Heirs or Errors to the Throne? The Importance of Thoughtful Business Entrance Planning

The following was authored by attorney, Shannon G. McCoy, Lamson, Dugan & Murray, LLP and written for submission in the National Land Improvement Contractors of America (LICA) newsletter.   

Succession planning frustration

One Month before Your Planned Retirement, 2038:

Owner:            Alright Steve, Mike, and Kelsey, the day has finally come, it is time to sell my 100% ownership interest in Family Business, LLC, and each of you gets to purchase an equal share, so I can finally retire!  Wait, where is Steve?

Mike:               Uh, Steve accepted an offer from Competitor Business Inc., he didn’t tell you?  Apparently they pay more than we do.  Also, I think I saw him downloading something from our computer onto a portable hard drive last week, some file called “customer contacts,” probably not that important though…

You:                What?!?  Steve was my best manager for the last 15 years, why did he never say he wasn’t paid enough?  Fine, I’ll just sell you two an equal share, I’ve already got reservations in Cancun next week, and I’m not cancelling them!

Kelsey:            Yeah actually I am looking elsewhere too.  I got tired of having no direction or control of my career. Everyone knew my title of “Vice President” meant nothing.

Owner:            Seriously?!? Fine, congrats Mike, you’re in charge.

Mike:               Awesome!  Finally, I can sell the company and use the money to support myself while I go back to art school, the world needs my velvet paintings! All I ever got to do around here was sweep floors anyway, soon I’ll be out of here!

Owner:             On second thought, the deal is off…get out of my office!

Owner:            *inner thoughts* Great, now who will run my company?  Is this the end of Family Business, LLC?  Who will I sell my ownership interests to, and who would even be willing to buy them?  Can I afford to retire?  How can I retire and let my life’s work just end?  How did I get to this point?

             While hopefully an exaggeration, the above scenario represents the consequences that can occur when family business owners neglect to create a thoughtful, proactive business entrance plan.  Business owners often focus on their own exit plan and neglect to think about the significance of entry planning.  The purpose of a business entrance plan is to identify those family members, key employees or “outsiders” who are the best candidates for becoming future owners of your business, and bringing them into the mix before it’s too late.

One of the biggest decisions faced by any business owner is how to develop and retain talented family members and key employees, and prepare these individuals to eventually become owners of the company.  A well-reasoned approach to developing your “heirs to the throne” avoids a scenario where the heirs are unprepared or unwilling to take ownership and guide the company to future success.  On the other end of the timeline, choosing the wrong individuals from the beginning to develop into future owners of the business leads to a tremendous waste of time, money, and effort, leaving the ownership and future of the company in doubt at the important moment when you are prepared to transition away from the business but still depend on the continuity of the business to fund your exit.

Let’s consider what the Owner of Family Business, LLC could have done to avoid the situation presented above:

  • Steve represents the scenario where a skilled family member or key employee working for the business is poached by a competitor. This could have been avoided by Owner if an honest discussion occurred wherein Owner could ensure that Steve was receiving a level of pay and incentives premised upon Steve being a future owner of the business.  The sooner this discussion occurs the better.  While business owners often consider the risks created by their weakest employees, too often their most talented employees are ignored until it is too late.  A dissatisfied star employee may leave the company when he or she is needed the most.  Reasonable negotiating with this employee and an open line of communication can avoid costly surprises.
  • Kelsey represents an employee who may have talent, but who was placed in the wrong role without actual authority or responsibility. Business owners need to evaluate the key skills of their family members and key employees to ensure their job responsibilities reflect their strengths.  In fact, it may be even more important for family businesses to have a firm understanding of the best roles for each employee.  While every job responsibility for every employee won’t be a perfect match, such an approach can avoid a scenario where an employee is clearly placed in the wrong role, harming the company and effectively removing any interest by the family member or employee in promoting the business or gaining an ownership interest in the company.
  • Mike represents the employee that clearly lacks the entrepreneurial drive and ability necessary to run a family business. His heart is elsewhere, and while the role of part time employee may have been perfect, he was never a serious candidate for an ownership role with the company. A discussion years prior would have avoided any expectation by Owner or Mike that he would gain any ownership of the company.
  • If it becomes clear that any of these individuals is not invested in the long term success of the company, determining this early in the process allows the Owner to find an alternative individual to bring into the business and develop. Perhaps Owner had other relatives, skilled employees, or even outside sources he could have chosen to develop years prior, placing the business in a position to succeed moving forward as a result of a wise transition in ownership.

