1 OWNERSHIP AND LEADERSHIP SUCCESSION A STRATEGIC ISSUE By: Keith A. Clark, Chairman SHUMAKER WILLIAMS, P.C. Harrisburg/Camp Hill/York, PA and Towson, MD Direct Telephone By: Richard E. Harper, Principal R.E. Harper Associates, LLC 112 Market Street, 7th Floor Harrisburg, PA Phone:
2 I. A Strategic Issue Whether a closely held business or a publicly held business
3 II. Succession is not just about the CEO It is about management, leadership, and ownership progression at all levels
4 III. Succession on the Micro Level Two deep with respect to each material function Discussion/Planning Back up on material functions should be part of periodic one to one reviews Should always be an area of review in preparation of periodic strategic plan Deal from a proactive posture vs. a reactive posture
5 IV. Two Types of Succession Unplanned The proverbial beer truck scenario Planned
6 V. Unplanned Succession Adequate working capital/liquidity/key man life insurance to fund the interim process The alternative forced to sell Planning for such crisis and sale
7 VI. Planned Succession for the Closely Held/Family Businesses
8 Options to consider Retain family ownership and management control Retain ownership but hire outside management Sell to an outsider or employee Close the doors
9 The answers to these questions become more critical and complicated when involving a familyowned business.
10 Why do family firms fail to transfer the business successfully from generation to generation? Lack of viability of the business Lack of planning Little desire on the owner s part to transfer the company Reluctance of offspring to join the company
11 Uniqueness of a family-owned business Majority of the ownership or control lies within a family two or more family members directly involved Duel system consisting of the family and business different roles, different expectations Conflicts arise when the roles assumed in one system intrude on the roles in the other
12 Issues in the family business Participation Leadership and ownership Letting go Liquidity for estate taxes Attracting and retaining non-family executives
13 Issues in the family business Compensation of family members equality vs. merit Successors who chooses and how to choose among multiple successors Strengthening family harmony
14 Different relationships Family members neither an employee nor an owner Family members an employee but not an owner Family members an employee and an owner Family members not an employee but an owner Non-family member employee but not an owner Non-family member employee and an owner
15 Strategic planning for the familyowned business What are the long-term personal and professional goals of family members What is the family mission Is the family committed to establishing and operating a business
16 Strategic planning for the familyowned business How do you envision the business in the future Will family members be active in the management or will they be passive How will issues, such as compensation, benefits and performance evaluations, be determined
17 The family retreat Family creed or mission statement Management succession Estate planning Strategic business planning The reward system
18 The family retreat Performance evaluation Communication within the family Preparing adult children to enter the business Transition timing Entrance and exit policies
19 Succession issues for the founder Fear of death Reluctance to let go of power and control Personal loss of identity Fear of losing work activity Feelings of jealousy and rivalry towards successor
20 Succession issues for family Founder s spouse s reluctance to let go of role in firm Norms against discussing family s futures beyond lifetime of parents Norms against favoring siblings Fear of parents death
21 Succession issues for employees Reluctance to let go of personal relationships with founder Fears of differentiating among key managers Reluctance to establish formal controls Fear of change
22 Environmental succession issues Founder, colleagues and friends continue to work Dependence of clients on founder Cultural values that discourage succession planning
23 Planned Succession Within the Family or Outside the Family
24 Ownership succession may be different from leadership succession
25 Separate passive investment from active management and leadership
26 Fair vs. equal treatment of second and third generations working actively in the business and those not working actively in the business
27 Transition from entrepreneurial stage to administrative stage: Separation of investment from management function Use of board of directors/board of advisors Use of tiebreaking vote
28 Should we sell when and who are the best prospects (family, employees, competition) Want to sell before any downward spiral
29 Succession Planning and Capital Planning go hand-in-hand If selling to family bargain-sale How will they pay for it security and controls for seller If transfer on death may be too late sufficient liquidity in estate so that taxes do not devour business
30 Some techniques for transferring family-owned businesses: Methods to freeze value: Recapitalization to freeze value (difficult in sub-s s) Family Limited Partnerships Gifting of ownership interests (annual valuation issue) Redemption
31 Some techniques for transferring family-owned businesses: Charitable Remainder Trusts Bargain-Sale ESOP s Buy-Sell Agreement
32 VIII. BUY SELL AGREEMENTS
33 What is a Buy Sell Agreement? Written Document Essential Provisions: Buy-Sell Agreement Ownership Triggering events Valuation Funding
34 Buy Sell Agreement Advantages Help Establish Business Value with the IRS Create a Market for the Business Create Liquidity if Funded Provide Support for the Family if Funded Provide Protection for non-family Member Owners Provide Protection for Minority Owners Help Minimize Conflict Among Owners
35 Buy Sell Agreement Disadvantages Cost Time
36 Types of Buy Sell Agreement Entity Purchase Cross Purchase Wait and See Trusteed
37 Entity Purchase Buy Sell Agreement (Stock Redemption) Today... Business $ (2) Life Insurer (1) Agreement Owner A Owner B How the Agreement Works: 1.The Business agrees to purchase the interest of the deceased owner. 2.Business pays premium on each owner s policy.
38 Entity Purchase Buy Sell Agreement (Stock Redemption) At A s Death... Business (3) $ Life Insurer (4) Agreement (5) Owner A s Family Owner B Now Owns 100% How the Agreement Works: 3. Business receives generally income tax-free insurance proceeds. 4.Business uses cash to purchase owner A s business interest. 5.Surviving owner B now owns 100% of the business.
