Family works on their business succession plan together.

July 08, 2019

8 Things to Include in a Succession Plan When Transitioning to Multiple Successors

Family business owners may assume their clearly articulated succession plans will assure a smooth transition for the company. If they haven't formally documented and adopted those plans, however, the owners may leave a messy, complex surprise for their heirs or partners and, potentially, themselves.

Consider the real-world case of a couple who planned to leave the family business to their children, with each inheriting the company in stages based on age, education and outside work experience. The plans, never formally written into business documents, envisioned all the children eventually owning equal shares.

When the parents died unexpectedly early and at roughly the same time, however, their eldest grown child wound up with a bigger stake than the younger siblings — a situation that none of the company governing documents, the parents' estate paperwork, the trustee nor family bonds could fix. The siblings disagreed on a resolution and wound up selling the business, receiving unequal proceeds from the sale.

“It's better to communicate those things rather than have hostilities, so it keeps the family in order," said Natasha Davis, City National Bank senior wealth planner, who encountered the situation while in private practice. She recently worked with another family to avoid a similar scenario.

How to Create a Succession Plan for Multiple New Owners

Whether gifting to children or selling to outsiders, a business owner shifting the company from one to multiple owners needs to take care — working with a lawyer, banker and CPA — to assure a successful transition.

By the same token, groups of people buying a company together need to decide, in detail, how they will operate the business and participate in the transaction.

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

Formalize It

Rather than simply stating their intentions, owners need to adopt a written succession plan into company documents and potentially take other formal steps to make sure the business transitions to new owners the way they intend.

Succession plans need to be part of the company's governing documents, adopted as a formal plan and recorded into the minutes, said Davis. A company's operating or shareholder agreement defines what action is permissible and how it should occur, she said.

Business owners face several choices in deciding how to exit ownership, depending on their personal and company goals. If no family members want to take control, an owner might sell to outsiders, managers or employees.

No matter whom you plan to transfer ownership to, it's important to detail and formalize an array of expectations, processes, goals and contingency plans, and to do your homework before signing any agreements.

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

The agreement can provide for veto rights, exit rights upon a material disagreement between owners, purchase rights upon an owner's death, divorce or disability, and minority-owner checks on majority owners, he said.

"In any scenario, buy-sell terms should be carefully considered to protect the interests of all the owners," Rust said.

Define Roles

Buyers, however they may be connected to each other, also need a clear plan on who will do what in the business, in terms of money invested and repaid, management, daily operations, decisions and compensation, said Alicia Goodrow, a partner in the virtual 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.

The buyers may be siblings, people who met on the sidelines at a Little League game, or strangers brought together by someone else. Regardless, said Goodrow, it's important to develop a clear, written understanding of their roles and responsibilities.

Goodrow advises clients to use a spreadsheet that lists every decision — significant and seemingly trivial — the business faces, and to detail who will handle which decisions. (Tip: Everyone shouldn't be deciding everything.) The owners should incorporate the decision into their LLC or share management agreements, she said.

“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's complicated," she said.

Management control is very important, Rust said, noting that minority shareholders can wind up with little to show for their investment — and lose their employment at the company — if their relationship with a majority owner sours.

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

His advice for minority buyers? "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," Rust said.

Find Trusted Advisors

If siblings or other family members comprise the buyer group, they should jointly designate a neutral third party to advise the owners and break ties on disagreements, said Goodrow, who works with three brother-sister owner sets.

She regularly counsels sibling buyers to put together an advisory committee, usually composed of older people trusted by both the younger and retiring generations. They may be paid a fee for attending quarterly meetings but shouldn't have equity in the business.

“They can serve as a brain trust. They usually have a mentorship relationship with the parties involved," said Goodrow. “I find that that can be very helpful."

Specify Contingencies

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

"Provisions should be made for the purchase of each owner's shares upon his or her death. This provides not only 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 can be especially important to the remaining owners if the spouse and heirs are not active in the business or if personality conflicts would create issues with ongoing business operations. The same issue exists if an owner divorces his or her spouse where there is the possibility the former spouse may receive shares in the business as a result of the divorce proceeding or marital property settlement," he said.

Partners also may want to specify that if one owner stops working for the business voluntarily or because of an illness or disability, the remaining working owners 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 serious deadlocks. For disputes among 50 percent owners, Rust sometimes recommends a "shotgun buy-sell" process that allows one owner to quickly buy out the other at a set price, based on agreed-upon procedures.

Vet Buyers

Sellers need to conduct due diligence on buyers and make sure they know what they're doing, Goodrow advises.

“If you're a seller and you're trying to choose among buyers, you want the buyer who's most organized, especially if there's an earnout," she said. Sales often involve an earnout, in which the seller receives a percentage of revenue over time, and a transitional consulting period, she noted.

A dysfunctional buyer can spell trouble for the seller, Goodrow noted, citing a case in which a business lost most of its customers shortly after a sale, prompting the buyer to sue the seller to rescind the deal.

She usually encourages business owners to sell to an established competitor or private equity group or someone bigger in their supply or purchasing chain, “but not to four people who've said '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."

Put together a term sheet and try to entertain multiple offers, Goodrow advises.

Handle Legacy Employees

Weaker legacy employees can pose a challenge in family succession plans, said Goodrow. When outsiders buy the company, they tend to do whatever they want regarding unproductive employees, but these relationships can be tricky 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 maybe Harvery's a godfather, an uncle or an uncle-like figure, it's really hard to get rid of Harvey," she said. While letting Harvey go may be healthy for the business in the long run, "it can be incredibly disruptive to the business in the short run."

Tend To Family

A parent selling or giving a business to offspring may choose any number of ways to structure that transition. If some of the children plan to inherit and run the business while their siblings pursue other careers, parents should consider ways to assure all parties are treated equitably in estate planning, said City National's Davis.

One option for achieving this would be purchasing a life insurance policy to benefit a child not inheriting the family business, for an amount equal to the value of each sibling's shares in the company at the time the parent gifts the firm to them.

If two brothers take control of the business and receive shares equal to $5 million each, the parent could make their sister who's not involved 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. It doesn't matter, though, because the value was set equitably at the time the parent gifted the business to the children taking ownership.

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 Davis. A parent passing along a business might also include buyout provisions so the next generation can buy out a sibling who is not interested in making a career in the family business, she said.

If one son is actively involved in a parent's business and his siblings have other careers, the parent might give that child equity in the company and form a separate business for all the children, giving it a passive stake in the main venture and allotting the active child a bigger portion, Goodrow suggested.

“It's fairly common to put together a solution with different kinds and different levels of involvement," said Goodrow.

Remember Tax Implications

Owners should consult with professionals to ensure they experience the optimal tax treatment in organizing the business succession. A parent redeeming his stock in a family-owned corporation, for example, might inadvertently cause the sale to be treated as a dividend rather than a sale of interest said Davis.

"Careful planning must occur with a CPA and tax attorney to avoid unintended tax consequences," she said.

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. City National Bank's experienced wealth planners and commercial bankers are ready to help guide your succession planning with care and expertise. 

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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.

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