Chapter 15Succession Planning and Strategies

for Harvesting and Ending the Venture

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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Learning Objectives

• To understand the planning that is necessary to allow for the effective succession of ownership or leadership in a business

• To examine the options in providing for an exit strategy, such as the sale of the business to employees (ESOP) or to an external source

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Learning Objectives

• To illustrate differences in alternative types of bankruptcy under the Bankruptcy Act of 1978 (amended in 1984 and again in 2005)

• To illustrate the rights of creditors and entrepreneurs in different cases of bankruptcy

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Learning Objectives

• To provide the entrepreneur with an understanding of the typical warning signs of bankruptcy

• To illustrate how some entrepreneurs can turn bankruptcy into a successful business

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Exit Strategy

• Exit strategies include:• Initial public offering (IPO)• Private sale of stock• Succession by a family member or a nonfamily

member• Merger with another company• Liquidation

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Table 15.1 - Succession Planning Tips

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Succession of Business

• Transfer to family members• Role of owner - Full-time/part-time/retire• Family dynamics• Income for working family members and

shareholders• Transition business environment• Treatment of loyal employees• Tax consequences

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Succession of Business

• Transfer to nonfamily members• Train a key employee and retain some equity• Retain control and hire a manager• Sell the business outright

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Succession of Business

• In an S corporation or an LLC:• Senior management of the company must be

committed to any succession plan• Well-defined job descriptions and a clear

designation of skills• Process needs to be an open one

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Options for Selling the Business

• Direct sale• Strategies to be considered: • Focus on a narrow, well-defined segment• Control costs and focus on higher margins and profits• Get all financial statements in order• Prepare a management documentation• Assess the condition of capital equipment• Get tax advice

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Options for Selling the Business

• Get nondisclosures from key employees• Try to maintain a good management team• Prepare and plan in advance

• Type of payment the buyer will use• Business brokers• Business plan• Sale agreement or contract with the new

owners

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Options for Selling the Business

• Employee stock option plan: A two-to three-year plan to sell the business to employees• Establishes a new legal entity - An employee stock

ownership trust• Obligates the firm to repay the loan plus interest

out of business cash flows• Results in significant stock values for employees

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Options for Selling the Business

• Advantages• Motivates employees to put in extra time• Provides a mechanism to pay back loyal employees• Allows transfer of business under a planned written

agreement• Permits the company to reap the advantage of

deducting contributions on ESOP

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Options for Selling the Business

• Disadvantages• Quite complex to establish• Raises issues such as:

• Taxes, payout ratios, amount of equity to be transferred per year, and the amount actually invested by the employees

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Options for Selling the Business

• Management buyout• Direct sale of the venture for some predetermined

price• To establish a price, the entrepreneur should:• Have an appraisal of all the assets • Determine the goodwill value established from past

revenue

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Options for Selling the Business

• Sale of a venture• For cash• Financed through banks

• Entrepreneur could also agree to carry the note

• Sale of voting or nonvoting stock

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Bankruptcy—An Overview

• Common types of bankruptcies:• Chapter 7 or liquidation (70% in 2011)• Chapter 11 or reorganization (21% in 2011)• Chapter 13 or installment payments (9% in 2011)

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Bankruptcy—An Overview

• Bankruptcy lessons• Too much time and effort is spent on diversifying

in markets where entrepreneurs lack knowledge• Bankruptcy protects entrepreneurs from creditors,

not from competitors• Difficult to separate entrepreneurs from the

business• Entrepreneurs should file for bankruptcy early• Bankruptcy should be shared with employees

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Bankruptcy—An Overview

• Bankruptcy Act of 1978 (with amendments added in 1984 and 2005) ensures:• Fair distribution of assets to creditors• Protection of debtors from unfair depletion of

assets• Protection of debtors from unfair demands by

creditors

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Bankruptcy—An Overview

• Bankruptcy Act of 1978 provides three alternative positions• Chapter 11 bankruptcy: Provides the opportunity

to reorganize and make the venture more solvent• Chapter 13 bankruptcy: Voluntarily allows

individuals with regular income the opportunity to make extended time payments

• Chapter 7 bankruptcy: Requires the venture to liquidate, either voluntarily or involuntarily

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Chapter 11—Reorganization

• Courts try to give the venture “breathing room” to pay its debts

• Plan for reorganization is prepared and approved by the US Bankruptcy Court

• Decisions made reflect one or a combination of the following:• Extension - Postpone claims• Substitution - Exchange stock for debt

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Chapter 11—Reorganization

• Composition settlement - Debt is prorated to creditors as settlement

• Surviving bankruptcy• Bankruptcy can be used as a bargaining chip to

voluntarily restructure and reorganize the venture• File before failure of cash or revenue• Chapter 11 should be filed only if a chance of

recovery exists• Be prepared for examination of transactions for

fraud

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Chapter 11—Reorganization

• Surviving bankruptcy• Maintain good records• Understand how protection against creditors

works• Transfer litigation to bankruptcy court• Prepare a realistic financial reorganization plan

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Chapter 13—Extended Time Payment Plans

• Individual creates a five-year repayment plan under court supervision

• A court appointed trustee: • Receives money from debtor• Bears responsibility for making scheduled

payments to all creditors• About two of every three Chapter 13 filers fail

to meet their planned obligations• Result in a Chapter 7 filing

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Chapter 7—Liquidation

• Extreme case of bankruptcy• Voluntary bankruptcy: Entrepreneur’s

decision to file for bankruptcy• Courts will require a current income and expense

statement• Involuntary bankruptcy: Petition of

bankruptcy filed by creditors without consent of entrepreneur

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Table 15.2 - Liquidation under Chapter 7 Involuntary Bankruptcy

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Strategy During Reorganization

• The entrepreneur can speed up the process by:• Taking the initiative in preparing a plan• Selling the plan to secured creditors• Communicating with groups of creditors• Not writing checks that cannot be covered

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Strategy During Reorganization

• Enhancing the bankruptcy process by:• Keeping creditors abreast of how the business is

doing• Stressing the significance of creditors’ support

during the process

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Table 15.3 - Requirements for Keeping a Venture Afloat

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Table 15.4 - Warning Signs of Bankruptcy

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Starting Over

• Entrepreneurs start new ventures even after failing

• Entrepreneurs have the need for:• Market research• More initial capitalization• Stronger business skills

• Business failure does not have to be a stigma when seeking venture capital

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The Reality of Failure

• Important considerations for the entrepreneur in case of failure:• Consult with family• Seek outside assistance from professionals,

friends, and business associates• Do not hang on to a venture that will continually

drain resources

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Business Turnarounds

• Learn to recognize the warning signs of bankruptcy

• Principles of a successful turnaround:• Aggressive hands-on management• Management must have a plan• Action