          Making critical decisions regarding the future ownership of your company is often a challenging endeavor.  It is easy to place these considerations on the back burner, focusing instead on the day to day responsibilities of your business.  However, careful contemplation of these issues sooner rather than later will lead to greater peace of mind in knowing that the right individuals are being trained and put in the best position possible to continue the legacy (and cash flow) of the business beyond the days of your active ownership and involvement.  Consider the following questions when deciding whom to select for placement on the path towards future ownership, and considering how to best develop these individuals into responsible owners of the business:

  • Evaluate the educational background, skill sets, and entrepreneurship ability of each potential successor considered for the path to ownership. Choosing a position for each employee that best correlates with these attributes increases the chance of success for both the individual and business.  A properly motivated, entrepreneurial-minded employee is a powerful force of growth for your business.
  • Communicate to the selected individual your desire that he or she eventually gain a position of ownership in the company. However, do not make any promises, at least at first.  Remind the individual that ownership in the company is something to be earned through hard work, consistency, and loyalty to the business.
  • Consider working with your advisors to develop an incentive program for the employee through which ownership in the company is gradually earned over time based on the satisfaction of certain tangible benchmarks, such as sales numbers and new customers gained by the employee.
  • Choose an appropriate leadership title for the individual, reflecting their specific responsibilities. The title of “Vice President” is used with such frequency in certain companies that it has begun to lose meaning.  Instead, consider a role specific title such as Director of Operations or Lead Project Manager.  Granting an appropriate title gives the individual a sense of pride and the means of describing their role to others.
  • Create a mentorship program within your business to ensure the selected individual learns the rights skills from the right people in the years leading up to eventual ownership. Mentorship programs are not just for big companies, and do not need to involve detailed spreadsheets and statistics.  Something as simple as a meeting between owner and employee over coffee or lunch every other week to have a candid discussion can avoid numerous unexpected pitfalls and can address concerns of both parties up front rather than allowing them to simmer.  As an owner you must be proactive, the passing of the torch does not occur on its own, it requires action.
  • Consider choosing an individual who has shown an ability to develop and grow positive relationships with clients. Alternatively, ensure that the selected individual has the ability to develop a strong rapport with clients.  A strong relationship between future owner and clients is vital to the health of the business after your assumption of a minority ownership role or retirement from ownership.
  • Similarly, ensure that the selected individual has a positive relationship with key third parties, such as bankers, insurers, accountants, financial advisors, and attorneys. Being able to work with outside parties and delegate particular tasks is a sign of leadership ability, and is vital for business owners seeking to defend their business from threats and maintain and grow their business when opportunities arise.
  • Use this process as a means of encouraging the retention of key personnel. Your selection of an individual for potential future ownership demonstrates to that person that you believe in their ability to properly operate and promote the business.  It is not simply for your benefit as owner, but should also clearly benefit the selected individual.  Otherwise, more responsibility without high pay, greater benefits, and a clear path to gaining ownership shares will eventually lead to an employee who develops their talents only to join another business that is more willing to properly incentivize his or her entrepreneurial spirit.
  • Do not hesitate too long to begin this process of developing future owners. The sooner the right individuals are committed to the long term success of the business, the more likely they will stay long enough to ensure your smooth transition out of the business or into the role of a smaller ownership interest holder.
  • Lastly, by starting this process early and using a set of well-defined check points, it can be determined whether the individual is meant to be an owner of the company. If the ability or interest is not there, an owner must find a replacement or place greater focus on other selected individuals that have demonstrated the proper skills to run the business.  The importance of being proactive cannot be understated, waiting until your retirement is not a plan, it is a disaster waiting to happen.

As an owner, whether you plan to hold an ownership interest in the company until your death, or desire to transition out of the business in the near future, development of a thoughtful business entrance plan for new owners is vital to the long term success of your company.  According to Forbes, less than one-third of family businesses survive the shift from first generation to second generation.  Of those business that last to the second general, half fail to survive to the third generation.  While the topics and discussion points presented in this article may lead to challenging conversations with family members and key employees, the importance of planning the future ownership of your business cannot be overstated.  Develop the proper heirs, and avoid the unfortunate errors.

 Disclaimer: The content of this article is for informational purposes only.  It is not legal advice, nor is it intended to create, and your receipt of it does not constitute, an attorney-client relationship.  This article may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.  The content of this article is intended to be up-to-date, but may or may not reflect the most current legal developments.  The authors assume no liability or responsibility for any errors or omissions contained within this article.  You should not act or refrain from acting based upon this article without seeking professional legal counsel.  This article only provides a brief overview and an attorney should be consulted if you have questions regarding this topic in relation to your specific situation.

About the Author:

Sean Minahan
Sean Minahan is a partner of Lamson, Dugan and Murray and a member of the Litigation Department. Prior to joining Lamson, Dugan and Murray, Mr. Minahan independently contracted with the Iowa State Public Defender’s Office in handling juvenile and adult cases for indigent clients.

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