Why successful business succession starts long before you're ready

As a business owner, you’re likely too busy taking care of day-to-day operations and planning how to grow your company to spend a lot of time looking at possible exit strategies. As a result, you may find it hard to see how closely decisions about succession planning are intertwined with considerations about current strategy and personal wealth planning. Yet your business probably makes up the lion’s share of your personal net worth, and the steps you take now to secure the financing you need to grow and build its value could help ensure that you can fund your retirement and other personal financial goals later on. This means that thinking about how you’ll ultimately leave the business may influence current plans.
 

If you’re thinking about selling the business now or later, any potential buyer will want to know that your current results are sustainable, repeatable and accurate. In addition, creditworthiness matters: Many of the succession options available to you require some amount of debt financing that will rely on the ability of your company to repay. All the actions your company might take to maintain access to debt financing are likely to be the same steps that would increase its value for a sale, says Brian Roth, National Executive, ESOP Finance and Advisory at Bank of America.

“In thinking about how the business strategy for your company and your own wealth planning may align with succession planning, keep in mind that there are really only seven ways to depart a business,” Roth says. You could sell to a competitor or another strategic buyer in your industry; to a financial buyer such as a private equity firm; to your management team; to a family member; to your employees through an employee stock ownership plan (ESOP); or to investors through an initial public offering (IPO). You could also simply shutter the business. 

Some of those may not be available to your company, narrowing your choices. But before you start eliminating possible options, it makes sense to consider what you want the future of the business to be. “What are your priorities?” asks Roth. “How important is it for you to maintain influence over your business, even after you’ve pulled back from everyday involvement?” While the need to monetize your ownership interest in the business and any efforts to account for potential taxes incurred by a sale — and other considerations — may also affect your plans, it’s important to integrate those goals into your long-term strategic plans for your business. This would also include your desire to safeguard your employees and to see the business continue to operate.

Sorting through the possibilities means considering the requirements, advantages, drawbacks and compromises that each may entail.

“If you want maximum valuation, and thus maximum liquidity, this is likely the way to go,” says Roth. “A buyer in your industry may very well be willing to pay more than fair market value—you’ll get what’s called a strategic premium.” The acquiring company may be motivated by the chance to reduce competition or expand operations, and it will expect to reduce management costs and other expenses. Working with an investment bank, you may be able to choose from competing bids, helping push the sales price higher. “But a strategic buyer will want 100% of your company, and it’s unlikely there will be a continuing role for you after the sale,” Roth says. Another key consideration for many business owners: Your management team and employees have no guarantee their jobs won’t be cut.

If a private equity firm, high-net-worth individual or another kind of financial buyer acquires your business, you can expect several key differences compared with a sale to a strategic buyer. “Private equity will pay market value for some or all of your business,” says Roth. You’ll get some cash from the deal, but you’ll also get an owner whose main interest is to leverage the value of your company. “The buyer may want to run the business, or they may ask you to help run it, and although this could allow you to retain more control than after a sale to a strategic buyer, the PE firm’s goal will be to maximize the company’s value for its own exit,” Roth says. The financial buyer’s vision for the business’s future may not necessarily align with yours.

If you sell to your company’s other leaders, you may have an opportunity to shape your departure in several important ways, says Roth. You can negotiate a price and structure the deal so that it works for both you and the managers, making sure that you receive enough to support your retirement and other financial needs while also ensuring that the company remains viable. “The business will likely have to borrow to fund your liquidity and then repay the loan out of its earnings,” Roth says. “The financing needs to be structured in a way that doesn’t impair the company from maintaining a line of credit, say, or from having the capital to expand into a new facility.” A sale to management can benefit the company and its key employees, and you have the potential to negotiate how you’ll wind down your involvement.

Selling or giving the company to family members is the first choice for many business owners, and if one or more relatives is already working in the business and interested in taking over, the transaction can be structured to benefit everyone. The process could start with an independent valuation of the business that can be used in arranging financing for a sale or to take advantage of the lifetime federal gift tax exemption (which in 2023 is $12.92 million). Once you establish your ongoing income needs, you could arrange to receive a lump sum payment, finance the sale directly or draw a salary. You may also decide to retain an ownership share and work with the new owners to determine your ongoing role.

This kind of transfer is technically known as an employee stock ownership plan, or ESOP. “But I prefer to talk about it simply as employee ownership,” Roth says. “The transition to an ESOP-owned company essentially puts the value and wealth of a company into the hands of the employees over time.” That is accomplished through financing the transfer of the company’s ownership to a trust established to benefit employees, who can cash in their ownership shares when they leave the company or retire. “The potential benefits are quite unique and can’t be achieved through the other approaches to business succession,” Roth says.

Those benefits include something called a 1042 exchange, which lets you defer capital gains taxes on a business sale — potentially indefinitely. This exit strategy can also help ensure that your business remains a vital part of your community.  But this is a highly regulated exchange that must follow the rules of the Employee Retirement Income Security Act of 1974 (ERISA), which protects the interests of employees in retirement plans. Moreover, a company considering a transition to employee ownership needs to think about how it will pay off the loans used to finance the transaction so that it can free up capital for the ongoing growth of the business – just as with other exit strategies that rely on some amount of debt to complete the transaction.

This can be an appealing exit strategy because of the potential for a substantial payout for owners, but for many small and midsize businesses, an IPO may be the least likely option. “You need scale, and you probably need patented technology or other attributes that make you truly stand out in your industry,” says Roth, who also notes that the process of preparing for an IPO can be time-consuming. Moreover, the appetite for IPOs tends to fluctuate with stock market movements. In 2022, there were barely half as many IPOs globally — and 78% fewer in the U.S. — as during the previous year, and just 20 U.S. companies went public in 2022’s fourth quarter.

Each of these exit strategies has pros and cons that you’ll need to weigh as you determine a succession plan for your business. In some cases, though, the best approach may be to combine two or more of them to create a plan that perfectly fits your business and retirement goals. “You can daisy chain them together,” says Roth. “You could sell a portion of your company to management, sell another portion to an ESOP and, further down the line, sell the business you’ve grown to private equity. And through all of this, you can determine what your own role will be.”

Whatever route you choose, you’ll need a team of experienced legal, accounting and financial experts, as well as bank relationship managers and wealth strategists, to help you plan and implement your ultimate departure from your business as well as your personal financial future.

These advisors can also help you establish contingency plans for divorce, disability, death and other events that could disrupt your intended succession plan. And if their expertise doesn’t align with your goals, they can connect you to trusted and experienced professionals who can address your specific needs. “The earlier you begin working on all of this, the more likely you’ll be able to create exactly the future you want for your business and yourself,” Roth says.