Business Succession – How do I retire on the wealth I've built into my business?
By Don Sihota
For non-business owners, the question of how to retire is really quite simple, especially if they can rely on a Pension Plan or an RRSP. When they reach retirement age, they simply leave their job and start collecting their pension. For you, as the owner of a business, it's just not that simple. As a business owner who may be contemplating retirement, you have many more issues to consider than does an employee who is contemplating retirement.
Your business is the lasting evidence of your initiative and leadership over the years and the value inherent in your business must be realized. If you are like most business owners, your business is your largest asset – and that is both a blessing and a curse! On the one hand, you own an asset of substantial value. On the other hand, you own an asset of incredible complexity. This type of asset can not simply be "converted to cash" such as you would a house. It's up to you to take the initiative, to arrange your affairs in such a way to allow you to retire. If you are in your mid fifties or older, or if you intend to retire within the next five years, now is the time to start planning your retirement.
For an owner wishing to retire from business there are really only a few options available. In fact, you can count the options on one hand:
- sell the business to a third party;
- sell the business to employees;
- sell the business to children;
- take the business public;
- shut the business down and walk away with nothing.
The first four options are the most desirable, allowing the business owner to successfully convert the value in the business into the cash needed for retirement. Option number four, while an excellent way of creating liquidity for the business owner, is an expensive process and applicable to only a small percentage of businesses. You should avoid option number five at all costs because it means losing all the value created by a lifetime of work. Even though option five is to be avoided, you might be surprised at how often business owners find it to be their only option. This not by choice, but through a lack of knowledge or by a failure to plan.
With proper planning and enough lead time, a business can be transitioned using one of the first four options. In this booklet, I will not address the option of taking the company public because it is suitable for only a small minority of businesses. If you have questions on whether your business is a good candidate for a public offering of shares, please contact me, and I will discuss this option with you. A short primer on the other three options follows.
Selling to a Third Party
The first option set out above is to sell the business to a third party, hopefully realizing enough cash to form a retirement fund. This can be a desirable method of retiring, but it is by no means certain that a buyer will be found for the business at a price that is acceptable. Furthermore, if the buyer can't pay for the business in full, the owner will be forced to sell on terms, thereby incurring the risk that the buyer might default in making payments for the business. This is akin to having your retirement fund in the hands of a third party who does not have your best interests at heart. Clearly this option can have significant risks.
Selling to a third party requires careful planning. Your business may need to be reorganized to make it more saleable, to enhance its value, and to minimize the taxes you will pay on a sale. You may decide or need to hire an agent or broker to market your business (if you're interested, we can help you find one). In some cases it may take a few years to restructure your business in order to maximize the tax savings. Too often tax savings are lost because there was not enough planning before the sale. You will also have to decide whether to sell assets or shares and it is important that you put in place confidentiality agreements to protect your business from unscrupulous buyers. Some buyers may want you to sign a standstill agreement and if this is the case, be very careful. In addition, care is required when it comes time to prepare the letter of intent or memorandum of understanding. Of course, the final purchase and sale documentation must be reviewed carefully and you should never make the mistake of relying on documentation prepared by the buyer’s lawyer. Finally, if you are asked to take back some financing, it is imperative that you ensure that you have security for any money owing to you after the sale.
Selling your business to a third party is a major undertaking and there are many traps for the unwary. Make sure you get the best results by having advisors that are knowledgeable in this area and who can ensure your retirement nest egg is well-protected.
Passing the Business on to Children
The second option for a business owner is to pass the business on to his or her children. This option poses its own difficulties, the first of which is that often children don’t have sufficient money to buy the business. Furthermore, where there is more than one child, the business owner has to determine who will be in control of the business. It is not uncommon for difficult situations to arise where children fight for control of a family business and place the parents in the uncomfortable position of having to choose sides. There are also other challenges with this option. As a parent, you know that each child is an individual with his or her own interests, abilities, desires and goals. The question is, how does the business owner allocate the business to children who have different interests and abilities? For example, if one daughter is now in management, one son is employed but not in management, and the third child has pursued a completely separate career, should the daughter be given absolute control? How does the owner/parent allocate some of the value of the asset to the other children? These are just some of the issues that will arise under this option.
There are many ways to structure a transaction of this nature and the following example will illustrate just one of these methods. Let's assume that a couple has built a business worth $1,000,000 and is now at a stage where they wish to retire. The owners have one adult child who has worked in the business since she was a young girl and has proven to be a very astute business person. The daughter very much wants to carry on in the business after her parents retire. The parents do want to give the daughter the opportunity that the business represents, but don’t want to give it to her outright – after all, that $1,000,000 tied into their business is their only retirement fund. Unfortunately, the daughter does not have any personal wealth that would enable her to purchase the business from her parents. In this situation, how can the parents' wishes be accommodated while at the same time assisting the daughter in taking over the business? To illustrate this concept with an analogy, think of the business as a box filled with gold, with the gold representing the value of the business created by the parents. The parents want to give their daughter the box that holds the gold, but keep ownership of the gold for themselves. The opportunity they give to their daughter is to provide her with the "container" that will help her to build up her own store of gold.
