Why There’s no Success in Succession and What to do About It

Succession planning is defined as the process for preparing the future owners and managers of the business. As Winston Churchill said, “the process of planning is more valuable than the plan.”

Owner’s Goals and Objectives — The most important step in succession planning is to begin the process so you can take control of your future and your options. Succession planning makes you face your own mortality, make difficult choices among family members for possible successors, obtain enormous amounts of life and disability insurance to protect creditors, let go of your status as president and business owner, deal with conflict and emotions, and put it all in writing. Other than those factors, what’s not to like about succession planning ? The most important part is the courage to start so that you have control over your legacy. After all, you can leave a legacy, or you can leave a mess.

  • Letting go — This requires a clear view of the future and a confidence that the business will continue to operate in the future without you at the helm. The first step is setting goals for yourself. These goals include personal financial requirements from the business, lifestyle goals for your retirement, and business goals that will support you financially and support the business. The only way for you to obtain confidence is to start and steer the succession process. You are in control. Your accountants, lawyers, financial planners, employees, and customers are not in charge. They are important advisors and resources to support you, but you need to be clear on your goals.
  • Financial security — Financial planning is the top issue for most entrepreneurs because their business is often their largest retirement asset and they are reluctant to give up control of their financial futures. The key to financial comfort is to develop a long-term plan and hold personal financial assets outside of the operating company. The conflict is that bankers require equity to support debt, so you may have to leave assets sitting in your company, supporting its growth and operations.
  • Information — Succession alternatives are required to support your business decisions and to provide your professional advisors with data so that they can make recommendations that suit your goals. Key information includes legal structures, organization chart, historical financial statements and tax returns, business plans, management structure, customer analysis, product/service gross margin analysis, and key customer contracts.

Timing — A business owner can control timing by being proactive and making decisions early in the process.

  • Immediate — An immediate change can be unnerving for major customers and suppliers, who would rather see a seamless transition. Planning done in the emergency room or funeral home is wrought with stress, fear, and grief, and is too late to maximize the value of the firm for the benefit of the founder’s family and employee group. A continuity plan can quickly outline the key variables in your succession plan and protect your business.
  • Gradual — A gradual change allows different people to perform and develop in different roles, gaining broad experience across the firm. This will increase the chances of finding a capable leader who understands the entire business. It will allow for important introductions to major customers and suppliers. It will allow for mistakes to be made, learning to occur, and confidence to build throughout the organization.
  • Never — Some owners plan to die with their boots on. One eighty plus year old owner was still running the show when his fifty plus year old adult children were beginning to contemplate their own retirements, and not interested in being the next leader for twenty years. This is an unhealthy situation, compounded by an owner’s lack of outside interests or hobbies and fear of losing status once their role as president is given up. Often, banker, customer, and family pressure can nudge the owner to strengthen the management team and ownership structure for the future. But family pressure is the most difficult and riskiest to apply.

Advisors — Your professional advisors have a wealth of experience and wisdom to help you through the process, but the most important factor is that you clearly identify and communicate your goals to your advisors. Advisors without clear direction from their clients will not be effective advisors. You must also stipulate that they communicate with you in plain language, write summaries of your meetings and their advice, draw pictures to represent structures of what they have planned, give you proactive advice, and allow time for your questions and explanations. A professional who only responds to your questions and does not give you ideas or ask probing questions is not going to be a valuable contributor to something as emotional and important as succession planning.

  • Tax and accounting — The accountant’s main role is to recommend tax structures for the future ownership and to structure the transaction in order to manage the tax load. The accountants who focus on solely minimizing taxes can save you thousands of dollars, but this can also reduce the equity in your business, reduce your ability to borrow to fund growth, and ultimately reduce your wealth. The goal of tax planning should be to maximize after-tax cash flow and not just minimize taxes in the short term. The same applies to succession planning. The business will require working capital and borrowing capacity to operate and grow in the future. Therefore, the estate plan cannot take all surplus cash out of the business.
  • Legal — The legal advisor’s role is to identify risks, develop structures, and prepare documents and agreements. Although the technical language of documents can be intimidating, it is very important for all parties to understand the contents and intentions of the agreements.
  • Financial planner — The financial planner can prepare financial investment plans that will address your current and future financial needs while diversifying your investments and protecting your future. There are several sophisticated tools available to shelter and protect your wealth. The key is getting the money out of your company and into a creditor protected personal investment account.

Valuation — A business valuation will provide an independent verification of the market value of your business, which may be required for tax purposes in the event of an estate freeze. This valuation will likely be a conservative number and below the value that a strategic buyer, such as a competitor, would likely be willing to pay for your business.