39 Cross Purchase Agreement Today... Business Owner A (1) Agreement Owner B $ (2) Life Insurer $ (2) How the Agreement Works: 1.The surviving business owner agrees to purchase the interest of the deceased owner. 2.Each business owner individually purchases insurance on the other business owner s life.
40 Cross Purchase Agreement At A s Death... Life Insurer (3) $ Owner A $ (4) (5) Owner B How the Agreement Works: 3.The surviving owner B receives generally income tax-free insurance proceeds. 4.The surviving owner B uses the policy proceeds to purchase owner A s business. 5.The surviving owner B now owns 100% of the business.
41 Trusteed Cross Redemption Agreement Today... Buy-Sell Agreement (1) Corporation Premiums (3) Life Insurer Owner A Trustee Owner B (2) Holds Life Insurance & Stock Certificates How the Agreement Works: 1.Owners agree that upon the death of an owner, the Corporation will redeem his/her entire stock interest. They adopt a Trusteed Cross-Redemption Plan. 2.The Corporation purchases life insurance on the life of each owner to fund the redemption with the Trustee named as owner and beneficiary. The Trustee receives stock certificates and holds them in trust. 3.Premiums are paid to Life Insurer by the Corporation.
42 Trusteed Cross Redemption Agreement At A s Death.. Corporation Life Insurer (4) Life Insurance Proceeds Trustee (6) Stock Certificate (5) Cash Stock Certificates (7) Holds Life Insurance & Stock Certificates Holds Life Insurance & Stock Certificates How the Agreement Works: 4.Upon the death of Owner A, Trustee receives the proceeds of the policy.* 5.Trustee uses the proceeds to purchase the stock certificates from owner A s estate. 6.Trustee releases A s stock to the Corporation in accordance with the terms of the agreement. 7.B now owns 100% of the outstanding stock.
43 Trusteed Cross Purchase Agreement Today... Owner A ($) Premiums (3) (1) Life Insurer Owner B Buy-Sell Agreement Owner C $ Trustee (2) Holds Life Insurance & Stock Certificates How the Agreement Works: 1.Owners agree that upon the death of an owner, the survivors will purchase his/her entire stock interest. They adopt a Trusteed Cross-Purchase Plan. 2.Life insurance is purchased on the life of each owner to fund the agreement and certificates and holds them in trust. 3.Premiums are paid to Life Insurer either by the owners or through a Split-Dollar Plan.*
44 Trusteed Cross Purchase Agreement ($) At A s Death Life Insurer Trustee (4) Life Insurance Proceeds How the Agreement Works: (5) Cash Owner A s Estate (6) Stock Certificates Holds Life Insurance & Stock Certificates 4.Upon the death of owner A, trustee receives the generally income tax free proceeds of the policy. * 5.Trustee uses the proceeds to purchase the stock certificates form owner A s estate. 6.Trustee releases owner A s stock to B and C in accordance with the terms of the agreement.
45 Business Succession Planning Fundamentals: Traditional Plan
47 Insurance Payment Strategies Cash Financed Split Dollar Profit Sharing Plan
48 Funding Technique: Cash Cash (Terminal Funding) Advantages Simple No Immediate Outlay Disadvantages Cost Full value of business as determined in buy sell agreement Cash may not be available when needed Adverse affect on cash flow may be harmful to business operations.
49 Funding Technique: Sinking Fund/ Reserve Reserve (Sinking Fund) Advantages Simple No Immediate Outlay Disadvantages Cost Full value of business as determined in buy sell agreement although interest may be earned on the reserve, which reduces the cost of this alternative Death may occur before sufficient funds are accumulated Business may not make annual contributions to sinking fund because of other expenses
50 Funding Technique: Borrowing Borrowing (Bank Loan) Advantages Simple No Immediate Outlay Disadvantages Cost Full value of business as determined in buy sell agreement plus cost of interest payments on borrowed money. Credit may not be available after death of an owner. Surviving business owner may have to borrow at a time of high interest rates. Indebtedness may impair business growth by decreasing cash flow which could otherwise be used for expansion.
51 Funding Technique: Installment Sale Installment Sale Advantages No Outflow Until Sale Outflow Reduced Recipients Receive Interest on Unpaid Balance Spread Gain Over Several Years Estate Tax Value Frozen Disadvantages Cost Full value of business as determined in buy sell agreement plus interest. Heirs may not receive all of payments if business encounters financial difficulties. Business growth may be inhibited by decreased cash flow. Credit, which is needed to finance other business needs, may be impaired. Owner who survives cannot fully realize the benefit from increased profits until installment obligation paid off.
52 Funding Technique: ESOP Overview of ESOP (Employee Stock Ownership Plan) ESOP can be written as a stand alone plan or can be combined with a 401(k) plan C and S corporations are allowed 25% deductions of eligible payroll for contributions C corporations can deduct dividends if funds are used to retire debt or pay participants Typically, the ESOP purchases between 25% and 75% of the total company s stock. Upon purchase of stock, the ESOP is a single tax exempt shareholder.
53 Funding Technique: Life Insurance Life Insurance Advantages Agreement Funded When Policies are Issued Death Proceeds Generally Received Income Tax Free Most Economical Financing Method Credit Position Strengthened Cash Value Can Be Used for Buy Out Due to Retirement or Disability Disadvantages Possible Lack of Insurability Other methods can be used for uninsurable owner Installment Sale Sinking Fund Premium Payments
54 Suggested Financing Strategy Hybrid Approach Insurance Installment Sale
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