There are now more financing sources for succession planning than ever before. While some options involve insurance or reserve funds, most business leaders will still have to make the difficult choice between debt or equity financing.
Simply put, succession planning prepares a company for the future. Many profitable businesses operate for decades, so it only makes sense the founder will leave at some point due to retirement, death or disability. Succession planning ensures continuity in times of crisis, emergency or opportunity.
Just as important as the succession plan itself is determining the best way to fund it. Smart business leaders hire professional advisors early in the process to get the most out of the sale and minimize costs and tax consequences.
Here are some of the many reasons why cash is important to succession planning:
- Provides the founder’s retirement income
- Pays out existing shareholders
- Funds certain types of buy-sell agreements
- Pays for a designated replacement who is qualified, trained and able to fill the role
- Protects the company’s value by incentivizing key employees with benefits, such as deferred compensation, to keep them from leaving
- Avoids family strife and potential lawsuits against business partners
- Helps fund exits that rely on life insurance of deferral plans
- Avoids a forced sale to pay taxes
- Avoids a distress sale at a fraction of the company’s potential value
Most of the time, succession plan financing involves lining up equity investors or lenders to fund the transition. It’s up to the company’s leadership to determine what type of funding makes the most sense for the company.
Debt
- Commercial loans: Relatively low interest rates make debt financing more attractive, and inflation may lower the effective cost of borrowing. The owner retains control of the business, and interest payments on corporate debt are generally tax deductible. However, the loan costs money in the form of interest and the bank ill have reasonable cash flow expectations and require collateral to secure the loan.
- Seller-held financing: The buyer pays part of the company’s purchase price in cash and the seller holds a promissory note on the balance. This lets the buyer hold onto cash and avoid administrative fees. But it may come with a premium interest rate, collateral and other provisions to cover risk, such as mandatory buyout terms and a forced cash distribution formula.
Equity
- Private equity: When investors place capital in private companies it allows the company to avoid additional debt and remain financially flexible if there’s a slowdown. However, private equity investors often restructure the company. They also charge annual management fees (often about 2 percent) and typically 20 percent of the profits from the sale of the company.
- Mezzanine financing: This type of funding is a hybrid that bridges the gap between debt and equity financing. It often involves a long-term commitment in the company. But, in the case of default, it gives the lender the right to convert to an equity interest in the company. It’s also quite complex and one of the highest-risk forms of debt.
- Seller retains an equity interest in the company: This option involves a buyer who gives value to the seller through future payments. It works when the seller doesn’t need cash and has a lot of confidence in the successor. Sometimes the seller becomes a consultant, and/or a minority shareholder, in the succeeding business.