This is carried out through a transaction called an "estate freeze", whereby the value of the business is frozen at its current value. For example, if the business is worth $1,000,000 today, that $1,000,000 should be retained by the parents. The opportunity to grow the business and increase its value can then be passed on to the daughter. In a company, the method of allocating these interests is through share capital. First, the owner’s lawyer would create a special class of shares which can be cashed in or redeemed by the holder for a certain specified amount. This class of shares would always have "priority" over any other classes of shares, in other words, they get paid first, before other shareholders realize any financial reward from their shares.
To use legal terms in the example given, we would create preferred shares having a redemption amount, let’s say $100 each, which would entitle whoever owns those preferred shares to cash them in at will and get $100 for each share redeemed. To ensure the business owner can lay claim to the first $1 million in the company, he would exchange his existing common shares for 10,000 preferred shares (10,000 times $100 is $1 million). Once that is done, the daughter can subscribe for new common shares at a very low price because all the value of the company is locked up in the preferred shares. These new common shares are called "growth shares" because any increase in value of the company will be attributed to the common shares since the value of the preferred shares is locked at $1 million. As time goes by, the owner can slowly liquidate the preferred shares. For example, he could redeem 100 preferred shares per month resulting in an income of $10,000 per month. At the same time, the daughter can grow the business and she keeps every increase in value she creates after she takes over.
There are numerous variations on the foregoing simple retirement plan. This area of planning requires sophisticated advice and each retirement plan for a business owner must be designed and reviewed by a tax specialist, an accountant and a corporate lawyer.
Selling to Employees
What happens when there is no obvious buyer for the business and the children are not interested in pursuing the business (or, perhaps are not deserving!)? In that case, the owner may decide to pass the business on to a favoured employee, or perhaps a group of employees. In that case, just like a sale to children, the biggest challenge is that the employees often don’t have the money to pay for the business.
Before offering ownership to an employee or a group of employees, I can not over emphasize the importance of picking the right person or persons. After all, if you intend to pass on your business to the key employee, you had better be sure that the employee has the same entrepreneurial spirit that you do. The employee is going to be "in charge" of your retirement fund, so it is critical that you do not pick the wrong person for the job!
Finding the right person is a challenge in and of itself. You may be able to do this on your own, or you may want to hire a consultant to assist you. Don’t assume that you can easily pick the right person. I have seen many situations where the "wrong" person was chosen and the ownership transfer had to be reversed. Fortunately, by structuring the business deal correctly, these reversals can be carried out with a minimum of cost and trouble.
Let's assume that you have chosen your successor: a key employee in whom you see great potential. You would start by transferring a small interest in the business to the employee with your employee having an ability to eventually buy you out. By doing this you will be creating a large incentive for the employee to stay in your business, which is exactly what you want of a person that you see as your successor. If you do it right, you will achieve both your objective and the objectives of the employee (to have an opportunity to build their own future). The key is to make sure that you, as majority owner, have complete flexibility and control. Some of the things you will want your lawyer to consider are:
- what if the employee quits;
- what if the employee is fired;
- what if you want to sell the business
- what if the employee dies, and
- what if you just can’t get along with the employee?
There are a number of ways to give shares to employees and still retain control and flexibility. One way is through a shareholders agreement (sometimes called a "buy/sell agreement") which would provide certain rights to the majority shareholder. One of the many provisions the owner would want in the shareholders agreement is a "drag along" provision. This provision allows the majority owner to accept an offer to purchase all of the shares and force the minority shareholder to sell shares on the same terms. The shareholders agreement would also have a provision in it prohibiting the minority shareholder from having a right to seat on the Board of Directors. In addition, you would provide that the employee sells his shares back to the company if he leaves the employment of the company.
Another way to deal with employee ownership is to create a different class of shares with certain limited rights. If the owner did not want the employee to have voting rights, the shares would not be given voting rights. The "employee" shares could be created with a right of the company to redeem them for a certain price. Thus if the employee causes any problems, the company would simply purchase the shares.
If the ownership structure is established properly, then you as the majority owner of the company retains a significant amount of control, at the same time giving the employee the desired feeling of belonging to the business and participating in the growth and the future of the business. This means that the employee is much less likely to leave the employ of the company and the owner's objective has been achieved. Eventually, a staged buy-out will happen and you will be able to receive your retirement funds.
As you can see, there are number of considerations involved in establishing this type of ownership structure. To avoid problems in the future, there should be some serious planning which will result in the corporate documentation being prepared. It is possible to reach the objectives of both the owner and the key employee. However, it is extremely important that proper legal advice, accounting advice, and tax advice be obtained.
A Final Thought
There are many considerations involved in planning for business succession and it is extremely important that proper legal, accounting and tax advice be obtained. It is also imperative that consideration be given to life insurance of critical illness products, as these are often an integral part of the business succession plan. issues that will arise under this option.
In addition to providing you with experienced legal advice, we will work with your existing professional service advisors such as your accountant and insurance and financial advisor. If needed, we can use our extensive network to refer you to persons knowledgeable in this field, such as accountants, financial planners, insurance advisors and even business brokers. By gathering the right team, you can be assured that your business succession plan will allow you to retire on the wealth you’ve built into your business.
You only retire once and you only have one chance to get it right. As a prudent business owner, you need to take the time now to start planning for this process. By picking up this booklet, you are taking the first step in your planning process to maximize your retirement wealth. Your next step is to set up an appointment with us to discuss how we can assist you to achieve your retirement goals.