Securing your business for the next generation

Fabrication shop owners spend their entire careers trying to manage uncertainty. Whether it’s the next spike in input costs, supply chain disruption, or economic slowdown, owners spend a tremendous amount of energy trying to protect the company from unpredictable risks that are often beyond anyone’s control.

In spite of all of the risks, one of the biggest threats to long-term success involves a decision that every business will face with 100 percent certainty: succession. Whether the need for succession occurs because the owner retires, dies, or becomes disabled, either a successful leadership transition occurs or the business ceases to exist. Too many owners view succession planning as an optional luxury. Given its importance and inevitability, the question that shop owners should ask themselves is, “Will I control the process, or will the process control me?”

Benefits of Succession Planning

Without a clear plan in place, businesses invite chaos. In the event of the owner’s untimely death or disability, the business is left without clear leadership and may find itself mired in “management by democracy” with no clear leader, or embroiled in costly litigation for control of the company. This disarray could cause turmoil in the family and reduce the value of the business. It may even create an opportunity for competitors to hire away key employees or purchase the business at a discounted price. A well-crafted business succession plan provides a host of important benefits for the company’s owners, employees, and family members.

Business Continuity and Stability. For many fabricating businesses, the owner’s technical knowledge, business relationships, and industry experience often are the company’s most valuable assets, so the owner’s departure can be tremendously destabilizing. A well-documented succession plan helps the company navigate the difficult transition to the next generation of leaders. It also gives employees confidence that the business will continue to be in good hands. If key employees know a solid plan is in place, they are more likely to remain committed to the continued success of the business.

Family Harmony. Intrigue can be an enormous source of turmoil. Which child will be picked to run the company? Who in the family will inherit what? While spouses, children, and other family members may not always like the answers, they need to understand the plan. Proactively addressing these questions and communicating the plan go a long way in minimizing hurt feelings and preventing painful infighting that can occur after the founder is gone.

Maximizing Value and Avoiding Taxes. Business owners pour an immeasurable amount of blood, sweat, and tears into growing the company, and succession planning is essential for preserving the value of the company for the owner’s family. If the company wants to sell to a third party, succession planning early on helps owners identify and address any financial or business issues that could undermine the value of the business in the eyes of potential buyers. If the company is passing the business on to family members, the use of trusts, discounting mechanisms, and other estate-planning techniques can reduce estate and income taxes associated with the transfer. If structured correctly, a succession plan can even create cash flow for the owner in retirement.

Peace of Mind. For many fab shop owners, the business is more than their source of income; it is their legacy. Owners want to make sure the business continues to provide not only wealth for their family, but also jobs and security for employees. Knowing that the business will be in good hands after they’re gone can be a tremendous source of comfort.

Common Elements

Every succession plan is tailored to match the unique nature of the business and the desires of the business owner, but plans typically share a few common elements.

The shareholders’ agreement describes who can be a shareholder, the rights of each shareholder, and governance rules for the company. These agreements help protect owners from getting stuck in situations where they end up being partners with unwanted parties.

The buy-sell agreement describes the terms of a potential sale, such as who has the first right to purchase shares, how such a purchase may be financed, and how those shares are valued. The funding mechanism for the buy-sell agreement often involves a combination of life and/or disability insurance, a promissory note, a prearranged bank loan, or a way for new owners to purchase shares gradually.

The employment agreement ensures continuity after the owner’s exit, because it helps retain key employees. Employment agreements often contain noncompete or nonsolicitation provisions that protect businesses from losing these key people to competing firms. These agreements often are coupled with a benefit, such as a promotion, raise, or a deferred compensation arrangement.

Regardless of its specifics, the succession plan should be integrated with the owner’s overall estate plan. This helps eliminate conflicting arrangements and maximize benefits from tax exemptions.

Keeping It in the Family

Navigating family dynamics can be one of the most challenging aspects of succession planning. The most difficult decisions often involve situations with multiple children who have varying levels of interest in and aptitude for running the family business.

One approach is to give all children equal shares whether or not they plan to be involved in running the business. A more nuanced approach is to give children who will be actively involved shares with voting rights while giving children who aren’t involved nonvoting shares. Owners may want to give the children with nonvoting shares additional assets to compensate them for the fact that their nonvoting shares are worth less than the voting shares. Another strategy is to give the children involved in management the option to buy shares from siblings not involved in the business.

There is no one right answer for how to handle these situations, and often the best approach is to use a combination of strategies. Regardless, owners should structure the succession plan in a way that management and ownership interests do not inadvertently undermine one another. Regardless of the method, the goal is to avoid any potential conflict between control and ownership of the business.

Family members can transfer ownerships using a number of financial mechanisms, including direct gifts and various types of trusts. With a trust, the owner can select a “friendly” trustee who understands the owner’s values and priorities. Because the owner is not making gifts of equity directly to his or her family members, the laws of many states protect the assets in the event of a divorce or other unforeseen family changes.

Some Successors Are Made, Not Born

Some children are not interested in taking over the business, or they may have interest but lack the necessary technical and managerial know-how. In either situation, those best suited to be the next generation of business leaders may be key employees outside the family.

Owners can transfer ownership to these employees in several ways. They can allow key employees to purchase equity on an annual basis, provide them with equity as part of a bonus plan, or tie equity participation to business growth.

In many cases, it may make more sense to transfer power to key employees without transferring equity. Key employees might understand the limitations, and potential headaches, of being a nonfamily shareholder in a largely family-owned business and prefer additional compensation instead of ownership interests. To give these employees a vested interest without equity, owners can grant these employees the right to participate in profits from certain business lines or provide a compensation package tied to the company’s success.

Preparing for a Sale

Even if the ultimate goal is to sell the business to a third party, succession planning plays an important role in maximizing company value. Having a succession plan helps to reduce the “key-man risk” that may scare away potential bidders. Without a succession plan, bidders will likely wonder, “If the business owners hold all the knowledge that keeps a business running, will the business fall apart without them?”

Owners should work with trusted attorneys and accountants to determine the best ownership structure for effecting a sale, obtain a reliable business valuation, and begin cleaning up any negatives that may undermine the value of the company. The earlier the owner understands the company’s value drivers (and potential negatives), the more time he or she has to address those issues before a sale.

The Future Is Now

In succession planning, as in most things in life, it is never too early to start thinking about the future. From a strategic standpoint, more time means more options for deciding how to best structure the transition. From a financial standpoint, starting early provides more opportunity to leverage tax benefits, such as the annual gift tax exemption, and to transfer appreciating assets out of the owner’s estate to family members.

Preparation often makes the difference between business failure and success. With a strong business succession plan in place, shop owners can prepare their companies, their families, and their employees for a successful future.