Succession Planning - The Fundamentals

Ask almost any business owner and they will tell you they have "considered" succession planning. Yet, most surveys indicate that 50-75 percent of business owners have no documented succession plan. What accounts for the difference?

In most cases, consideration of succession planning consists of some thoughts as to potential owners and rough estimates as to business value, financial needs, and future cash flows. Unfortunately, such an analysis is mostly speculative and is not based on sound financial assumptions and analysis.

A complete, well documented succession plan does not begin with ownership transfer options, that is the last step of the process. A succession plan begins with two fundamental analyses - future cash flows and valuation of the business to the owner.

At first glance, future cash flows appear to be a simple concept, but it is not. On a macro level, the first consideration is a projected time period - i.e. based on ages, what time period must the cash flow cover - 20, 30, 40 years?

At a more detailed level, future cash flows break down into two sections:

(1) Annual cash receipts

Cash receipts consider dividend payout rates, appreciation rates, investment turnover (sales) rates, and federal and state income taxes.

(2) Annual cash requirements

Annual cash requirements is an analysis of current spending and projection of future expenses for items such as health insurance, medical care, and long-term care expenses. Don't forget, depending on the number of years for the analysis, an inflation factor should be applied.

In general, business owners will over estimate investment income and underestimate spending, without including any inflation factor. For those reasons it is important to consult closely with both investment advisers and tax professionals in developing the cash flow analysis. Once the base line analysis is complete, the analysis must also be extended to minimum required rates of return because in reality, with few exceptions, investment returns are linear and consistent from year to year.

The second fundamental the business owner must understand is business value. This is more than a simple business valuation. The business valuation is the first of three steps. Once that is established, assuming the buyer will pay the valuation amount, the business cash flow must be closely analyzed to determine when cash will be available from the business to pay the owner. And finally, once the business cash flow is considered, the income tax implications of the ownership transfer must be considered.

Many business owners make the mistake of stopping at the first step with a business valuation. Once they have an overall value, they tend to overestimate the net after-tax cash they will receive from the ownership transfer. Owners also tend to have unrealistic expectations of the cash flow available to fund a transfer. As a result, it is important to consult with a business valuation professional, tax adviser, and bankers to fully understand value and available cash flow.

Once the owner's cash flow analysis and business valuation/cash flow is fully analyzed, the owner and advisers can move to the final step of considering the ownership options that are available.

In the final analysis, two factors are imperative to developing a successful transition plan: (1) focusing on fundamentals of owner and business cash flow; and (2) consultation with professional advisers to provide guidance in developing the fundamental analysis.

• Jeffrey Conrad is a Partner at BKD, with a focus on business succession and wealth transfer planning. Jeff can be reached at (630) 282-9518 or jconrad@bkd.com.