Business succession: An undertaking that requires planning

September 2011

Business succession: An undertaking that requires planning

bouton-vers-francaisJean-Didier Bussières
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Business succession has been making headlines in newspapers, magazines and blogs1 for several years. We’ve all heard of the famous statistic published in 2005 by the Canadian Federation of Independent Business (CFIB) according to which 70%2 of business owners will retire by 2015.

Why this sense of urgency about business succession? The answer is twofold: firstly, entrepreneurs who attempt to transfer their business to their children have a high failure rate. Also, decreasing demographics in Québec could potentially have a negative impact on its economic structure.

An investigation conducted by the Fondation de l'entrepreneurship3 in 2010 showed that the succession issue is still a concern in Québec. Statistics indicate that from 2010 to 2015, 43,000 entrepreneurs plan to retire and will want to sell or transfer their business, whereas only 21,000 people would like to take over or purchase a business. This means that 22,000 business owners will not have potential successors. Until 2020, 98,000 entrepreneurs will leave their business to retire, whereas only 60,000 people say they want to take over, representing a shortage of 38,000 successors.

More transfers of family businesses4 are experiencing difficulties these days as well. The low success rate of intergenerational business transfers can be explained by a combination of factors, including the lack of a formal succession plan, the founder’s reticence, planning too late and the lack of clear communication. All these factors translate into missed opportunities for the business owner.

With extensive experience in all aspects of business succession, taxation and financing, our lawyers can accompany any intergenerational transfer, acquisition by employees or sale to a third party. They are experts who are very familiar with the impact these transactions can have on you, your loved ones and your key employees. They know how to deal with the legal, business and emotional complexities of such transactions. Here are some of their thoughts about the various aspects of business succession to help you increase the chances of success of your own succession process.

Business succession: A twofold process

The succession process consists of two major components: transfer of the decision-making power (management) and transfer of ownership (control) of the business. The decisions to be made are often difficult and complex. They include human, financial, tax and legal aspects. Transferring one’s business, whether it be to children, the company’s senior management or third parties, is a heart-wrenching decision for many entrepreneurs. That is why the transfer of management is often perceived as more difficult to carry out than the transfer of ownership itself. In every case, consulting outside experts is precious help which will ensure that all avenues are explored thoroughly. It is also important for the successor to have the necessary legitimacy with parties doing business with the company.

Demographics

The urgency is due to the rapid aging of the population. In Québec, all indicators are pointing to decreasing demographics, an aging of the population and a birth rate under the population renewal level. The age pyramid of Québec entrepreneurs confirms that some kind of structure is required for entrepreneurial renewal.

Role of SMEs

SMEs5 with less than 20 employees represent 90% of businesses in Québec and most are family-owned. Over 70% of businesses are run by men, often age 55 or over. A majority of entrepreneurs plan to retire within the next five to ten years. This will constitute the largest transfer of economic power in our history. The importance of family businesses in our economy along with the aging of the population amplify the challenges related to business succession. Quebec’s economic structure is not broken, but it will soon take a different turn. For the next generation, it will be a time of consolidating sectors which will see even more productive businesses emerge. Transferring owners should be asking the following questions now: “Who will be left to buy my business?”, “Who will I transfer it to?” and “Where are the successors?”.

Business valuation

One of the first questions an entrepreneur should ask is how much money he will need to retire comfortably. Often, the business is the entrepreneur’s main asset, in which he reinvested his profits throughout his career. An entrepreneur should always obtain an independent evaluation of his business. It is neither easy nor wise for an entrepreneur to valuate his own business. Emotions come into play, and this often causes the business to be overvalued. An entrepreneur wants to be compensated for the sacrifices he made over the years. He attaches great value to the building of his business. A potential successor, on the other hand, essentially analyzes how profitable the business is. He is buying assets, not emotions. Overvaluing the business can get in the way of the transfer. It demotivates and discourages potential external or internal successors.

The determination of the value of the business and the terms of payment must represent a fair and equitable value for the entrepreneur who is withdrawing from the business, while allowing the business to maintain the necessary liquidity without requiring too many outside players.

Human aspects of business transfers

The problems of evaluating the true value of a SME, the sometimes difficult financing of successors and complex taxation are not enough to explain the high failure rate. Several human factors come into play. A succession plan should be prepared well in advance. Despite this, many entrepreneurs still hesitate or put off the inevitable, claiming they are not ready to accept a change of role in their business. The succession plan is a structured step which includes several phases spread over a three to five-year period. Such a step is often incompatible with the personality of an entrepreneur who is first and foremost an “operator”. He is focussed on day-to-day problems and has neither the time nor the desire to plan his succession.

