4 Steps to Succession Planning

The word “succession” literally means the “passing on” or “transition” of success.

Succession planning is a critically important “rite of passage” for a business from one generation of ownership and management to another, most often drawing on the resources of family members who are willing and able to carry on the business. While it is an important adjunct in the business owner’s overall estate plan, it doesn’t have to be complicated and should occur before probate.

There are four steps to choosing the proper and most appropriate team and process for changing out the business’ leadership.

1. Determine who is involved
2. Develop a strong business plan with new accountabilities
3. Determine when the plan needs to go into effect
4. Determine how the plan is to be executed

Depending on the family dynamics, each family member involved in the transition of wealth understands the difference between fair and equal. Additionally, all of the following provide fodder for the potential arguments that could arise over what the best succession plan is to achieve a transition for the business, for the employees and for the family:

• Relationships between siblings
• The role of in-laws in the business
• The ownership split
• The influence of owners and spouses
• The respect that the various family members have garnered among the employees and key customers

In some cases, the customers have a stake in the outcome as well.

Determine Who is Involved

There is the potential for strong dynamic tension in each part of the succession plan as it is developed and executed. Even simple “father to son/daughter” transitions can be complicated if there are other siblings, important key employees or critical customers. The size of the overall estate can add complications as well. Every aspect of the business is called into question as to its relevance and importance to the viability of the business after the owner, with whom all employees have in one way or another achieved a level of comfort and trust, steps out of the picture and new leadership emerges.  

It is critical to the current ownership that the business first “survives” and secondly “thrives.” Succession planning is not a one-sided activity for family members who become involved in the succession process discussions and the ones who end up with the business equity. The son or daughter who is about to carry on the business must be sure that this is what he/she really wants to do. He/she should clearly understand the obligations, not only to family and employees, but also to his/her own family, in terms of committed time and the risk to personal wealth. In most cases, it is a privilege to inherit the business, but in some cases, the burden can be very heavy and troublesome. 

There can only be one CEO. When there are two or more siblings or in laws involved, it is necessary to choose one of them as the head of the company. Protections and agreements can be put in place regarding major decision-making, profit distributions and roles and responsibilities, but there can be only one person in control who holds the accountability for the business. Ownership’s desires and rules for the business will only survive up until the transition and control transfer. It would make sense to choose the most capable person to succeed, but that is not always possible given the family character and sibling rivalries. Many retiring owners believe that keeping peace in the family is just as important as the money. The transitions that cannot occur smoothly due to family discord will often result in either the business being sold or outside leadership and management being brought in.  

When the first step has been accomplished and there has been a deliberate declaration of succession between the chosen parties, a judgment must be made about how much of the estate is to be collateralized behind the business, how much needs to be built into the balance sheet, how much debt can be afforded if needed and how this will be collateralized.  It should be understood that unless there is a screaming need to get out, the owners will want to take some of the business capital out of the business to live out the rest of their lives. Banks are the major lending institutions. In most cases, the banks need collateral and will be looking to the prior owner to bridge the time so that the bank can develop confidence in the next generation to stand on its own two feet, thus releasing the retiring owner’s collateral. Banks want the business to survive and thrive and will often have a significant say in how much of the business collateral can be pulled out by the owners.

The new owner is often a second-generation member of the business owner’s family. This person has usually not been through the hard times of the business start-up. In most transitions, a large and established business has emerged with problems in running the enterprise of new proportions and different degrees of accountabilities than in the earlier days of operations when the original owners were building their business and their family at the same time, and the problems weren’t as complex.  

Develop a Strong Business Plan

A strong business plan, updated annually, is a necessity for every business. Few businesses have current business plans and fewer yet implement them. A major mistake in business planning is the failure to recognize future changes in the market and the inability to adjust activities within the business plan to accommodate those changes. Another mistake of equal magnitude is the failure to delineate the responsibilities of each manager and executive and to not hold these managers and executives accountable for their responsibilities.  

The business plan, which is integral to the succession plan, should be defined to the profit center level. It should integrate all the key employees into common objectives, reward the outcome and provide for opportunities to measure and adjust as required. The strength of the succession depends on the ability of the successor’s management team to carry on the financial and marketing objectives of the business plan.

In most cases, the existing owners will need to finance the transition of their balance sheet equity to the next generation. If the current owners cannot be paid for what the business is worth today by the succeeding family members, they have the option to sell the company independently and divide the proceeds among the children instead.  

Strong business planning is sometimes not a priority of the entrepreneur when their time and circumstances have not allowed the luxury to plan. Many smaller businesses have been built from a lot of luck, sweat and tears. Also, risks were taken without regard to the consequences, since failure was not an option. Their successors, often the next generation, have been handed an opportunity of different dimensions requiring a different management approach. The newly leveraged business will have the potential to fail and the potential to succeed depending on the strength of the business plan and the execution of the plan.  

Determine When the Plan Goes Into Effect

There are no rules for when a succession should begin. The most common circumstances for beginning a succession plan are when:       

• Retirement is realized as a serious option          
• Illness prevents active involvement
• Children begin to take over naturally
• Old age arrives
• Exhaustion ensues

There is no clear trigger to begin the discussion with the children. Usually, the husband and wife will start the discussion and arrive at some common ground on how to look at the children and how to evaluate who would be best at taking over the reigns of the business. If a clear winner has not emerged, birth order is a classic option. Amongst three or more siblings, at least two, typically, are active in the business and the others have abandoned the family enterprise for other professions.

In the distant past, it wasn’t often that daughters succeeded over their male siblings in business. Gender has become less of an issue in the past decade because education has become an equal priority for sons and daughters, giving daughters the intellectual strength to compete equally for the business.  

