Small businesses are an economic powerhouse. According to the Small Business Administration, companies with fewer than 500 employees make up 99.9% of the businesses in the US—and they generate 44% of our total economic activity.1
An overwhelmingly large number of these small businesses are owned and operated by families. Some are pillars of their communities, started a century ago and passed down through three or even four generations. Others are newcomers to the local business scene, striving to carve out a sustainable and profitable business to pass down to their children when the time comes.
Although these small-business owners may intend to keep the business in the family, those intentions are not always formalized. In fact, the National Bureau of Economic Research’s Family Business Alliance reported in 2019 that only 15% of family-owned businesses have any sort of documented succession plan in place.
The need for succession planning
To be fair, a larger number of family-business owners likely have an informal verbal succession plan in place. However, a written plan not only spells out the first generation’s wishes for the company, but can also ensure the business can keep running after subsequent generations take the helm. Furthermore, a formalized succession plan also serves as a family peacekeeping tool.
For example, say Bob and Jill own a printing shop. As part of their estate planning process, the couple makes arrangements to leave the shop to their son, Ryan, who has been involved in the company for years. The couple also has two other grown children, both of whom have pursued careers outside the business. Bob and Jill make other arrangements to financially compensate those two children in other ways. By doing so, they ensure equitable distribution of their estate to their three children and spell out whom they want to run the business when they no longer can.
A documented succession plan also allows owners to direct what happens to nonfamily employees when the business changes hands. An owner may want to recognize longtime employees with financial distributions from the business, or even award them a percentage of ownership in the company. Without written documentation in place, these wishes could be challenged by heirs who would prefer to keep the business within the family.
Questions to address in your family business succession plan
For some family-owned businesses, transitioning ownership to the next generation will be simple and straightforward. For others, particularly those with some family members that are involved with the company and other family members that are not, the process will likely be more involved. A succession plan will include both corporate and estate planning documents. There may be new shareholder or operating agreements, or a number of trusts. But no matter its complexity, every family business succession plan should answer these questions:
Question 1: Who will take the reins?
First and foremost, a succession plan should lay out who will take ownership of the company and who will control operations, particularly if this involves two separate people or groups of people. This can be accomplished by dividing the ownership interests in the company into voting and nonvoting shares, which is especially useful when some family members are actively involved with the business and others are not. Those individuals actively involved with the business would hold the voting interests, and those not actively involved would hold nonvoting interests. This allows value to be shared with all members of the family.
Question 2: How—and when—will this transition take place?
For a planned transition, your business plan should address when the change in ownership/leadership takes place. The plan might also cover what role the first generation will continue to play in company operations (if any) and whether the transition will take place in phases or all at once.
Question 3: How will compensation work?
If the first generation remains involved in the company, the succession plan should cover how much compensation these employees will receive, how often they will be paid, and how long the income stream will continue.
Question 4: How will other family members be affected by the transition?
In some cases, the first generation may want to equalize their estate plan between those family members actively involved with the business and those family members that are not involved with the business. There are a number of options to consider when doing this, including structuring the company with voting and nonvoting interests, applying life insurance strategies, and balancing the estate with other assets outside of the business entity.
Question 5: What happens to current employees?
Do you wish to reward longtime employees for their performance and loyalty, or promote them to leadership within the company? Be sure to include details about your wishes in the succession plan or handle these decisions prior to implementing your succession plan.
Question 6: What is the contingency plan?
Sometimes, even the most well-thought-out succession plan will go awry. A contingency plan will cover what happens if younger generations must take control of the business sooner than expected.
Communication is critical
While a well-developed succession plan is important for the future of your family business, communicating the plan is critical to its success. We encourage our clients to regularly schedule family meetings to discuss the first generation’s financial picture and wishes. Families who own a business should also carve out time to discuss the company’s future. Doing so can help get everyone on the same page and ensure your business will continue serving your customers and community for generations to come.
At CIBC Private Wealth, we help families navigate the challenges of transferring a small business to the next generation. Visit our Privately Held Business page to learn more.