The criteria are two: the plan must be strategic, and the plan must be the basis for an enforceable owner agreement. The foreseeable long-term events such as death, disability, divorce, bankruptcy, and withdrawal from the business must be part of the planning perspective. Once the succession plan is completed, the next issue is how it can be made enforceable. The enforceable owners’ agreement is commonly referred to as the buy-sell agreement, but the owner agreement will contain more than buy-sell provisions. The owners start wanting buy-sell provisions, but will in time recognize that the buy-sell provisions will be effective only if the owner agreement contains additional planning.

The owner agreement with buy-sell provisions creates a contract under which each owner agrees to offer that owner’s interest in the business to the business or to the other owners of the business on the occurrence of certain events, commonly referred to as triggers. The owner agreement should contain additional provisions concerning the management of the business and the funding of a buy-sell transaction.

From the perspective of an owner of a closely held business interest (an interest for which no public market exists), there are some readily identifiable factors relating to that ownership status. The owner may be an owner who remains with the business and is affected by the departure of a withdrawing owner, or the owner may be an owner, or an owner’s estate, who is withdrawing from the business. Typically, the owner has a substantial portion of the owner’s wealth invested in the business interest, and this interest is relatively illiquid, with the value of the interest unstated. Generally, the owner is involved with the management of the business with other associates, who may or may not be family members, and the chemistry of the business management is fragile.

For a withdrawing owner, buy-sell provisions can state a value for the owner’s interest and provide a method of paying for that interest upon the owner’s withdrawal from the business. The determination of the value of the interest may be done with respect to tax issues, and the method of payment may be designed to avoid adverse tax consequences to the withdrawing owner.

For a remaining owner, buy-sell provisions will establish a fair value, identified in advance, for the interest of the withdrawing owner. The right to purchase the shares of the withdrawing owner can be restricted to those within a certain group or to a certain individual or individuals by the buy-sell provisions. The owner agreement can be used to establish management control and prevent deadlock with respect to the withdrawal. The owner agreement may establish the funding, including the purchase of life insurance, for the purchase of the shares of the withdrawing owner. If the business entity is an S corporation, there may be provisions in the agreement that protect the status of the S corporation. Where there is a potential that the withdrawing shareholder might compete with the business, appropriate restraint against competition may be placed in the owner agreement.

The owner agreement is a contract and should be a written document executed by all the parties. Some states require an owner agreement to be written; however, some courts have enforced oral agreements. The primary functions of an owner agreement are met only when the agreement is in writing and is the subject of the planning and negotiation of the parties. The owner agreement will be subject to relatively frequent modification.

There are three basic structures of buy-sell provisions: cross-purchase, redemption, and hybrid. These terms describe the essential transaction that is the focus of the reaction to the trigger event. Where a cross-purchase is triggered, the remaining owners are the buyers of the withdrawing owner’s interest. Upon the triggering of a redemption agreement, the business is the purchaser of the withdrawing owner’s interest. The enforcement of purchasing or selling a business interest may be placed in an option setting or in an absolute requirement to buy. One group may have a first opportunity to purchase with another group having a subsequent opportunity to purchase. Often, it is through these purchase opportunities or requirements that a hybrid agreement is constructed, involving components of redemption and cross-purchase.

In the context of a private business, as opposed to a public business where the ownership shares are sold in a market environment, it may be difficult to establish a value between owners. A complicating factor is that in owner-managed businesses, the owners will be unwilling to pay one another for the intangible aspects of the business, such as goodwill, that might be included in the valuation of a business interest between non-owners.

The owners typically know what they want, the buy-sell provisions, but are puzzled about how to answer the questions asked so that the owner agreement may be drafted appropriately. The owners who get to the effective agreement are the ones who, using all the help necessary, are willing to create the complete succession plan, which will be the basis for the owner agreement.

At a succession-planning meeting, the first job is not to decide anything. It is to give the group the information a decision requires. If the topic is choosing a chief executive officer, the meeting opens with how comparable businesses handle that choice, not with a vote. Only once the group understands the choices and has had its questions answered does polling begin, and polling does not mean asking who in the room agrees.

Group Dynamics

Group dynamics distort decisions in predictable ways. A member yields to a position that seems good enough rather than fully forming an independent one, the bandwagon effect. A credible or dominant member states an opinion and the room falls in line, the halo effect. Neither is an accurate reading of what the group thinks.

To avoid the effect of the meeting environment, the reliable method is to have each member submit an independently formed written position before the group compares notes. The writings reveal what is shared and what is not, and later meetings can focus on the differences instead of trying to find a consensus that was never real.

