Succession Planning for Business Owners

Ownership in a closely-held business may take several forms depending on the structure of the entity.   Therefore, an ownership interest may be any of the following:

• Membership interest in a limited liability company (LLC)
• Stock ownership in a corporation
• Partnership interest in a general or limited partnership
• Sole proprietorship

A business succession plan is an agreement (or combination of agreements) among the owners of a closely-held business to provide for the transfer or sale of an ownership interest upon the occurrence of one or more  "triggering events".

A "triggering event" is any circumstance that causes a succession plan to be invoked.  Upon the occurrence of a triggering event, the succession plan will be carried out by the owners or their legal representatives.   Any of the following circumstances may be defined as a "triggering event" in a succession plan:

• Death 
• Disability
• Withdrawal
• Retirement
• Personal bankruptcy
• Divorce
• Misconduct
• Criminal conviction
• Loss of professional licensure
• Any other event agreed upon by owners

A business succession plan has several benefits for the company and the owners:

• Create predictable market value for an ownership interest;
• Provide continuity for the business upon the occurrence of a triggering event;
• Prevent an ownership interest from being transferred to an undesirable recipient; and,
• Prevent litigation over succession issues. 

A succession plan is advisable for any business with more than 1 owner.  It should be created as soon as there is enough value in the business to warrant concerns over how an individual ownership interest will be transferred.

There are numerous possible outcomes when a succession plan is not in place, depending on which type of triggering event occurs.  The unpredictable nature of such outcomes is exactly why succession plans are so important.  These are some examples of what may happen without a succession plan:

• Upon the death of an owner, the ownership interest will be transferred to the deceased owner's heirs or beneficiaries, which means that the surviving owners will have new partners in the company

• If an owner wants to withdraw from a business, there may be no market value for his or her ownership interest, unless the remaining owners agree to buy it; or, if the withdrawing owner finds a buyer, then the remaining owners may be faced with an unwanted business partner

• If an owner becomes disabled, then the remaining owners may be forced to pay compensation to the disabled person even though he or she can no longer contribute to earnings for the company

• If an owner is divorced, his or her ownership interest may transferred to a former spouse as part of the divorce judgment

• If an owner declares personal bankruptcy, his or her ownership interest will be included in the bankruptcy proceedings

• If an owner commits misconduct, the other co-owners may not be able to terminate the person from the business, which may cripple the company's ability to operate

There are many other forseeable circumstances that can be addressed with a succession plan.  Each business owner will have different concerns. 

The first step is for each owner to designate a beneficiary who will receive their ownership interest upon death.  The designated beneficiary will then be required to fulfill the succession plan on behalf of the deceased owner.  Designating a beneficiary is usually done as part of an overall estate plan.  There are several ways to designate a beneficiary of an ownership interest:

• Last will & testament 
• Assignment to revocable trust 
• Transfer-on-death agreement
• Registration in "beneficiary form"

Ownership interests are freely transferable to anyone, unless the business owners agree to restrict them.  Therefore, it is important to limit the persons to whom an ownership interest may be transferred, or to restrict all transfers without approval.  Otherwise, the owners may find themselves with an unexpected business partner.  There are several ways to restrict transfers of an ownership interest, depending upon the form of entity:

• Articles of organization
• Articles of incorporation
• Bylaws
• Operating agreement
• Shareholder agreement
• Partnership agreement
• Consent resolution
• Ownership certificates

A succession plan is based upon "triggering events" which will cause the agreement to be invoked.  Upon the occurrence of any triggering event, the succession plan will require or permit an ownership interest to be transferred.   The owners may choose any triggering event, such as:

• Death 
• Disability
• Retirement
• Withdrawal
• Malfeasance or misconduct
• Criminal conviction
• Divorce
• Insolvency
• Predetermined date

The owners must decide who will receive the ownership interest of a transferring owner upon the occurrence of a triggering event.  They may choose any party, including:

• Other co-owners
• Employees
• Third party
• Family member
• Company

If an ownership interest will be sold when a triggering event occurs, then the owners should predetermine a purchase price to prevent disputes.  There are numerous ways to determine a purchase price for an ownership interest:

• Fixed price
• Adjusted price (updated regularly by the owners)
• Formula
• Fair market value (by appraisal)
• Bid option
• Book value
• Any other method agreed by the owners

It is important to predetermine how the purchase price will be paid upon transfer to a new owner.  Several options may be appropriate:

• Cash lump sum
• Installment payments
• Life insurance proceeds
• Formula based on earnings or profit

A succession plan must be committed to writing in order to be enforceable.  An agreement may be drafted in several ways, depending on the type of entity, and the preference of the owners:

• Shareholder agreement
• Operating agreement
• Partnership agreement
• Buy-sell agreement
• Redemption agreement
• Company resolution