Specialists point out other factors which could explain the high failure rate during a transfer, such as the fear of death and being of no use, the loss of power, hesitation to share information or knowledge and a lack of communication. For many entrepreneurs, selling their business means letting go of a life’s work, almost like selling one’s child. Entrepreneurs hesitate to discuss the value of their business with their children or to admit that the business is all they have for their retirement. The slightest doubt about whether the transfer will be a success becomes a great source of concern.

Business transfers within the family

The transfer or sale to one’s children is often the solution of choice for entrepreneurs. This scenario is based primarily on the wish and skills of family members to continue to develop the business. The success of this scenario also depends on an informed decision carried out according to trade practice.

For example, in a family business belonging to two branches of the same family, the majority owners may believe they are entitled to choose the successor – a favourite son. However, the minority owners in the family may not see things the same way and manage to obtain the support of other owners and Board members in order to vote in another contender whose qualifications seem easier to justify. The bitterness caused by such a situation could be avoided if rules, criteria and a clearer succession process are established from the outset.6

As the transfer is a process which is carried out over several years, an entrepreneur must take the time to transmit his knowledge and know-how while gradually delegating responsibilities to his successor. Most entrepreneurs underestimate the amount of work involved when they decide to transfer their business.

Preparing for the changeover, the setting up of a board of directors and/or family boards, the interaction between key employees and family members as well as the financial equilibrium between family members, are all elements which an entrepreneur must take into account in preparing to hand over the reins.

Business transfers to senior management

The sale of the business to senior management is a solution chosen more often by entrepreneurs who do not have family members to succeed them and who want to ensure the survival of their business. This scenario also depends on the willingness and skills of senior management to continue to develop the business. The business expertise and knowledge of the executives often make them the buyers of choice. Whether it be a transfer within the family or to senior management, control may be transferred progressively. This allows the entrepreneur to maintain an interest in the business and to contribute his experience and know-how to the new team. Sometimes several employees get together and become a shareholder to participate in the management and development of a business as a group, through a cooperative. Setting up a shareholding workers cooperative (SWC) can allow control and management to be transferred by the owner and the business to be recapitalized.

Sale of the business

In the absence of successors in the family, senior management, or employees with the skills to take over the business, the sale to a third party often seems to be the only solution. The sale to a person at arm’s length with the vendor can allow the individual to benefit from a capital gains deduction if there is a disposition of eligible shares of a corporation operating a small business. The selling price and possible deduction are obviously important aspects of the negotiations, but they are not the only criteria for the entrepreneur. The sale of a business to a third party is almost always perceived negatively both locally and regionally. An entrepreneur, especially when he is a leader in his community, is very aware of the disturbance and concerns caused by the sale of the business to third parties. Many hesitate to sell because it does not fit in with their personal values and their commitments in their social milieu. The sale to a third party is a scenario which many entrepreneurs prefer to avoid when they are very involved in their community. In a context of globalization, acquisitions are often dictated by a desire to reduce competition, consolidate activities and achieve economies of scale. The continuity of the business acquired is often a secondary motive. However, some industries and regions are taking action to retain their job-creating businesses.

Solutions for intial steps

Business succession can be challenging and preparation for it should begin several years in advance. Despite the urgency of the situation, too many entrepreneurs still do not have a strategic succession plan.   Business succession is like a marathon with an obstacle course. If an entrepreneur does not go through this exercise well in advance, he may be forced to sell his business hastily or to hang on well beyond the time he should have left. If he does not start the process in good time, an entrepreneur limits his options for ensuring his own financial security and the continuity of his business.   As a prospective successor, take an interest in a specific industry and approach one or more targets.   As a seller, find out the fair market value of your business and identify one or more potential successor.   If you plan to buy a family business, to buy from a third party or to transfer or sell your business over the short or long term, we suggest to take advantage of our expertise in business succession as soon as you begin thinking about it. The human side is often overlooked, but it plays a key role in the success of a business transfer. Beyond our skills and experience you can count on our team to provide quality service with an understanding and personalized approach.

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[1] http://bloguereleve.fondsftq.com [2] June 2005, p. 3. http://www.cfib.ca/research/reports/rr3007.pdf [3] “La relève est-elle au rendez-vous au Québec?” Centre de vigie et de recherche sur la culture entrepreneuriale, Fondation de l’entrepreneurship, 2010; http://www.durevealareleve.com [4] http://expertise.hec.ca/famillesenaffaires [5] We are using the definition given by the Ministère du Développement économique, de l’Innovation et de l’Exportation, i.e. small and medium-sized businesses having between 1 and 199 employees. [6] Revue internationale de gestion, “Les facteurs clés de la réussite des successions au sein des entreprises familiales”; spring 2011, Volume 36 No. 1, HEC Montréal.

This bulletin provides general comments on recent developments in the law. It does not constitute and should not be viewed as legal advice. No legal action should be taken on the basis of the information contained herein.

 

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