Investment Commentary
6 minute read time
When business owners and other professionals learn that I have worked on hundreds of succession plans, oftentimes they ask where to start. The answer is: Start with the business owner’s succession purpose and how that purpose translates to happiness. Stated another way, determine whether the transition of business ownership needs to result in legacy, loyalty or liquidity.
While some plans accomplish more than one purpose, it is critical that the business owner defines which purpose is the most important because, like all strategies, part of the process is deciding between trade-offs.
When it comes to the transition of ownership of a closely held business, there are generally only three categories of people who will own the business after the current owner does not: family, insiders or outsiders. Generally, the choice of who should own reflects a specific purpose and vice versa. If the business owner’s primary purpose is legacy, then the ownership tends to transition to family. If loyalty is key, then insiders (people who work for the business and have helped the business and the owner succeed) tend to get ownership. And if liquidity is the primary purpose, the business is generally sold to an outsider (a person who has not been involved in the business).
In my experience, this is the most common succession planning purpose of closely held business owners. For founders, many (if not most) of them view their business like one of their children. And there is good reason for that. The owner has birthed it, nurtured it, watched it grow, tried to let it operate independently, cared for it when it is sick and swelled with pride when it succeeds. For second or third generation owners, they often view the business as an extension of their ancestry, and the business offers an emotionally powerful connection to family members they love, respect, appreciate and miss. With all of these emotions swirling around, it is understandable why most business owners want to transition ownership to a family member – they are putting the care of something they love in the hands of someone they love.
But a plan of legacy has challenges and issues that must be addressed. First, the business owner has to recognize that the success and value of the business is a direct result of the business decisions that are made. The better the decisions, the more successful and valuable the business. That means a critical focus needs to be on creating a governance (decision making) structure to ensure that the best decision makers are empowered to make the best business decisions. That needs to be the priority regardless of family dynamics and considerations of familial equality or fairness.
Second, there needs to be thought on how to address involved and uninvolved family members. Does Mom’s and Dad’s collective definition of legacy mean that all children should own the business equally regardless of involvement? If so, what are the emotional challenges that need to be considered and addressed in that structure? If Mom and Dad do not believe that children should own business equity equally, how are concepts like fairness and equality addressed in the plan?
Third, if more than one child is to be involved in the business, how does the business structure the right roles to maximize each child’s impact, success and happiness? Is there thought given to how to protect the business from the outside emotional influences that come from siblings’ pasts? Finally, with the goal of maximizing business success, how should each dollar of profit be divided among owners, decision makers and employees? Are the right incentives in place for the business to thrive and grow?
When a business owner is driven by loyalty, the focus is less on the business’ success and longevity and more on what the business’ success means to people the owner feels a sense of loyalty to. Those feelings of loyalty might extend to the management team, employees, clients, involved family members or a combination of those groups.
When driven by a sense of loyalty, the succession plan is designed to empower loyal managers and minimize disruption to loyal employees. The buyers tend to be insiders – those who have worked at and managed the business. Because the financial wherewithal of management will almost undoubtedly be less robust than an outside buyer, when loyalty is the priority, the owner will generally be willing to take a lower price and/or take on more transactional risk through funding a larger percentage of the buyout as seller debt.
While loyalty is an admirable trait, the business owner needs to consider some key risks in transferring ownership to business insiders.
One risk is the possibility that current effective managers will be unable to evolve into effective leaders and owners. There are different skills to management and leadership; therefore, it is critical to work with a leadership consultant to help the future owners effectively change roles in a way that will not disrupt or, worse, harm the company.
A second risk is that the new owners will not have the skills to replace the former owner. Loyalty-based succession plans work best when leadership is transitioned before ownership. In other words, success tends to be conditioned on the prior owner becoming irrelevant to the business before the sale.
A third risk is that the current owner is critical to the collaborative functioning of the team, and when that calming presence is gone, the team loses its ability to function. Again, loyalty-based succession works best when the owner allows the team to operate on their own prior to transition.
As mentioned above, a closely held business can be an emotionally important asset. It might be thought of as a child or as a source of happiness for people the owner cares about. But there are situations where the business is looked at as a financial asset, the same as Google stock. When the business owner primarily views the business as an investment, and the business owner, as is typically the case, becomes uncomfortable about owning the investment beyond their retirement, liquidity is the primary goal. In other words, “How do I sell the business for the highest price possible?”
When liquidity is the priority, the succession plan is directed at maximizing price. In doing so, it is helpful for the owner to view the business through the eyes of a potential buyer. Key questions that an owner should consider are:
This self-scouting should be done in conjunction with a team that includes an investment banker who provides the best mirror to the owner to uncover blind spots and self-deceit.
As the White Rabbit told Alice in Wonderland, “If you do not know where you are going, any path will get you there.” A succession plan starts with an honest evaluation of the values and beliefs of the owner. Given that ownership and leadership will transition (it’s called mortality), who should own the business and why? How will that transition further the goal of taking care of the people the business owner cares about? And what does the business owner want for and from their business: legacy, loyalty or liquidity?
The answer to that question is the perfect place to start.
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