After working for years to build a successful business enterprise, are you ready to move on to retirement or something new? To maximize the value of your business and properly sell or pass it along to the next generation, a succession plan should be in place.
In the content below, we discuss the basics of succession planning for business owners hoping for a successful transfer.
Why is a Succession Plan Important?
Determining who will financially and legally take over your business upon retirement, death, or debilitation is no small matter. Even if you don’t plan to retire or sell in decades, having a thorough succession plan in place is vital to ensure long-term success. Emergencies happen, life happens, and dealing with the unexpected begins with preparing for the future.
According to ForbesFunds, succession planning is:
- A leadership development strategy
- A best practice for sustainability
- A risk management best practice
- Crucial for knowledge transfer
- Not just for the C-Suite
- Not just for when an Executive Director is leaving
Succession planning offers peace of mind for any business owner, regardless of retirement timetable.
3 Primary Ways to Transfer Ownership
Successful succession planning begins with determining a successor. Although every situation is unique, there are three primary methods of ownership transfer.
- Selling the Company: If you are a co-owner, you could sell your interests back to the company. If you are the sole owner of a business, you may sell your company to an outside party – such as an entrepreneur – or a trustworthy employee.
- Transfer to a Co-Owner: Rather than selling ownership interests back to the company, you may sell your share or interests directly to a co-owner.
- Pass the Company Along: You may choose to pass ownership interests along to an heir, such as a family member.
Once you have determined which transfer option is best for your specific situation, a succession plan can be crafted.
How Does a Succession Plan Work?
A succession plan is a detailed document intended to provide step-by-step instructions to an ownership change. Every small business succession plan should include a timeline, a list of potential successors, the valuation of your business, a succession funding plan, and standard operation procedures (SOPs).
Your Succession Plan Timeline
Your succession plan should include a detailed list of circumstances and, if applicable, dates for all major steps in the succession plan. Depending on the situation, your timeline may stretch across five years or twenty years.
A List of Potential Successors
Although you may have a single successor in mind, it is best to list multiple options, organized by order of consideration. If you are not planning to transition soon and do not have a set successor list in mind, begin by listing qualifications, skills, and/or personality traits you would like to find in a future successor.
Your Business Valuation
Regularly performing a business valuation is critical in many situations, from working with a potential investor to exit strategy planning. Furthermore, your business valuation should remain up-to-date. Regularly perform and update the business valuation section of your succession plan.
Depending on the size of your business and purpose of valuation, different methods may be used.
A few common methods for small-to-medium business valuation include:
- Asset-based valuation: a simple asset-based valuation is determined by adding the value of business assets and subtracting liabilities.
- Capitalization of cash flow (CCF): the capitalization of cash flow valuation method can be calculated by dividing cash flow by a capitalization rate. If one-time expenses or income events occurred during the selected time period, you should make adjustments to remove these events from the cash flows used in the calculation.
- Discounted cash flow (DCF): like CCF, the discounted cash flow method is income-based. However, DCF is often utilized for companies expecting a significant increase or decrease in income within the near future, while CCF is generally utilized for businesses at which the future is expected to be similar to the recent past. To determine current business value, DCF uses projected future cash flow, a discount rate, and the time value of money concept.
- Market-based valuation: this method is relatively straightforward. Market-based valuation looks at current market transactions and estimates value by comparing the subject company to transactions involving similar companies.
- Seller’s discretionary earnings (SDE): for small business valuations only, the seller’s discretionary earnings method is beneficial to estimate how much a future buyer can expect to make from the business. Business earnings before taxes and interest can be added to owner’s compensation and non-essential business expenses to calculate seller’s discretionary earnings.
Your Succession Funding Plan
You may choose to fund your succession via life insurance, external lines of credit, or internal sinking funds. An Employee Stock Ownership Plan (ESOP) is another alternative that works in certain situations. Other options requires the purchaser to secure their own financing, or negotiate seller-financing terms with you. Regardless of the chosen method, funding methodology will affect price, terms of succession, and responsibilities of buyers and sellers within the agreement.
Standard Operation Procedures (SOPs)
Before transferring ownership, be sure to coalesce a complete collection of formalized SOPs, including documents, employee handbooks, and training materials.
Determine if Your Business is Sellable
If you plan to sell your business to an outside organization, determine if your business is profitable within its industry.
- Does your business have a history of profitability? Of course, a financially stable company – with a history of consistent profitability – will be more attractive to potential buyers than a struggling organization.
- Is your business in an attractive industry? Although there are certainly buyers for niche industries, businesses in attractive industries may have a larger assortment of potential buyers.
- Where is your business located? Is your business in a highly desirable area based on the type of industry you are in? Do you have a consistent customer base? A consistent and diversified customer base points towards long-term profitability and business value.
- Are your assets in good condition? Assets with market value and remaining useful life assist in business value and potential buyer attraction.
- Do you have a strong balance sheet? Businesses that appear worth purchasing usually have good retained earnings, great net worth, and low or nonexistent debt.
Succession planning well in advance of a transition is extraordinarily helpful for rectifying any salability issues. If the answer to any of the previous questions is no, you have time to work on increasing the business value and long-term profitability for future owners.
DHJJ: Exit Planning Services
Succession planning is no small task – often, consulting professional advisors to assist in the task is the best method for creating a comprehensive strategy.
At DHJJ, our team of expert advisors customize our exit planning process based on your unique situation. The succession planning process may include wealth management, tax structuring, mediation, value and profitability enhancement consulting, business valuation, or any collection of succession strategies.
To schedule a consultation with our exit planning team, please contact us at 630.420.1360 – we will get in touch right away.