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Succession strategy vital - Normand Meunier (1/02)

A previous column discussed the succession crisis facing Canada's family businesses and the need for tax reform to encourage leveraged employee buyouts through employee share ownership plans, or ESOPs.

A previous column discussed the succession crisis facing Canada's family businesses and the need for tax reform to encourage leveraged employee buyouts through employee share ownership plans, or ESOPs.

I would like to continue this discussion by offering some advice to business owners who are approaching retirement without a succession strategy.

Make no mistake. The succession crisis and the threat it poses to private companies that are unprepared for the day the business changes hands are real.

A recent succession study by Deloitte & Touche revealed that in Canada today there are 124,000 private mid-market companies with sales of $1 million or more.

This research shows that 70,000 of these firms will be sold over the next 10 years as their owners retire. Within 15 years, 94,000 firms in this category will change hands. Yet only one-third have put in place any form of succession plan to guide the transition.

In Northern Ontario we can expect 56 per cent of mid-market companies will be sold by 2010, and 78 per cent by 2015.

The sheer number of companies being sold over such a relatively short period will create a scarcity of buyers and lower prices. Even more disturbing, businesses not supported by a viable succession strategy run a high risk of failure after the transition.

Successions most commonly fail because the buyer, or new management team, do not have sufficient experience or enough time to master the business. Not surprisingly, transitions with the greatest chance of success involve buyers with direct experience in the company. This is borne out by the fact that successions involving outside buyers fail in 50 percent of cases. In contrast, management buyouts succeed 80 percent of the time.

The bottom line is that owners who ignore succession place their equity and their business at risk. How well and how early owners plan succession determines not only the value they receive - and when and how they receive it - but also the future success of their companies.

How then can a soon-to-be-retiring owner get the best price and ensure the buyer is capable of successful management? One very viable option is to structure a gradual transition involving managers already working in the business.

With enough lead time, owners can identify appropriate managers, prepare them for the challenge of ownership and establish a financing structure that enables the incoming owner or owners to buy the business over time and deliver fair value for the owner's equity.

Owners who structure gradual transitions dramatically increase the odds for survival by acting as mentors and sources of experience for the new owner.

The beauty of the gradual transition is its flexibility. Those with sons or daughters in a business can give their children ample time to gain experience and prepare for the challenge of ownership. In cases where a child is just entering the business, or does not have the right experience, a structure can be established whereby they share ownership with capable and experienced managers working in the firm.

If there is no potential buyer in a business, the owner can attract a suitable candidate into the company on the understanding that they eventually acquire ownership.

Perhaps the gradual transition's greatest advantage is that an owner is able to more directly control the value they receive for their equity. Owners can usually take their money out in stages by leveraging earnings and the value of fixed assets - often years in advance of retirement - and gradually transfer equity to the new owners.

Capital structures to finance gradual buyouts include: secured term loans, which are based upon fixed assets; subordinated debt, most commonly used when cash flow is abundant, and equity investments, which rely on a history of strong earnings and growth potential.

Fixed assets generally are not sufficient to secure the required capital to pay for the true value of a business. As a result, ownership transitions are most often financed with subordinated debt and/or equity in combination with term financing.

A gradual buyout addresses one of the fundamental problems of succession: how can I sell my business to internal managers or my children working in the business if they do not have the money to buy the company? Savvy owners know the answer is to plan longterm and let the business pay for the transition.

By drawing money out over time, using a range of transition financing instruments according to preset deadlines established in the succession plan, an owner can have 100 per cent of his or her money out of a company by retirement. Even better, through careful planning owners can also stay in control until they are ready to leave the business.

Normand Meunier is the assistant vice-president of RoyNat Inc.’s Northern Ontario district, operating out of the Sudbury office.