Does your business need a succession plan?

What happens to a company if the owner has a heart attack and can’t take care of the business for a few months? What if the owner dies? What if they want to retire or move on to a new project? Few businesses have given much thought to these questions. But that’s a mistake because every owner will eventually exit a business, voluntarily or not. It’s just a matter of time.

Putting a plan in place for handling these scenarios is known as business-succession planning. To create a plan, you’ll want to address at least five topics. First, identify potential successors—people or companies that you might want to take over in case of death, disability, or retirement. Second, write down a succession timeline detailing when and how the succession will happen. Third, prepare standard operating procedures for your business such as an employee handbook, training documents, and a list of procedures for handling common situations. These documents will be an invaluable playbook for whoever steps into your shoes. Fourth, value your business using a commonly accepted valuation method. And plan on updating this valuation frequently. Finally, determine how the succession will be funded. For example, maybe the new owner will pay cash. But more likely, the succession will be funded through life insurance or an installment loan.

Not every business needs to bother with these steps. But you probably should create a succession plan if your business has complex processes, employs people other than you, and has repeat clients or ongoing contracts. You might also want to move forward with a plan if you already have a successor in mind. If so, it’s helpful to document the key terms between you and the successor.

When should you set up a succession plan? As soon as possible. But if you are nearing retirement age or beginning to think about selling or leaving the business, then a succession plan becomes especially urgent.

Succession plans come in many shapes and sizes. But some versions are more common than others. Below are the most frequent five.

The first option is to sell the business to a co-owner (assuming that you have one or more partners). Normally the partners will sign an agreement saying that if one of them passes away, the surviving partner will buy the deceased partner’s share of the business from the deceased partner’s heirs. The upside of this arrangement is that the heirs will receive fair compensation while the surviving partner (who likely cares more about the business) will get the business. But the downside is that technically each partner must be prepared to buy out the other partner’s shares at a moment’s notice. The usual solution is life insurance policies that can cover most if not all of the purchase.

A related avenue is for the business, not your partners, to buy your ownership interest. Under this option, the business will obtain life-insurance policies on each owner and then use the proceeds to buy the deceased owner’s stake in the business when they die. The net effect is that the remaining partners end up with a bigger share of the business. This alternative works best if a business has many owners. But it’s a poor choice if the business only has two or three owners. In that case, the owners will want to directly buy the deceased partner’s ownership stake because it leads to a better tax basis, which translates into lower capital gains tax later.

Scenario three is to transfer a business to an heir. This route works well if only one heir wants to take over the business and has the savvy to keep the business running. But if multiple heirs are in the mix, then expect some family drama. To smoothen the transition, you’ll need provide clear instructions on who will take over as well as what the other heirs will receive. You may also want to include a buy-sell agreement that enables heirs who don’t want to be part of the business to sell their shares to other heirs.

A fourth route is to sell the business to a key employee. This avenue makes sense if you don’t have a co-owner or a family member to entrust the business to. Like selling to a partner, you’ll want a buy-sell agreement between you and the key employee. But don’t expect the employee to have the funds to buy the company quickly. Instead, you’ll likely need to plan on getting paid back over time. For instance, the employee might pay 10% as a down payment and then make quarterly payments over several years.

Finally, you can sell the business to an outside party. This option works well if you have a turnkey business that another person can readily take over. But if, for example, your business is branded under your name or relies on your network of relationships to attract customers, then it will be much less valuable to an outsider.

If you need to set up a succession plan, consider speaking with a business attorney. And if the business has complex finances, then also include a CPA in those discussions.

This column is for informational purposes only and is not intended to be taken as legal advice. For your specific case, consult a lawyer.