Man and woman succession planning

June 24, 2020

Succession Planning: How to Transition Your Business to Multiple Owners

In some situations, ownership of a business may need to transition from a single entrepreneur to multiple owners or stakeholders. This is especially common in family businesses, where those destined to inherit the company could be multiple siblings with varying degrees of interest in taking an active role in the business.

In these situations, a succession plan can become particularly complex.

As you work to outline the different roles and responsibilities of multiple owners, you should create a blueprint for how your company will run after you transition the business from one owner to many.

A business succession plan for multiple owners has distinct features that can help ensure the company continues to succeed years after the initial transition.

Here's a general outline of each.

First, formalize your terms in great detail

It's not enough to simply state your intentions.

You must take time to understand your company's operating or shareholder agreement, which defines what action is permissible and how an action should occur.

According to Jeffrey Rust, partner in the Rivkin Radler law firm, a company's operating or shareholder agreement can provide for:

  • Veto rights.

  • Exit rights upon a material disagreement between owners.

  • Purchase rights upon an owner's death, divorce or disability.

  • Minority-owner checks on majority owners.

"Having an agreement in place that addresses both management issues and buy-sell terms among the owners is very important and should be signed before the single owner elects to transfer her shares to one or more of the other owners," Rust noted.

By considering the agreement beforehand, you ensure buy-sell terms protect the interests of all the owners and help eliminate the risk that competing expectations, processes and goals among the owners could lead to costly future litigation.

While you're at it, define different roles

New owners also need a clear plan on who will do what in the business.

In creating a plan, it's important to think in terms of money invested and repaid, management, daily operations, decisions and compensation, said Alicia Goodrow, a partner in the business law firm Culhane Meadows.

“The key thing when you have multiple owners, whether it's two or four or 15, is to really define the roles and to enter into a clear, concise, written agreement about who's doing what," she said.

Regardless of whether or not the new owners are siblings, people who met on the sidelines at a Little League game, or strangers brought together by someone else, it's important to develop a written understanding of everyone's role and responsibility, emphasized Goodrow.

How to get started

Goodrow advises clients to use a spreadsheet that lists every decision the business faces, including the seemingly trivial.

Detail out who will handle which decisions. Once that's decided, each owner should incorporate these responsibilities into their LLC or share management agreements.

“Before they go and engage with a seller, whether that seller is dad or that seller is a prospective exit party, they need to know what their story is and put their project together, and that can get complicated," she said.

Minority shareholders, listen up

Management control is very important, especially for minority shareholders, Rust said.

Minority shareholders could wind up with little to show for their investment, and they could lose their employment at the company if their relationship with a majority owner sours.

His advice?

"If you are taking shares as a minority owner, be sure to have an agreement addressing both control and exit rights to protect you from oppressive actions of the majority," said Rust.

"If the minority shareholder becomes unhappy with how the business is being run by the majority, the minority shareholder may have a few options to receive value for his or her financial investment or sweat equity."

Without agreed-upon veto rights and management or board representation, the minority owner's ability to achieve a return on his or her investment is left in the hands of the majority.

The majority can freeze out the minority holder by withholding earnings, management involvement and compensation.

Next, make sure everyone specifies contingencies

Among other issues for multiple owners to consider is the disposition of their shares in case of death, divorce or disability, said Rust.

"Provisions should be made for the purchase of each owner's shares upon his or her death. This not only provides liquidity to the estate of the decedent but also prevents the surviving spouse or the decedent's heirs from taking an ownership stake or possibly control of the business," he said.

This point is especially important to all remaining owners. In some cases, their spouses and heirs may have no involvement in the business, and different personalities can threaten ongoing business operations.

The same risk exists if an owner divorces his or her spouse, who is set up to receive shares in the business as a result of the divorce proceeding or marital property settlement, Rust said.

Here's what to look out for

In creating specific contingencies, partners may want to specify that if one owner stops working for the business voluntarily due to illness or disability, the remaining owners who continue to work may buy out his or her position.

"This way, only the remaining owners will receive value for their continuing efforts," Rust said.

Owners also should agree in advance on a mechanism to break down serious deadlocks.

For disputes among 50 percent owners, Rust sometimes recommends a "shotgun buy-sell" process.

This process allows one owner to quickly buy out the other at a set price, based on agreed-upon procedures.

What not to do

Goodrow cautions against selling, say, to four people who simply believe it's a great time to buy a business together.

"From a seller's perspective, I think it's much riskier to sell to a newly formed group of people," said Goodrow.

Instead, she usually encourages business owners to sell to an established competitor or a private equity group - anyone who is bigger in their supply or purchasing chain.

Then there are the legacy employees

Weaker legacy employees can pose a challenge in family succession plans, said Goodrow.

When outsiders buy the company, they tend to make their own decisions about unproductive employees, but these relationships can be trickier when children take over from a parent, she noted.

Family businesses often have a long-time employee — let's call him "Harvey" — who's close to the family but may not be the best fit for the future, said Goodrow.

“When Harvey has been an employee for longer than the buyers have been alive, and he's somewhat of a paternal figure, it's really hard to get rid of Harvey," she said.

While letting your "Harvey" go may be healthy for the business in the long run, be aware that it can be incredibly disruptive to the business in the short run.

Finally, family tends to family

If some of the children plan to inherit and run the business while their siblings pursue other careers, parents should try to ensure all parties are treated equitably in estate planning, said Paul DeLauro, manager of Wealth Planning at City National Bank.

One option for achieving this would be purchasing a life insurance policy to benefit the child who is not inheriting the family business.

This life insurance policy might reflect the amount of each sibling's shares in the company at the time when the parent transfers the business to them.

For example, if two brothers were to take control of the business and receive shares equal to $5 million each, the parents could make a sister who has opted out of involvement in the company the beneficiary of a $5 million life insurance policy.

When the parent dies, potentially decades later, that $5 million life insurance payout could far exceed the business's value or pale in comparison, depending on how well the firm has fared.

Regardless, however, the value was set equitably at the time when the parent gifted the business to the children taking ownership.

For your consideration

Another possibility would be to carve out a piece of the business — real estate, for example — to benefit the child not seeking active involvement in the company, said DeLauro.

Or, a parent passing along a business might include buyout provisions. These would allow the next generation to buy out siblings who are not interested in building their careers in the family business, he said.

In fact, if one child is actively involved in a parent's business while his siblings have other careers, the parent might give that child equity in the company and form a separate business for all of the children, allotting the active child a bigger portion, Goodrow suggested.

Regardless, there are multiple ways to approach succession before your business changes hands.

Your legal, tax and banking team can help assure that different pieces of your succession and estate plans align with each other to achieve the results that you and your heirs or partners expect.

Contact City National Bank today to speak with experienced wealth planners and business bankers who are ready to help guide your succession planning with care and expertise.

This article is for general information and education only. It is provided as a courtesy to the clients and friends of City National Bank (City National). City National does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors or persons quoted as of the date of the article with no obligation to update or notify of inaccuracy or change. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.

City National, as a matter of policy, does not give tax, accounting, regulatory or legal advice. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations. You should consult with your other advisors on the tax, accounting and legal implications of actions you may take based on any strategies presented, taking into account your own particular circumstances.

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