Passing it on: planning is needed for a smooth generational transition of the family business.

IN OUR EVERYDAY LIVES, failure to plan can lead to missed opportunities and disappointment. But when we're talking about continuity of the family business, failure to plan can mean the forced sale of the company at a bargain basement price.

"Many people think it's estate taxes that doom businesses to fail whenever there's a transition," says R.J. McConnell, partner, Bose McKinney & Evans, Indianapolis. "But while that can be an obstacle, that can easily be dealt with with life insurance or financing the taxes if they have to. The bigger problem is just flat failure to plan."

He recommends three things to improve the chances of transferring the company to the next generation. "Step one would be to professionalize management, have defined lines of authority, and have the founder pick his or her successor and groom them over a period of time and not just dump it in their lap at the time that an unexpected death occurs." Tied to the first step, he says, is the owner's recruitment of a board of directors or at least an advisory board to help manage the transition. "That's probably one of the biggest nuances that has emerged over the last five years." A group of peers, made up of other business owners as well as the lawyer and accountant, typically makes up these boards.

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Succession danger. Seattle-based wealth management firm Laird Norton Tyee, conducted a nationwide survey of nearly 800 family-owned businesses in 2007 in cooperation with Seattle University and Oregon State University. It concluded that lack of a strategic vision, succession planning and governance policies could spell the end of some of those businesses in the near future. The companies, 122 of which were from the Great Lakes area that includes Indiana, had all been in existence for at least five years with revenues of at least $5 million. Interestingly, 70 percent of the businesses surveyed had already made it through at least one generational change.

The survey's bad news should be both a wake-up call and a checklist for action. Nearly 60 percent of majority shareholders in the family businesses were 55 or older and 30 percent were 65 or older, but less a third had succession plans and fewer than 40 percent had a successor lined up.

Ninety-three percent of respondents reported little or no income diversification. Two-thirds didn't require family members to be qualified for their jobs when entering the business, and 25 percent said the next generation was not competent to take the reins.

Greta Roemer Lewis, partner, Barnes & Thornburg, South Bend, sees business succession planning as a subset of estate planning, but with succession planning often moving the estate plan forward because clients are most focused on their business. "They're really very inter-related," she says. "Estate planning is the process of transferring assets and figuring how to own them, and the best way to meet the family needs and also meet the estate taxes. Estate planning cannot be done in a void."

Lewis says a team approach is the best way to tackle succession planning, with the attorney, accountant and financial advisors included. "In that kind of situation, those people work together as a team on the business side and it's an easy transition for them to also bring up and work on the estate plan."

Lewis puts one of her clients, now in the second generation, under the heading of "done well" in terms of the estate planning. Before the business was sold to a child, the parent worked side-by-side with the child for quite some time to teach all aspects of the business before the sale. The real estate had been separated from the business and there was a lease agreement in place, funding the retirement of the parents. When the founder died, the business had already passed and the real estate was an easy asset to pass to that child and the rest of the family, because it did not involve stock in the business or control of the company.

Modeling the lessons learned from the founder, the second-generation owner is already beginning to plan for succession of the business to the third generation, even though the children are too young to take over and are getting valuable experience working elsewhere. The owner developed an "instruction manual," says Lewis, updated annually or biennially, detailing the people who are critical to keep the business running until a determination can be made whether any one of the children is able or interested in taking over. "I think that's a really good textbook example of good estate planning/ succession planning."

Just what's in a written succession plan? "Ordinarily at the inception of a plan every aspect of the business needs to be addressed," says Marc Fine, partner, Rudolph Fine Porter & Johnson in Evansville. That includes the financial component, banking relationships, consideration of current ownership both inside and outside the family, real estate ownership or lease agreements, deferred compensation plans and payment arrangements for retiring members, cash flow analysis and tax issues. "It's the interplay of every one of these that makes the plan come together so you can proceed to documentation," he says. And that's done in a team approach with key advisors.

Owners should also consider making the transfer of ownership now, if the value of the business is likely to increase dramatically in future years, suggests Mike Harpring, tax director, RJ Pile, Indianapolis. For example, a company may be worth $2 million now, but due to an expected government contract or a product in development it could be worth $10 million in a few years. "Then when the big increase in value happens that appreciation is outside of your taxable column and it's in your children's taxable column," he says.

Very often the sale of the ongoing business will be funding the owner's retirement plan, Harpring adds. "So, if the business isn't healthy and can't make the payments, your financial plan fails." Provisions need to be in place, he says, for the parents to reclaim control from the family member or the manager if things go badly. And if a non-family member is chosen to run the business, it's important to make sure that person is retained with an adequate compensation package, and that a non-compete is in place if the manager leaves.

Buy-sell agreements are common, says Harpring, whether it's a family business or not, where if one owner dies the other owner or owners buy that person's share, rather than it going to a spouse and losing control. This is typically funded through life insurance, he says, but too many people overlook a disability policy that would fund the buyout should one of the owners become disabled.

The stark reality is, in many cases, the owner is the company, with all the business and banking relationships held in tight control. With no plan or successor in place, there's little hope for a transition when that owner dies. "It's sad," says Fine, commenting on such a scenario. "They all end up with the same ultimate result of allowing a prosperous and profitable company to end up either being sold at a substantially reduced price or being closed in its entirety and having its remaining assets sold of at substantially reduced prices."

It's never too early to start developing a succession plan, says Fine, but he recommends starting about five years ahead of an expected transition. "It's a good idea at every annual meeting to consider a succession plan. Sometime that question will get a much greater level of discussion than in earlier years and that should be the beginning of serious longer-term planning."