Funding a Succession Strategy: Making Sure the Business Can Actually Change Hands

For many business owners, the hardest part of succession planning isn't deciding who should take over.

It's figuring out how to actually make the transition financially possible.

A business owner may spend 20, 30 or even 40 years building a company. By the time retirement approaches, the business may be their largest asset and the primary source of their family's wealth.

They may want to transfer it to a child, sell it to a key employee, transition it to a partner or sell it to an outside buyer.

But there is a fundamental problem:

A business can be worth millions of dollars without the next owner having millions of dollars available to buy it.

That's why succession planning and succession funding need to happen together.

Having a Succession Plan Isn't Enough

Imagine a business owner has a company worth $8 million.

They have two children, but only one is involved in the business.

The owner's intention is to eventually transfer the company to the child who works in the business while treating the other child fairly.

On paper, the solution seems straightforward.

The child who runs the company gets the business.

The other child receives other assets.

But what if the business represents 80% of the owner's net worth?

There may not be enough cash, investments or other assets to create an equitable inheritance.

Now the family has a problem.

The business may need to be sold simply because there isn't enough liquidity to execute the owner's wishes.

This is why succession planning isn't just about who gets the business.

It's about how the transition gets funded.

The Three Basic Paths

There are countless variations, but most business succession strategies generally revolve around a few fundamental possibilities.

The business can be sold to an outside buyer.

It can be transferred to family members.

Or it can transition to key employees or existing business partners.

Each approach creates different financial and tax considerations.

An outside sale may provide liquidity to the owner but can involve finding a buyer, negotiating valuation and determining how the transaction will be structured.

A family transfer may accomplish the owner's personal objectives but create significant estate and tax considerations.

A key-employee or management buyout can preserve the company with the people who already understand the business, but those individuals may not have the capital necessary to purchase it outright.

That's where creative funding becomes important.

The Family Business Problem

Family succession can be particularly complicated.

Consider a business owner with three children.

One works in the company.

Two don't.

The owner wants the child who runs the business to eventually own it, but also wants the other children to receive a meaningful inheritance.

This creates a balancing act.

The business may be worth $6 million, while the owner's remaining investments are worth only $1 million.

Simply dividing everything equally isn't necessarily practical.

The child receiving the business may receive substantially more economic value.

And the other children may have no interest in owning the company anyway.

A properly designed succession strategy can potentially use insurance, trusts, investment assets and other planning tools to create liquidity and make the owner's intentions more achievable.

Key Employees Can Be Future Owners

Sometimes the best successor isn't a family member.

It may be the person who has spent 15 years running the company alongside the owner.

They know the customers.

They know the employees.

They understand the operation.

They've helped build the business.

But there is one problem:

They may not have the money to buy it.

A succession strategy can potentially be designed years in advance to gradually prepare that individual for ownership.

The business owner can establish a valuation framework, determine how the transition will occur and explore funding mechanisms that could make the eventual purchase possible.

This can also create a powerful retention incentive.

A key employee who knows they have a legitimate path to ownership has a very different relationship with the company than someone who simply receives a paycheck.

Life Insurance Can Create Succession Liquidity

Life insurance can be particularly useful when the succession plan needs liquidity at death.

Suppose a business owner wants to ensure their spouse and children are financially protected while allowing a key employee to eventually acquire the business.

The business may be worth $5 million, but the successor may not have $5 million available.

Life insurance can potentially create a pool of liquidity that can help facilitate the transaction or address other obligations, depending on how the arrangement is structured.

The important concept is not the insurance itself.

It's creating liquidity when liquidity is otherwise difficult to obtain.

Funding Buy-Sell Agreements

For businesses with multiple owners, succession planning often overlaps with buy-sell planning.

If one owner dies, the remaining owners may have the right or obligation to purchase the deceased owner's interest.

That creates a financial obligation.

If the business is worth $10 million and one owner owns 40%, the purchase price could be $4 million.

Where does the $4 million come from?

A properly designed funding strategy can potentially provide the liquidity needed to execute the agreement.

Without funding, the buy-sell agreement may look great on paper but become extremely difficult to execute in reality.

Don't Wait Until Retirement

One of the biggest mistakes business owners make is waiting until they're ready to retire before thinking seriously about succession.

A good succession strategy can take years to implement.

The next owner may need time to develop leadership experience.

The business may need to restructure its debt.

Ownership interests may need to be reorganized.

Valuation methodologies may need to be established.

Insurance coverage may need to be acquired while the owner and other key individuals are insurable.

Tax and legal structures may need to be coordinated.

And perhaps most importantly, the family needs time to understand what the owner actually wants.

Succession planning isn't an event.

It's a process.

Valuation Is Critical

You can't effectively fund a succession strategy without having a reasonable understanding of what the business is worth.

A valuation today may be very different five years from now.

Revenue could double.

Profit margins could change.

A major customer could leave.

The company could acquire another business.

Debt could increase or decrease.

The business could become significantly more valuable.

That's why succession strategies need periodic reviews.

A $2 million business and a $10 million business require very different succession funding.

The Real Goal: Preserve the Business and the Family

Good succession planning accomplishes more than transferring ownership.

It protects relationships.

It can prevent family disputes.

It can give employees confidence.

It can preserve jobs.

It can provide liquidity to heirs.

And it can give the business owner confidence that the company they've spent decades building won't be forced into an unfavorable sale simply because there wasn't enough liquidity to execute the plan.

Ultimately, succession planning is about answering three questions:

Who should own the business?

How will they acquire it?

How will everyone else be treated fairly?

The first question is often the easiest.

The second and third require actual planning.

Because a succession strategy without funding is really just an intention.

If you've spent a lifetime building a business, don't leave the most important transition in its history to chance.

This article is for educational purposes only and does not constitute individualized legal, tax, accounting, financial or insurance advice. Business succession strategies are highly fact-specific and can involve significant tax and legal considerations. Business owners should work with qualified legal, tax, valuation and financial professionals when developing and implementing a succession plan.