Business owners should understand that what establishes the value in a business is not the appraisal of the business but funds received from selling it. If the business has a proven market for the product or service, the business will transition from owner-managed to having professional (non-owner) management, and then (assuming continued existence) the business will be transferred through either an internal (sale to existing managers) or external (sale to third parties not involved in the business) sale.
The key element is that to get the most value for the business, the business cannot rely upon the owner’s contribution. A sophisticated buyer will not pay top dollar for a business that must include the seller’s services. Depending upon this planning, the business may build a balance sheet or may distribute earnings to the greatest extent possible. If the succession plan is a “dues” based plan for internal succession, ownership may be obtained for a relatively small amount and transferred for a relatively small amount, but while the ownership is held, the owner receives the maximum distribution of earnings possible. In this case (a strategy for internal succession), the business does not maintain a high net worth but the owners are rewarded with cash distributions. On the other hand, the value strategy is to build the value of the business hoping for a third party sale at fair market value (only possible if the owners’ participation is not essential to the performance of the business). Appraisers may value the result of these plans quite differently, but the value may be roughly the same to the owners.
The succession plan must identify the correct legal entity with the correct tax attributes to perform according to the requirements of the succession plan. The succession planning for the business should anticipate the difficulty of selling a business and provide a plan for selling the business to those who are managing it if a more attractive sale to a third party does not materialize. Typically I encourage a business try for a fair market value external sale but at the same time plan for an internal buying and selling of business interests based on certain contingencies.
