Posted on Feb 11, 2015 by Michael G. Roberts
Is your closely-held business protected from the five dreaded Ds – death, disability, divorce, disaster and disagreement?
Turmoil, and even business failure, can follow if you don’t have a legal succession plan in place when any of these events occur. While this may not offer you any comfort, you are certainly not alone if you haven’t yet set up a succession plan: fewer than half of closely-held and family-owned businesses have a plan in place that covers these contingencies.
Succession planning often focuses on having someone ready to run a business when the owner or CEO moves out of the picture. However, ownership and control issues can be even more important. These are legal issues that must be addressed in agreements that are written with a knowledge of state laws on business entities, contracts and estate planning.
Start with objectives
We always tell clients to start by defining their goals and objectives. This will take some time, and will involve all stakeholders in the business, as well as the owners’ children if it’s a family-owned enterprise. Some owners will want to ensure that the business continues as a profitable enterprise when they step out of the picture, continuing to provide support for their family. Others will want to integrate family members into ownership and perhaps management. For some business owners, continuity isn’t an option, and they want to identify an exit strategy that allows them to turn their interest into cash, which can be complicated when there are business partners.
And while two of the Ds – divorce and disagreement – may seem unlikely to many business owners, these are contingencies that should be included in a prudent plan. Business partners can have a falling out or simply want to part ways. How do they divide assets or set terms for a buyout? Or, one of the partner’s divorce decree may award an ex-spouse an ownership share of the business that goes up for sale to the highest bidder.
Incorporation status will affect the plan
Most closely-held businesses are organized either as an S corporation, limited liability corporation (LLC) or partnership. All have their own advantages, particularly in how taxes are treated. Most people don’t realize it when they organize a company, but each of these entities carries limitations on succession planning.
For example, in an S corporation, there are limitations on who can be a shareholder, which will impact what kind of trusts can be used if an owner wants to pass on interests in the business to heirs.
LLCs are growing in popularity because they seem to combine some of the better aspects of a corporation and a partnership, but there are caveats.
For instance, in South Carolina, anyone can register an LLC by going to the Secretary of State’s website, and there’s no requirement to obtain the signature or advice of an attorney. While we’re glad to see the state encourage entrepreneurship, we can also foreshadow problems that could emerge down the road when LLC members end up being unknowingly governed by the state’s default rules for these entities. An LLC in South Carolina, for example, allows for the easy transfer of an owner’s interest to a spouse, something that other business partners may regard as disruptive.
Operating agreements provide certainty
Many uncertainties can be contained through an operating agreement among business principals, which can address all the potential problems related to the five Ds. An agreement can establish the terms under which a partner can sell an interest in the business, and can include restrictions on buyers.
For example, it might say that other partners have first-refusal rights if another partner wants to sell an interest, and establish a discounted price and other terms.
Many people are not aware that if they don’t have an operating agreement, taking value out of the business can be so difficult that litigation becomes their only option.
Benchmark the price now
As in any transaction, transferring or selling a business interest begins with price. If a partner dies and the spouse wants the remaining partners to buy out the deceased’s interest, it’s not unusual for there to be disagreement on the value of the business.
I often advise clients going through the succession planning process to have their business appraised professionally. Even if they’re not selling now, this will provide a benchmark valuation if that time comes. Some owners resist this advice because of the time and expense involved in an appraisal, although I think it is money well spent.
The second-best option is to settle on a valuation formula, such as a certain multiple over EBITDA and place that into the operating agreement.
Start with legal counsel
None of these matters can be addressed without advice of counsel experienced in business incorporation, transaction and tax issues, and, in some cases, experience in trusts and wealth planning. Every business and family situation has its own special considerations, and legal counsel can advise you on the advantages and disadvantages of different plans. But there’s one step that only the business owner can take, and that’s to make the decision to take stock of his or her long-term objectives for the business and start the process of succession planning today.
Michael G. Roberts chairs Turner Padget’s Business Transactions Group, and he is a shareholder based in the firm’s Charleston, S.C. office. He focuses his practice in the areas of federal and state taxation, estate planning, business transactions (including mergers and acquisitions), commercial real estate and health care law. He may be reached at (843) 576-2832 or by email at firstname.lastname@example.org.