Every business starts out as somebody’s baby—which is why stepping away can be so difficult. But the only thing more daunting than coming up with a succession plan is doing so on short notice.
Having helped countless business owners, I’ve seen firsthand the high costs of deferred or inadequate succession planning. Some owners may assume an heir is interested in taking over the business, only to find out too late that he or she has no such desire. Others might believe their business is worth more than it actually is, which can make selling difficult, if not impossible.
In short, successfully transferring your business to a new owner takes a pragmatic and proactive approach. Although it’s never too early to begin planning how to divest from your business, at least five years before a planned sale or transfer is best, allowing you time to consult with heirs and possibly restructure.
With that said, here’s what to consider as you get started.
Valuing the business
Whether you’re gifting or selling the business, you’ll need to assess its value. Owners who are emotionally attached to their business may have a difficult time doing this objectively, so it’s wise to work with a qualified business appraiser who can help determine not only an appropriate valuation but also the proper metric by which to measure it. The three most common methods of valuation are:
- Cost-based, which estimates a business’s value by subtracting the fair-market value of its liabilities from its assets
- Income-based, which estimates a business’s value according to its cash flow
- Market-based, which estimates a business’s value by looking at comparable companies
The American Society of Appraisers, a good accountant, or an attorney should be able to refer you to an appraiser specializing in your area of business. Industry associations can also help.
Once you have an appropriate valuation, it’s time to weigh which of three common methods is the best option for transferring ownership of your business.
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1. Gift it to heirs
Many owners dream of their kids taking over the family business—but while some heirs will jump at the opportunity, others won’t. Still others may want to quickly sell their stakes, which can put the business at risk. The family successions that tend to work best involve children either starting at the bottom or working outside the firm to prove their mettle as potential entrepreneurs.
According to consulting firm Deloitte, only 30% of family-owned businesses survive into the second generation, 12% into the third, and 3% or less beyond that,1 so it’s critical to start your succession planning with a frank assessment of who has both the desire and the aptitude to take the reins. You may ultimately decide to exclude one or more heirs from the company, in which case you might want to compensate them in some other way in your estate plan.
Finally, you’ll want to consider the tax ramifications of passing on the business. Individuals can currently give away up to $11.7 million ($23.4 million for married couples) without triggering gift or estate tax. But if the combined value of your business and your estate surpasses this amount, the taxes are steep: up to 40% of the amount that exceeds the limit.
2. Sell to family or a colleague
If you can’t afford to gift the business to your heirs, you could sell it to them instead. One common hurdle is that heirs may lack the capital to purchase the business outright, in which case a seller-financed installment note might be a viable solution. Instead of paying you a lump sum, the buyer would send you fixed regular payments over a set number of years, similar to a mortgage.
For example, if your business is valued at $4 million, you could establish an installment note in which the buyer agrees to pay you $200,000 plus interest annually for 20 years. The note’s regular payments can make the purchase more manageable for the buyer and provide steady income for you. Plus, if you sold the business for a gain, receiving payments in increments can help spread your tax liability over several years.
If selling to heirs isn’t a viable option, selling to co-owners or key employees can make for smooth handovers. Some owners even spend years laying the groundwork, slowly offloading duties to others so clients won’t notice a transition. If your business partner or employees lack financing, an installment note could be a solution here, as well. Just make sure the buyer can keep the business going long enough to repay you.
3. Sell to a third party
This option is perhaps best suited to more turnkey operations, like a restaurant or retail shop, rather than a business that’s reliant on the owner’s unique brand or expertise. But selling to an outsider can be complex—typically requiring lengthy negotiations and potentially triggering significant taxes—so many owners opt to work with a team of specialists, including a broker who can identify the strongest buyers and a tax attorney who can help plan for the tax consequences of a profitable sale.
By constructing a succession plan alongside a retirement plan, you can not only make sure your cash flow needs are met but also think about what will give your life meaning after you’ve handed over the reins. Will you keep a hand in the business, or move on to the next stage in life? Planning well and early can make it easier to find the option that’s right for you.
1Business succession planning: Cultivating enduring value, deloitte.com, 2015.