Strategies And Tactics Of Ownership Succession

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Roger Lockwood had two careers; his first was as a professional baseball player in the 1960s. After retiring from baseball, his second career started when he founded his own materials distribution company.

Roger was successful in attracting customers to his new business because of name recognition from his first career and because of his business smarts. His company grew, and by the mid-1990s, revenues approached $20 million.

However, Roger had some concerns. His grown children were not interested in the business, and his wife wanted to spend more time with him, pursuing travel and hobbies. Personally, Roger decided he was tired of bearing the responsibility for his company and was at a crossroads–what path of ownership succession should he take?

Rogers situation (his profile has been changed to protect his privacy) parallels that of all successful entrepreneurs. Owners dont live forever, so strategies and tactics must be devised to execute a successful transition. Unfortunately, it seems the deck is stacked against the entrepreneur; its estimated that only one-third of companies successfully transition to a second generation of ownership.

But, when business owners carefully evaluate the available exit strategies and work with experts in the field (lawyers, business valuators and insurance professionals), a successful transition can be made.

Before determining potential tactics of ownership succession, business owners need to do some soul searching and consider themselves, their family, money, employees, and taxes. These business owners must answer some difficult questions, such as:

1) Do you want out completely? Would you like to stay on as long as possible, but with reduced responsibility?

2) Do you want the company to be a legacy for your children? Are your heirs capable of running the firm, and if not, should they continue to own stock in the firm?

3) How much money do you need from the business to make personal retirement comfortable? Is that amount feasible if you want to walk away from the firm?

4) Is the management team capable of successfully running the firm? Should they be given the opportunity?

5) What will Uncle Sam take from any transaction? What tactics can help minimize the amount paid in taxes?

Business owners have a number of options to execute ownership transition, which we will consider here.

Outright sale. Probably the most obvious choice is to sell the company, pay taxes on the sale of the business and move on. It should be noted that third-party sales can have some strings attached (usually an employment contract for one to three years, an escrow account for potential liabilities at closing, and potential payouts over time through a seller note), but they can represent the simplest exit route for an owner.

But third-party sales may not always be clean. Notes issued to the sellers may not be repaid on a timely basis, and in many instances, an owner can forget about having an enduring legacy when an acquirer takes over the company–it is often barely recognizable a year or two later.

Transition To Children. Another ownership transfer alternative is to transition the company to ones children. Some entrepreneurs have children who are active and want to see the business stay “in the family.” This means the company retains all previous customer, employee and vendor relationships, including those with its insurers.

There are, however, roadblocks to this kind of transition, which can include deciding who among the active family members should lead the firm (management by committee is no way to run a business), and how to share the ownership among the second generation. Should the family members who do not work at the firm be eligible for a “free ride” based on the efforts of their sibling(s) leading the company?

And last but not least–the federal government assesses a tax on shares gifted from one generation to the next. Furthermore, in the event of an untimely death, the estate tax liability can be daunting. In this exit strategy, it is essential to look into the variety of insurance products available to ensure a smooth transition and to protect against unforeseen events.

Sale To Management. In a sale to management, the people who have worked closely with the entrepreneur buy out the owner and run the firm. Since they know the business very well, management teams can maintain important customer relationships and continue the prosperity of the company. Unfortunately, management teams also often lack the financial wherewithal to make a cash purchase for 100% of the stock, leaving the owner to take a note or retain an equity stake that would allow the owner a second chance to cash out more stock in future years.

In this kind of transition, sellers can retain a position with the firm. With diminished responsibilities, however, the former owner may lose interest in continuing to work for the company. In addition, unless some provisions have been made, capital gains taxes are payable in each sale, reducing net proceeds to the seller. Banks supporting a sale-to-management strategy will insist on corporate-owned life insurance policies on the buyers to protect against loan repayment problems that could arise due to a premature death.

Sale To Employees. For owners interested in deferring capital gains taxes on the sale of their stock, Employee Stock Ownership Plans, or ESOPs, are worth investigating. ESOPs are defined contribution employee benefit plans designed to hold employer stock. Congress chose to emphasize ESOPs as an ownership transition tool, and as a result, provided a capital gains tax deferral benefit to sellers.

The benefit to the ESOP as buyer is that it can repay the loan it used to acquire the sellers shares–both principal and interest–in pretax rather than after-tax dollars. This makes the ESOP exit strategy more favorable to the seller than the management buyout alternative because the principal repayment of the bank or seller note is not tax-deductible in a management buyout.

An owner selling to an ESOP can choose a staggered sale by first selling a minority interest to the ESOP and selling the remaining shares thereafter. This piecemeal approach allows the owner to take some cash off the table and diversify assets. Whether an owner sells all or a partial interest to an ESOP, insurance products once again become important because the bank or seller may require corporate-owned life insurance to support loan repayment in the event a tragedy befalls a key employee.

Close The Doors. Finally, an owner may choose to sell all assets, collect the receivables, pay all liabilities and close the business. Generally this option is exercised by firms that do not have an important role in their markets or are in a market that is rapidly declining. Profitable businesses with a talented workforce, a strong customer list, dedicated suppliers, and product or service proficiency lose all of that value if the business is closed.

An owner should be sure none of the companys intangible assets are salable before proceeding to shut the doors.

Owners planning for succession need to exercise introspection to determine what is important to them before choosing an exit strategy. Each approach to exiting a business has advantages and disadvantages. But, with a carefully structured and executed transition plan, a business owner can truly enjoy a blissful retirement.

is a principal at Lakeshore Valuation, L.L.C. in Chicago, Ill. He can be reached at jahern

@lakeshore-valuation.com.


Reproduced from National Underwriter Edition, February 10, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.