Avoiding this can sink a biz...but doesn't have to

The vast majority of businesses in the United States are small businesses, and many of those are family-owned operations or partnerships.

Unlike large corporations, small businesses and partnerships without solid succession plans often fail when the owner or a senior-level partner retires, becomes incapacitated or dies. What's more, problems can arise when partners no longer get along and decide to their own ways.

That's why industry observers say proper succession planning is essential, especially for family businesses, which will have to either identify family members who are qualified for leadership positions or consider other contingencies beyond the family. Succession planning for family-owned businesses, however, involves the nuances of family relationships and can be a difficult process.

Starting and growing a business usually involves a fair amount of sweat and sacrifice. Yet many entrepreneurs who have spent years building successful businesses would rather have a root canal than undertake the often-painstaking process of succession planning.

A succession plan is essentially an exit strategy, ideally one that ensures the current owner of a business, or that person's heirs, will be able to cash out at a fair value under certain circumstances.

In many cases, succession plans are also designed to ensure businesses survive and prosper when their current leaders are no longer in charge — because they either retired, met an untimely death or suddenly became unable to work.

"A succession plan helps to ensure the orderly transfer of a business from the current owners and founders to the next generation," said Richard Kahler, a certified financial planner and president of Kahler Financial Group based in Rapid City, South Dakota, in an interview last year.

"A business owner should consider having a succession plan if monetizing their investment and the continuation of the business are important, although it's not a given that these issues are important to every owner," he added.

A small business is often the largest asset belonging to its owner. Yet many owners procrastinate when it comes to succession planning, if they bother to do it at all.

Some avoid succession planning because they don't ever expect to fully retire or, like many people, haven't come to terms with their own mortality.

Having devoted a good chunk of their lives to building a business from scratch, some founders are reluctant to face the fact that they will eventually have to hand over the reins if their companies are to go on without them. Others may be loath to make certain hard choices, such as whether to pick a grown child or a long-time employee who is not related as their successor.

"If a business owner and his advisors do a really good job with succession planning, they may determine that the most-qualified successor is not a blood relative," said Martin Durbin, managing partner at accounting firm Crawford, Carter, Thompson & Durbin and financial advisor at Aperture Retirement Designs of Arlington, Texas, in an interview last year.

Given the complex issues involved, succession planning can be very time consuming. In some cases, it can take a year for a business owner to draft and begin to implement a succession plan.

Small-business owners tend to be very busy people, and many figure they don't have the time to address certain long-range issues. Others balk at the notion of paying thousands of dollars in fees to financial advisors, lawyers, accountants and other professionals.

But the absence of a succession plan leaves a lot to chance. Squabbles between the heirs of a deceased owner, or between heirs and employees, can sink a business.

So can a disability that renders an owner unable to work. As part of the succession-planning process, some advisors work with clients to determine whether they have sufficient life and disability insurance. Advisors may also draft employment agreements intended to ensure that owners can continue to draw salaries from their companies, until a certain age, if they suddenly find themselves unable to work because of a disability.

"Business owners need to make a choice about whether they want things to happen by default or design," said Durbin. "The default method will be easy on the owner, but could be incredibly difficult for his or her family."

Although succession planning isn't an exact science, the process typically involves a fair amount of soul searching, fact finding and goal setting. Advisors who specialize in the field usually have lengthy discussions with new clients about their goals and values, both personal and businesswise.

Clients often must wrestle with emotionally charged issues, such as whether to eventually sell a given business to a loyal employee or an outside buyer.

"It can be hard to get a business owner to face up to the fact that they may not own the business forever or to identify who might be capable of carrying on the operation," said Michael Branham of Minneapolis-St. Paul, a certified financial planner with Cornerstone Wealth Advisors, in an interview last year.

Succession plans may detail how ownership interests will be transferred — such as through an immediate buyout, a stock transfer or a so-called "earn-out provision" — and over what time period the transfer should take place, according to Branham.

Many successors don't have the money to purchase a business outright and decide to pay over time through an earn-out provision, which can be structured so that the new owners make yearly payments from company earnings over a designated period.

Some owners decide to provide financing for a buyer, but sell their companies in increments so that they have time to evaluate the performance of a potential successor.

Determining what a business is actually worth is usually a critical part of succession planning. Some advisors work with professionals who specialize in valuing businesses. Potential buyers, including internal successors, tend to look more favorably upon valuations prepared by an objective third party, experts say.

Valuations are based on a number of factors, including the worth of hard assets, such as real estate and machinery, and the ongoing cash flow of a business. The latter is usually given a good deal of weight when it comes to valuing service-oriented businesses.

"You can have an owner who insists his business is worth $1 million, but his employees say they wouldn't give him $300,000," said Martin Kurtz, a certified financial planner in Moline, Illinois, and CEO of The Planning Center, in an interview last year. "It is important to get to a common denominator."

Sometimes, the valuation process is a wake-up call for business owners, according to John Barnes of Columbia, South Carolina, a certified financial planner and chief executive officer of Pendleton Street Advisors.

Some owners find that they aren't likely to net enough from the sale of their businesses to maintain their current lifestyle during retirement, even after investing the proceeds. That realization may prompt some to take steps to improve cash flow while they are still calling the shots, said Barnes.

"We try to give them a pair of glasses that lets them see their business the way an outsider would," Barnes added in an interview last year. "A lot of what we do is an education process."

In the eyes of many investors and clients, a business with a succession in place, particularly a plan that has been updated periodically, has more appeal than one that isn't likely to outlive its current owner, experts say.

"Our clients have been very interested in our succession plans and how effective those plans might be should something happen to me, the old guy," said Kurtz at The Planning Center.