  • Profitability and cash flow — The primary factor affecting your business value is your earnings. Frequently, earnings before interest, taxes, depreciation, and amortization (EBITDA) is used as a base, and then increased using an industry multiplier to arrive at a business value. A general rule of thumb is that a multiple of three to four times your EBITDA can give you your business value, however this value will depend on your industry and business cycle. It is recommended that you engage a professional business valuator to prepare this valuation report, as it will be accepted by tax authorities and reduce risk of retroactive, one-sided tax assessments in the future.
  • Asset value — A business such as a manufacturer that relies on equipment infrastructure or a re- source-based entity may be valued using an asset approach. This approach recognizes the future earnings potential from the capacity of the assets. Given today’s skilled labour shortage, having the equipment available does not necessarily mean you will have the staff to operate it.
  • Management team — Management team strength and autonomy impact value. Managers need real decision making power so that they can run the business without you. The business is more valuable if it doesn’t require your constant attention. If you, the owner, need to be involved in every decision, then you don’t have a business, you have a job and most buyers are not interested in purchasing a job. To make decisions, your managers require detailed financial and business information. Many family businesses keep critical information private and this prevents managers from performing as managers and reduces business value.

Options for ownership succession — The future leaders of your company will come from the successors you identify today. Leaders require vision, expertise, and courage. Your business and its culture will reflect your personal values and leadership style. A new leader will impart his or her own style. A dramatic change in values will not be successful unless the current values are not suitable for the long-term growth of the firm. Frequently, founders are very controlling and secretive. Unless the business remains family owned, these factors can stifle profitability. Long-term growth and employee commitment revolve around sharing a vision, assigning responsibility, and providing information for decision making.

  • Family — Family ownership can create a legacy for the founders and unite the family around their common futures. Successful family businesses include large international corporations such as Cargill, Ford, BMW, Johnson and Johnson, and many other private and public companies. Large or small, a family owned business is a source of pride where the family’s values are the foundation for the future. Unfortunately, family ownership only experiences 30% transfer to the second generation and 15% transfer to the third generation (Lee, Lim, and Lim, 2003).
  • Employees — An employee ownership purchase, or management buyout as it is frequently called, is often a viable method for the owner to transfer ownership to a group that is familiar to the owner and who may continue to access the owner for guidance in the future, thus preserving some status for the owner. Disadvantages are that this group usually has less capital, will likely require an extended period of time to finance the transaction, and will require ongoing support and guidance. Thus, the owner is not given a large cheque and immediately set free of responsibilities, unless a venture capital or debt structure is in place to finance the transaction and a successor or management group has been groomed to take over.
  • Strategic buyer — A strategic buyer, such as a competitor or customer, has deeper pockets and higher potential to justify a premium price and can pay you quickly, but will require you to stay on for a while to ensure customers stay. Many owners do not like this option because they are working for someone else. These important factors show that money is not the only decision point in selecting a future owner.

Financing — Financing is largely driven by the type of successor arrangement being considered, as successors have different levels of capital to fund an acquisition.

  • Vendor — Business owners frequently finance their own exits by creating preferred shares in an estate freeze where the shares are redeemed in the future from surplus cash flow or by accepting payments from earnings, called an earn-out. Vendor financing provides the owner with some say and control into future operations, since the owner is a large creditor of the company. This process ties the owner to the financial health of the company and the skills of the new management team.
  • Banks — Debt financing is a low cost source of capital if you have collateral, as it can provide full or partial payment to the retiring owner. However, debt comes with tight restrictions on financial and performance ratios which are controlled through covenants. Banks force management discipline on companies by requiring annual business plans and budgets. This is a very positive step for businesses that are not currently planning. Statistics indicate that only one-third of businesses have a formal plan but that this one-third outperforms the two-thirds that do not have a plan. Banker relationships, and treating the bank as a partner and trusted advisor, can be very beneficial for the entire management and ownership team. Proper leverage of debt can facilitate growth and profit improvement, which are required to support payments to vendors and a larger ownership team.
  • Venture capital — Equity financing can provide cash to fund the owner’s sale and also strengthen management with the creation of a board and addition of managers or board members. If the business is highly profitable and has a strong growth trend, then the business may be able to support equity financing. Where banks add management discipline but are relatively hands-off, equity players are investing their own money and play a very proactive and important hands-on role in strengthening management. Equity is more expensive than debt, but can be used effectively to create leverage to take on more debt or growth.

Business owners can quickly take control of their futures and the succession process by identifying their goals and objectives, and communicating these to their advisors who can then help to structure the transaction and integrate the new successors.