Succession Planning: Why You Need to Start Now

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Small business owners tend to become so caught up in day-to-day activities that they find it difficult to plan for the future. Succession planning should be part of every company’s strategy from the day they open their doors, but most entrepreneurs don’t plan their exit strategy more than a few months ahead. Here is an interview on succession planning conducted with TJ Van Voorhees, one of the co-founders of Pacific Crest Group, who has helped a number of client companies with their exit strategy:

Q. So how long in advance should a typical small business start its succession planning?

The earlier they start planning the more successful they will be. A lot of succession planning revolves around financial structure and tax strategies, and they take time to implement. Unfortunately, 95 percent of small business owners decide they want to sell within a few months and they don’t have enough time to prepare.

Q. Entrepreneurs tend to make themselves an integral part of their operation. How long does it take for them to wean themselves from “indispensability”? What are some of the steps you need to consider?

If a business owner wants to wean themselves from being the focal point of their business it requires more than a few weeks. It can take years. However, it’s essential to implementing a successful handoff.

If you are a small business owner delivering services, for example, you need to consider how you can extract yourself as the central source delivering those services. Are you acting as a technician so no one else can do the job? If a process is dependent on you, how do you turn that process into a system that you can transfer to someone else? If it’s a strategic function, then it’s not dependent on you and you have a saleable asset. But if you are working 80 hours a week and you’re not doing business development, then you need to systematize your business. If you can take five weeks off and the business runs without you, then you are looking at a turnkey business you can sell or transfer.

Q. When you are planning to sell your business, what’s the difference between an investment and a strategic purchase?

I can give you a real simple example of an investment purchase. If you have $1 million and you put that in the bank at 5 percent interest you will earn $50,000 in a year. If you were to sell your business for $1 million, then it needs to earn more than you would get from a safe investment like a bank. If you buy a business, you want to be able to recoup your money in three to four years.

When valuing your business, you want to make your money back at three to five times EBITDA (earnings before interest, taxes, depreciation, and amortization). For example, if you make $1 million in revenue and $300,000 in EBITDA profit, then your business is worth about $900,000.

Q. What about technology and other businesses with unusual valuations?

Those are often good examples of a strategic purchase. Say I am a medical component manufacturer and I have $100 million in products that I manufacture. Someone comes to me with a new design for a mechanical heart valve. If I can add that business to my manufacturing company without any of the overhead then I can add that product line to my existing line. That’s a strategic purchase and the value would be calculated differently.

Q. What about key employees? How do you determine who is a corporate asset?

If you have an employee with exceptional cultural value, a high performer in their sales and marketing skills, or someone who provides the type of leadership that allows you to be less involved, they are key employees. A key employee helps keep the machine running so you don’t have to be there. This is different from someone who holds you over a barrel, such as an accountant who is too secretive. You can lock in key employees with benefits, a stock ownership plan, and other benefits. As part of your succession plan, you should sell the transition strategy to your key employees.

Q. How far can you go with the concept of systems not process, or process and not people as part of your succession strategy?

All the way! That doesn’t mean you don’t need people to run the systems, but every process should have a system around it. Even your most skilled people, such as the MBA in finance, needs a system to efficiently deliver the services. The CFOs who work for our client companies are highly trained individuals, but they deliver a highly repeatable process. We know every CFO will have a budget, objectives, cash flow statements, and other deliverables as part of the system.

Q. How important is the concept of intellectual property in terms of succession planning?

It varies by industry. For example, IP can be the policies and procedures that document your systems. If you buy an accounting firm and the accountants leave, then the IP goes with them. If you document everything and capture the accounting information and procedures as part of your systems, then it becomes a transferrable asset.

Q. What about your own bookkeeping? Many entrepreneurs tend to mix their personal and business finances. Is that a problem for succession planning?

If you have a corporation that is not run as a corporation then that’s a risk management issue. For example, if there are personal expenses or non-deductible items mixed in the company books, then the buyer is assuming IRS risk and exposure.

You need to look at your books and take forward-looking action immediately. Of course, it’s easy to make corrections moving forward, but most buyers are going to look at the last three years, if not the last five years. That’s why it’s important to use good GAAP and accounting practices.