Regardless of when the succession process begins, it is crucial to allow ample time to implement the plan. Transition periods are critical to most owners, since they are often not totally convinced their children can succeed them. Their children have only half the entrepreneur’s blood and not necessarily the same guts, courage and wisdom to be as successful as their parent.

The ideal succession plan starts from working backwards in the process. Begin by asking:

“When does the owner want to be totally out?” and “How long does the owner anticipate it will take to build the confidence to a level where the reigns can be turned over permanently?” The steps will require the owner’s time and investment.   

Determine How to Execute the Plan

Regardless of how close an owner is to his children, he must consult with his tax advisor, corporate lawyer and business consultant before executing a succession plan. The owner must include these three advisors, at a minimum, into the process.  

The tax advisor should provide the parameters for the transaction to minimize the tax consequences that could eat into the valuable working capital, which may be needed to bridge the transition. He can also provide advice regarding the number of inheritance structures established in tax law that impact all transitions.

Few corporate attorneys understand the idiosyncrasies of tax law. Tax law is a specialized practice, often best managed by the accountants who actually prepare the tax returns. To get the best results from tax advisors, it is important to include the advisor in the planning stage.  

The corporate attorney will provide the best advice on structure to correspond to the level of risk the owner is willing to take in turning over the voting rights and control of the business. Questions the tax attorney should address are:

Does the owner want the option to remove his child from the company if the results are not being achieved and the business is in jeopardy?

If the estate is at risk, how are the other siblings protected so that they can rely on some degree of inheritance?

Does the owner consider the difference between what is fair and what is equal?

The fair and equal choice is quite significant. Equal means that regardless of what the business needs, the owner makes sure that each of his children receives an equal piece of the inheritance through the estate. What is fair comes down to a decision of what each child should receive based on criteria, including prior transfers where the owners used money to support other children in doing other activities in the past. Is it fair to give the business to one child and nothing to the others? Is it fair to have the child selected to run the business borrow against his inheritance to protect the rest of the estate? Do not forget that how you will be remembered and how each of your children will get along after you leave is very dependent on how they interpret how they were loved by you through what they receive in the probate process.

The answer to many questions can be made clearer once the business plan has been written and confirmed. It will reveal business debt and equity—what the business can afford to do and what is needed in capital and working capital. The importance of having an independent business consultant construct the business plan cannot be over-emphasized. This independent and unprejudiced view of the market and the potential for the business to be successful under new leadership with the current volume of sales, current customer relationships and existing management team is important to help determine the risks involved to the owner in making the transition and the risks to the son or daughter taking over the business.  

Collectively, the lawyer, accountant and business consultant will develop the succession plan with the owner and his children. They will help to sort through the fair and equal issue, the required working capital, the required debt and all the risks associated with a successful transition. Once the plan is in place, the person who is important to the succession plan, other than family, is identified and measurable accountabilities to results are accepted, rewards for achievement are put in place and the implementation can begin.  

A Successful Transition 

Our client, Hobbs Inc., a high-end custom residential builder based in New Canaan, CT, made an unusual transition over three generations, yet their succession plan proved to be very successful for fundamental reasons. 

Ted Hobbs started in building construction in 1949 (which incorporated in 1954) after building ships as a government engineer during World War II. His son Mike joined the firm in 1968 after a stint in the U. S. Air Force.  In 1975, the first Hobbs transition went very quickly. Hobbs returned from a doctor’s visit after being told that he should quit or the stress would end his life. He cleaned out his desk and literally turned the keys over to his son Mike. Ted and Mike agreed that Ted could stay as long as he wished, but when Ted was ready to leave he would really leave and not remain “passively aggressively” in control.  No one believed that Ted would really ever “retire,” but even though he lived another twenty-three years, Ted never stepped in to the business after the day he turned over the keys to his son. 

Mike’s three sons worked on and off in the business throughout their high school and college years. His son Michael eventually moved on to work outside the family business as an intellectual attorney.  In 1992, his son Scott completed a commitment in the U. S. Army and began working with his dad as a laborer, the basic of all construction work. When Mike Sr. retired in 1998, Scott was handed the reigns of the business just as his grandfather had handed his father the reigns, however with learned differences.   

Nearly three years before retiring, Mike Sr. had begun working with his business advisors and a Family Business Program through the University of Connecticut to help insure a smooth transition. He notified his company personnel of his intent to retire eight months before retiring so everyone could prepare. After Mike Sr. gave the keys to Scott, he took a long vacation to mark his trust in his sons to run the business. Scott was given Mike Sr.’s office, and Mike Sr. moved to Scott’s office to emphasize the transition. Mike Sr. continued to work at the office for another six months, but he did not work on any new projects, nor did he become involved in any business or personnel issues.  

Scott soon thereafter, made an offer to his brother Ian to join the company. After joining forces, the two of them have worked through a number of decision-making agreements, which have served them well ever since. Each has a veto on major decisions, and one has a majority interest. It is the respect and commitment that they give to one another that makes this team successful. They have also surrounded themselves with a core group of key executives who reinforce their management skills and leadership requirements, keeping a successful operation profitable in good times, as well as bad times. 

It is critical to note the uniqueness of the father’s trust in the Hobbs’ transitions; he put his trust totally, without question, in the laps of his sons and then walked away in full confidence of the company’s future success. There continues to be a family tradition of trusting each other’s commitment and competence, and the business continues to develop through their strong customer relationship management skills. One of the main ingredients to their continuing success is that the new owners seek professional advice and services to improve their business performance and planning just as their father did when he was at the helm.

Construction Business Owner, November 2007