New England Biz Law Update
Transitioning a family, founder, or other privately held business to the next generation is rarely a single decision or a one-step process. The question is: Where does the ownership group start, and how do you build a holistic plan that addresses the owner group’s financial goals, the future leadership of the business, the interests of key employees, customers, vendors, and other stakeholders, and the long-term health of the enterprise?
Here, we’ll start with the potential future leadership. This may be children, nieces, nephews, or other family members; key employees; employees generally (i.e., ESOPs); a perpetual purpose trust (made famous by Patagonia, among others); or a third party, such as a strategic buyer or private equity group. If you’re reading this article, our guess is that your preference is not the latter, or, if this becomes your choice, it’s for a variety of reasons, including that a third-party sale is the best option for preserving your personal relationships.
When we are engaged, the ownership group has often already selected the business’s future stewards but is struggling to conceptualize how to commence the planning process. The critical question here is: What is keeping you awake at night? Is it a concern that your successors or your customers/vendors are not ready, or that a sudden, tragic event may throw off the business because there is no plan? Or is it simply that you want to retire soon?
A successful transition plan requires a 360-degree approach, grounded in an understanding of that driving concern, your and the future leaders’ professional and personal goals, the interpersonal dynamics at play, and the business’s needs. Once that is established, your team of advisors must work through your financial, retirement and estate planning needs, current corporate governance structure, and any advisable changes, tax considerations, key employee retention planning, financial and capital requirements, and customer and vendor transition strategies. Together, these considerations shape the framework for the plan and help determine the related legal documents and their terms as discussed below.
Starting with corporate governance, the complexity of this part can vary and is important whenever there will be multiple owners. As businesses move through generations and grow into larger ownership groups, a thoughtful approach to governance matters is critical for their long-term health. At the highest level, businesses have their equity holders, directors, officers, and employees. In privately held businesses, especially those with smaller ownership groups, the owner and director groups often overlap. Even when they don’t do so fully, the ownership group often has a close relationship with those acting as directors, officers or event employees. And in all instances, the same issue arises — how do you resolve differences?
Strong governance requires a clear understanding of who fills what role, the scope of each decision-maker’s authority, and when a different group must be consulted. This includes specifying how these matters will be addressed through corporate bylaws, operating agreements, or similar documents, so that the key stakeholders have a clear path to agree on them. Successful ownership groups also focus on building strong communication skills and creating boundaries, so that, if a disagreement arises on the business side, everyone can still walk away as family, friends, or with whatever other relationship that brought you together intact.
In addition to providing a roadmap for decision-making and dispute resolution, equity holder agreements usually also set out buy-sell and share-transfer restrictions. These agreements’ terms address the owners’ decisions on who can be shareholders and prohibit transfers accordingly, lay out the buy-out process for shareholders who have an unfortunate event (such as death, disability, or divorce) or whose employment is terminated, or provide the terms for a succession plan that occurs in phases. These documents, combined with proper estate planning, can be used to effectuate a succession plan and provide for automatic succession in the event of a catastrophic event.
Beyond governance, how is a succession plan achieved? Commonly, this is done through an equity purchase agreement, which will lay out the terms of transfer and set out representations and warranties regarding title to the equity interests and ability to conduct the transaction, among other things. Often, this includes specific concerns of the transferring party (e.g., if the business is sold for an amount in excess of this transaction within a certain period of time, the seller receives a portion of such sale’s proceeds). The transition’s financing must also be considered. If the closing cannot be financed in at closing (which is typically the case), you must analyze whether, over time, cash from company operations will be sufficient or whether third-party financing, such as commercial financing, will be required. In the latter instances, creditors’ rights need to be considered, including the selling owner taking a lien on the sold equity and negotiating related intercreditor agreements if third-party financing is involved. We’ve barely touched on estate planning and tax strategies in this article, but those must also be considered to create a balanced succession plan and maximize the benefit to the transitioning owners.
Succession planning is also an opportunity to consider other factors for the business’s long-term success. You should identify which employees are critical to the company’s operations over the next 5 years and the next 20. The occurrence of a succession plan is an impactful time for these employees as well. A fulsome plan often considers their concerns and motivators and establishes plans to keep them in place. This may include a bonus if they stay for a certain period of time, a phantom equity or other plan that provides them with a stake in the business’s future, or sometimes even equity in the business. You must balance what you are comfortable with providing and what will potentially incentivize the employee.
Succession plans often start with a basic concern — what is this business’s future, how do I prepare it for its next phase, and what will happen in the event of tragedy? Addressing these questions presents numerous opportunities to create a plan that you are comfortable with that accomplishes your financial and estate planning goals and establishes the groundwork for the business’s continued success. This is all possible by identifying your wants and needs and building a plan step by step from there.
Isaac Figueras, a partner with Nixon Peabody, guides families, founders, and leaders of other privately held companies through all stages of their businesses, including planning for the next stage of a business’s growth.
