyer drafts it. Her tax professional checks how the sale will be taxed. Ruth sleeps better. Daniel feels trusted. Both are right.

Where it goes wrong

I have seen good people make the same few mistakes. The biggest is waiting. An owner who begins at 64 and hopes to leave at 65 has left no room for surprises. Start early. Five years is a kind gift to yourself.

Another mistake is assuming the family wants the business. Children may have their own dreams, and that is fine. Ask them plainly and listen to the answer. A third mistake is picking a successor without telling the others. Staff who feel passed over may quit, and customers may follow them. Talk openly, and praise what each person does well.

Owners also forget that fair and equal are different things. If one child runs the shop and another does not, splitting ownership evenly can cause fights. A plan may give the working child the business and the other child assets of matching value. Your lawyer can help you think that through.

Many owners let the value sit in their own heads. If you are the only one who knows the suppliers, the passwords, and the pricing, the business is worth less to a buyer. Write it down. Also, do not treat the plan as finished. Marriages, health, and markets all change. Review your plan once a year. And do not skip the professionals. A lawyer, an accountant, and a valuation expert cost money. A botched handoff costs far more.

Questions to answer before you leave this page

Who do you picture running your business in five years, and have you asked them if they want it? What would happen to your family and your staff if you could not work starting tomorrow? Do you know what your business is worth today, and who could tell you? Have you written down how customers, suppliers, and accounts are handled so someone else could step in? Do you have a buy sell agreement, and does it name a price or a way to set one? How will the buyer pay, and is there cash or insurance behind that promise? Have you met with a lawyer and a tax professional about the path you prefer? And when will you sit down with your family and your team to say the plan out loud?