What Is Succession Planning? Mapping the Future of Leadership


Succession planning is the implementation of a strategy to ensure the business owner’s eventual graceful exit from the business. A succession plan:

  • keeps the business viable and valuable
  • reduces capital gains and estate taxes
  • preserves control of the exit process
  • safeguards employee security
  • maintains control of the business when family ownership will continue

Creating an Exit Plan

To fully realize the benefits of succession planning, a business owner needs to prepare an exit plan. This involves answering these questions:

  • When does the owner plan to leave?
  • Who will manage the business when the owner is gone?
  • How will the company meet its financial needs when the owner exits?
  • Will the owner’s departure affect others?
  • What can the owner do to protect business value during the transition?

Does Every Business Need a Succession Plan?

Every business needs a succession plan. Here are the major reasons why:

  • A business succession plan is an integral part of estate planning. A business owner cannot create an effective estate plan without creating a business succession plan. Consider liquidity needs, for example. The need for liquidity in a business owner’s estate plan is directly related to the succession plan for the business. Will this major asset be sold, managed by the next generation, or liquidated?
  • Transition timing is uncertain. Not every business owner is eager to retire. Leaving the business can be complex and difficult, especially when the owner is driven, started the business from scratch, and nurtured it over a lifetime. Unfortunately, no one has discovered a remedy for old age or pill that will let us live forever. No one knows when illness, incapacity, or death will strike. Even business owners who never plan to retire need to prepare the business for its inevitable transition.
  • Failure to plan is a recipe for business failure. Failure to plan can result in chaos if the unexpected happens and the business owner is suddenly out of the picture—chaos the business may never recover from. Let’s take a look at a real-life example.

A Succession Planning Disaster: Jon Smith Design

Jon Smith (age 50) and Curtiss Stern (age 40), co-owners of Jon Smith Design Ltd., had just purchased a competitor—a high-end furniture store—weeks before they were both killed in a plane crash. Employees initially pulled together to take care of clients, but soon several employees left to start their own competing firm.

Both Smith and Stern were heavily in debt for the newly purchased store, mortgages on family and vacation homes, and millions of dollars in claims by banks and business vendors. Stern left everything to Smith. Stern’s parents contested the will, claiming that he meant to provide for them if Smith was no longer around and wouldn’t have wanted everything to go to Smith’s family. They lost at the circuit court level but appealed to the Wisconsin Supreme Court to fight for a 50 percent ownership interest in the furniture business. The legal battle tied up both estates in probate.

While ownership of the business remained in limbo, Smith’s niece stepped in to run the company, even though she had no prior experience managing a retail business. Her first year was rough, but she learned as she went along and managed to finish strong in the second year.

Identifying the Problems of Transition

Whether a business owner retires or dies, three important challenges face owners and their heirs. We can see these challenges clearly in the Smith example.

  1. Heirs or retiring owners need income and financial security, while new owners need control of the business. While an owner’s retirement may present challenges, an owner’s death can paralyze a business. Heirs may be forced to work in the business to protect their financial interests, or they may decide to put their own needs above those of the business. Without a written plan, heirs may have a legal right to become active in the business—perhaps even making important decisions—all without the necessary business expertise and managerial skills. When we look to our real-life example, we see that Smith’s niece stepped in to run the company despite having no prior experience managing a retail business.
  2. The loss or retirement of an owner can create uncertainty about the future of the business. A business that appears weak can lose credibility. Clients and key employees may leave, as we saw in the Smith scenario when key employees left to start their own firm. Creditors may also lose confidence and refuse to extend payment periods on existing debt or provide additional credit. There may even be a threat to the reputation and goodwill the business has built over the years.
  3. Competitors may take over, displacing businesses or stealing clients. The loss or retirement of an owner may encourage outsiders to take advantage of the business’ perceived weakness. In the case of Jon Smith Design, it was a group of key employees who became competitors trying to benefit from the company’s upheaval.

In our example, a succession plan would have simplified this unexpected transition immensely. The partners could have provided liquidity to pay off debts, put measures in place to retain key employees during the transition, and chosen competent successors to step in and run the business.

Solidifying Business Value

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Ensuring Stability During the Transition

A business owner who wants to get the most value for a business interest while keeping it stable and viable through the transition needs to keep key employees in place. These are the employees who have a significant impact on sales, are responsible for management decisions, or have significant relationships with customers or creditors. They are the highly compensated individuals who are vital to the continued profitability and future marketability of the business.

The quality of a company’s key employees sets the tone for the entire business. Losing a critical employee can be devastating, whether the employee takes another job, retires, or dies. Productivity and profits can decline; customers may withhold their business; banks and other vendors may hold back until they’re sure the company can weather the change. Add in the time, energy, and cost of hiring a replacement and you can see how losing key people can be enough to cripple an otherwise healthy company.

Critical Steps

It’s imperative for any business owner to protect the business against the untimely loss of key people. Whether an employee leaves in the wake of the owner’s departure (as happened at Jon Smith Design) or whether they are taken by a sudden illness or even death, the business will suffer financially if the owner isn’t prepared.

There are two steps to complete at this stage of the succession planning process:

  • Ensure that critical people are rewarded and retained during and after the transition.
  • Ensure key employees so the business is compensated if a key employee dies prematurely.

life insurance can play a central role in protecting a business.

Providing Family Liquidity


A Look at Estate Expenses

Let’s begin by quickly reviewing the costs associated with settling a typical estate. If the business owner dies, the family must pay these expenses, which are due immediately (or almost immediately) at death:

  • Probate costs. These include court costs, attorneys’ fees, executors’ fees, commissions, administrative costs, appraisers’ fees and accountants’ fees.
  • Final expenses. These include settlement of debts, end-of-life medical expenses, and funeral expenses.
  • State taxes. Inheritance and estate taxes are nonexistent in some states but significant in others.
  • Federal estate tax. While this is always subject to change, the effect of this transfer tax can be harsh. Depending on the size and value of the business, some owners may find that their estates are large enough for the estate tax to shrink the estate significantly.

A Large Illiquid Asset

Unfortunately, business owners often do not have a great deal of liquidity because much of their wealth is tied up in the business. Without enough cash to meet estate obligations, heirs may be forced to borrow money or sell assets to raise the cash they need to meet immediate obligations. For a business owner who is intent on keeping the business in the family, this is a worst-case scenario.

Heirs who sell a company under these circumstances usually don’t have a ready buyer, and as a result, they’re forced to sell at sacrifice prices, dramatically reducing the value of the estate.

In addition, business sales take time—sometimes lots of it, especially in a down market. Heirs don’t usually have an unlimited amount of time before expenses become due. This places them in a very difficult situation.

The Life Insurance Solution: An Example

Of course, personal life insurance proceeds ensure that the estate has immediate cash to pay debts, taxes, and other estate expenses without forcing the sale of assets or the liquidation of the business. Let’s look at an example.

Lorraine is a widow and the sole owner of a popular local toy store. She makes a good income, but the store isn’t so valuable that she has to worry about federal estate taxes. Nonetheless, she understands the need to ensure estate liquidity for her son, Nate, who works as a manager in the store and will eventually take over the business.

Lorraine carries a large amount of debt, including a personal mortgage and business loans. In addition, she knows all too well that as much as 8 percent of the estate may be lost to state inheritance taxes, executor’s fees, and legal fees.

To provide the liquidity her estate needs, Lorraine purchases a life insurance policy. The death benefits will allow Nate to retire debts, pay taxes, and meet other estate expenses. The policy provides affordable protection along with cash value accumulation that she can access to cover unexpected business or personal expenses.

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