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How business succession planning can protect your small business

Female business owner
10'000 Hours/Getty Images

As a small business owner, you've worked hard to build a business with loyal customers and a healthy bottom line, and you may play a vital role in your community. However, in managing day-to-day operations, you might not have had time to ponder some big questions, like when and how you'll retire and enjoy the fruits of your labor. That's where business succession planning comes in.

A succession plan is vital to making sure your business can continue to thrive in the right hands, and a good exit strategy can help you smoothly transition into enjoying the benefits of having owned a successful business. Let's explore why you may want to create a succession plan, how it works and more.

Why small business owners need a succession plan

Only a third of small business owners have a succession plan. Given the notoriously high demands on business owners' resources, that's not surprising, yet those demands are why succession planning is so critical.

That's not the only obstacle. Many business owners may feel unsure of where to start or fear the process might be expensive and complex. Some might feel that their business is so unique and personal that it might be impossible to value or hand off to a successor. Others may assume family will step in when the time comes. There's also a contingency of people who simply love their work so much that they may not plan to retire.

Regardless of your situation, it's worth thinking ahead. The alternative is an unsure direction for your business if you're suddenly forced away due to death, disability or some other unanticipated life event. Business succession planning can help prevent the need for liquidation to cover estate taxes and can minimize the ripple effects on co-owners, employees and customers.

Business succession planning isn't just about avoiding unhappy endings. It can also offer a path to positive rewards throughout the business life cycle. Retirement readiness is a milestone that rarely happens by accident, and a thoughtful succession plan can enable owners to map out the circumstances of a planned (or unplanned) departure. The related process improvements may even result in smoother operations as well as greater customer and employee satisfaction—and potentially more time off for the boss.

Ultimately, having a succession plan in place can add value for potential successors, and owners can walk away with a bigger nest egg to fund a rewarding retirement.

5 ways to transfer ownership in business succession

As with all planning, the process involves determining goals, evaluating alternatives and charting a course forward. Essentially, you'll need to provide instructions on how to handle logistics, finances, people, tools, processes and other considerations in your absence. The details can vary depending on which of the five ownership transfer methods you choose.

1. Sell your business to a co-owner

Perhaps the most obvious succession plan is to sell your portion of the business to a co-owner. This strategy can be implemented via a buy-sell agreement, a legally binding contract that documents the conditions, terms and process to follow should one partner exit. For businesses with more than two owners, succession planning includes choosing whom to include in a buy-sell agreement.

Say you love having your own business and can't imagine doing anything else. However, your partner has started thinking about retirement. They're not going anywhere anytime soon, though, and certainly doesn't want to be forced to close the business if something happens to you. A cross-purchase agreement where you each agree to buy each other out addresses both of your needs handily.

2. Pass it on to an heir

Suppose your business has been under your sole ownership for more than a decade, but recently, your son or daughter has started working alongside you. They possess the same qualities that have kept your customers loyal over the years, and they'd be thrilled to step into your shoes when the time comes. While you love the idea of them taking over, you also want to be fair to your other children, even if they don't see the shop as a career path and are fine with your other child taking over the shop.

In this scenario, you likely have it easier than businesses where multiple heirs are vying for leadership. However, no family is immune to the dynamics that can complicate changing roles. That's why it's your responsibility to craft a plan that describes each of your children's future roles, responsibilities and compensation. You should also include a buy-sell agreement so that if any end up inactive partners, their path to exit is clear.

3. Sell your business to a key employee

If your business has no heirs to take over, you may want to consider selling the business to a key employee. For example, let's say you own the business and have an employee who is key to helping the business thrive. This employee has expressed interest in taking over the business, and you feel that they are fully competent and able to do so.

After discussing it and deciding to move forward, you can create a buy-sell agreement defining the terms of the sale of your business to your key employee.

4. Sell it to another entrepreneur

If the previous options are not viable, you may have to look outside the business for an interested buyer. For example, you may know of a competitor in your area who's been buying similar local businesses. You could approach them about purchasing your business and continuing its legacy under their banner.

Closing this type of sale calls for greater formality. While the insiders of prior examples might willingly buy a "labor of love," outsiders might focus on the shop's ability to turn a predictable profit. That means you may have to document operations to determine a believable value on which a buy-sell agreement can be based.

5. Sell your ownership interest to the company itself

Let's say your business has grown to the point where it's acquired a number of different businesses and owners across the region in which you operate. This situation is probably best addressed by a type of buy-sell agreement called an entity-purchase agreement, where the business itself buys out any exiting partners.

This arrangement is not as tax-advantaged as multiple cross-purchase agreements would be, but it is dramatically simpler, enabling you to sell your interest to the company itself.

How life insurance helps business succession plans

Once the value of your business is quantified, a buyer is identified and a transfer method is chosen, the final piece of the puzzle is financing the transaction. In many of the previous scenarios, you might be wondering: Where's the money coming from?

There are several options available to a key employee—or anyone, for that matter—trying to afford the business of their dreams. One option is self-funding. However, even buyers with substantial assets rarely keep enough cash on hand to go that route. Buyers may opt for seller financing, where a buyer (such as a key employee) pays the owner back over time. Others may look to third-party business loans, but those may not be easy to get.

That's why many small business owners turn to life insurance to fund their succession plans. Term life insurance can be a relatively affordable way to offset the costs associated with an owner's death. However, this coverage expires after a specified period. In contrast, permanent life insurance lasts a lifetime. It comes with a higher price tag, but it also delivers other benefits prized by small business owners. In particular, these contracts potentially build cash value that owners can lean on in times of need, such as following a disability or the loss of a key employee. The cash value could potentially be used to fund a buyout. Another option is a waiver of a premium rider, which pays premiums if you become disabled.

Prepare your business for the future

The examples illustrated here showcase some of the principles of business succession planning. That said, figuring out how to create a succession plan and determining the right path forward for you and your business may look different from the processes and decisions other types of businesses and owners make.

As you navigate the choices for your particular situation, consider connecting with a financial advisor. Expert input can help fast-track the process, alert you to potential pitfalls and help you get the best return on your investment.

Hypothetical examples are for illustrative purposes. May not be representative of actual results.

If requested, a licensed insurance agent/producer may contact you and financial solutions, including insurance, may be solicited.

Life insurance contracts have exclusions, limitations and terms under which the benefits may be reduced, or the contract may be discontinued. For costs and complete details of coverage, contact your licensed insurance agent/producer.

Riders are optional and available for an additional cost.