Topics

Developing the topics for the plan is its own challenge, and two methods work. The first is direct questioning: how did the business begin, what is different about it now, what is the greatest vulnerability, who are the key employees, could the business be sold quickly, has an outside party ever made an offer and why. Some questions extend past the business itself, an owner’s estate plan, insurance coverage, retirement intentions, whether family members belong in the business at all. The value of the questioning method is not the answers on the first pass. It is that one question reliably generates the next, and the group ends up further into the real issues than a scripted agenda would have taken them.

The second method is the fire drill^[1]. An event is selected, an owner’s death, a sudden disability, and assumed to have already happened. The group then works through, step by step, what would occur. The visualization does the work that abstract questions cannot: as the group walks through the probable sequence of events, the gaps in the plan become obvious, and the substance of what needs to be decided comes into focus.

Among the topics a plan must resolve, one comes up in nearly every closely held business: whether ownership should be restricted. Owners work together daily and want a say in who joins them. Some businesses restrict ownership to family. Professional practices often restrict it to licensed practitioners, by choice or by law. In most others, the real test is simpler: will a prospective owner fit with the people already there? The plan should state the restriction or qualification, not leave it to assumption.

Governance

Ownership motivates on two fronts: a say in decisions, and a greater share of value. Both point toward management structure. A business controlled by its owners but not run day-to-day by them has functioning middle management, and building that layer is the hardest structural work most closely held businesses face, training nonowner employees to do what owners have always done themselves. Retaining monitoring and policy authority does not require retaining daily operations. The payoff is direct: an owner’s interest is worth more if that owner’s departure does not diminish how the business runs.

Control also decides who leads. The threshold question, does the chief executive need to be an owner, surprises owners who have never asked it. A CEO executes policy; owners or a board set it. The selection should be as structured and open as a search committee’s, the way a school or a church runs one, comparing candidates against the role rather than defaulting to whoever is already closest to it. Family businesses in particular benefit from bringing in outside leadership when no family member is qualified, and a leader developed at a competitor can bring change a business badly needs. The specific choice will vary. The process for making it belongs in the plan regardless.

Governance is the interaction of three distinct functions: ownership, policy-making, and execution, and the corporate model, shareholders electing a board that appoints officers, works when the boundaries between them are respected. The diagnostic question is simple: who reviews the chief executive? If the honest answer is some version of the CEO reviewing themselves, the boundaries have collapsed, and that collapse is most common exactly where the CEO is also the majority owner. A hierarchy may work at the start, but it is the least stable structure over time. What owners need is confidence that they can affect the quality of decisions, whether through parity of ownership or through a structure that takes minority concerns seriously. That confidence, and the structure that produces it, belongs in the plan.

Ownership succession also raises the possibility that a departing owner ends up competing with the business that is still paying that owner for the interest. It is an uncomfortable scenario and a common one, an owner leaves with no intention of competing, then a competitor recruits them. A management employee would typically sign a noncompete; the plan should decide, deliberately, whether departing owners are held to the same restraint.

Triggers and Funding

The buy-sell provisions activate on triggers, and each trigger carries its own value and payment logic. Death ends further involvement and usually calls for prompt payment, which is why life insurance so often funds it. Disability is more likely than death for most owners and more often ignored in planning; the plan should distinguish temporary from permanent and set payment terms accordingly. Retirement, nonproductivity, and voluntary withdrawal raise separate questions about what the owner contributed and what happens to employment status. An involuntary or improper transfer of ownership can be its own trigger. Where deadlock is a real risk given the ownership structure, a deadlock trigger gives the business a remedy when governance simply stops functioning.

Valuation belongs in the plan, and it is not the same question as fair market value. What the succession plan sets is what one owner should pay another for that owner’s interest, courts and statutes call it, confusingly, “fair value.” There is no single correct process. Financial statements are the starting point. Accountants and certified appraisers each bring something, though appraisers trained to find fair market value do not always translate well to owner-to-owner value. A useful backward test: if the majority owner died today, what could the company actually afford to pay over the next five years? Whatever valuation approach is chosen, it has to be something the business can fund, and that satisfies every trigger the plan defines.

Funding comes last, by necessity, because it depends on everything decided before it. Most of the money to buy and sell ownership interests comes from the business itself, so if the business cannot fund the obligation, the plan is aspirational rather than real. Funding should never drive valuation in reverse, a large insurance policy does not mean the interest is worth that amount, and an uninsurable owner’s interest is not worth less because no policy exists. Even simple funding mechanisms, a reserve or a life insurance purchase, carry tax consequences that belong in the planning conversation, not discovered afterward.

None of this holds together undocumented. The plan should be drafted topic by topic as the group works through it, then reviewed as a whole and tested for consistency; a decision about triggers that made sense in isolation can conflict with a valuation decision made three meetings later. The succession plan is not a document produced at the end of a process. It has to coordinate with, and be supported by, the long-term planning of the business as a whole.

^[1]Developed by Bonnie Brown Hartley, PhD and Patricia A. Frishkoff, DBA. See transitiondynamicsinc.com.