When internal transitions go wrong

For good reason, most financial advisers prefer internal to external transitions when planning their business' succession.

For good reason, most financial advisers prefer internal to external transitions when planning their business’ succession. Internal transitions allow for greater client and staff continuity, give the departing owner an opportunity to play a continuing role and fulfill his or her desire to leave a legacy.

But since practice often differs from theory, many internal transitions don’t work. Here are some real-life lessons from clients and advisers with whom I stay in touch that may make your succession planning more successful:

1. Make sure that your potential successor actually wants to be a business owner. Many employees and potential successors like the idea of being an owner or a partner, but find the actual performance of those roles not so appealing. One of my favorite former clients worked for years to groom a successor, and then for almost a year to structure a transaction. The successor was involved throughout, but got cold feet in the final hour when the responsibility for buying out the senior partner became overwhelming.

Being a business owner is mostly not about title and status and mostly is about investment, commitment and responsibility. It requires more than professional competence and good technical skills; it is about being able to invest in the business and bear risk.

Many internal transitions are in the final stages before successors realize what it all means. Although current owners view the assumption of business risk as an opportunity, some internal successors see it as daunting and too much of a commitment.

Unless the internal succession candidate is interested in being an owner of a very small business, or a small owner in a large business (which requires a larger pool of successors), he or she may not be a good choice. If that is the case, there are other ways to engage such an individual — including profit-sharing and/or a status title — but he or she probably is not a viable successor to the business owner.

2. Make sure that you understand what your successor wants and what he or she is willing to give to achieve that. Are you on the same page about timing, cost and contribution? I have seen these as challenges for both buyer and seller.

In some cases, the seller wants to sell only a small share of the business to an internal successor, say 5% or 10%, so the seller can prepare to exit at an undetermined time in the future. For a successor who wants to own the business outright, this is buying into a black box.

In other cases, the owner wants to sell the entire business and the successor wants to own only enough to be called an owner, which won’t ultimately fulfill the seller’s transition desires. Such a mismatch can create frustration.

Price can also be a challenge. Internal buyers frequently feel that they should be given a discount on the purchase price, since they are insiders and probably contributed to the business’ growth. That sentiment — and pure affordability — are two reasons internal successions don’t usually command the same premiums as external transactions.

Still, the discounts expected by many successors are beyond unreasonable.

Price can also be a challenge in terms of timing: Are the seller’s exit timing and cash flow needs aligned with the successor’s? Can the successor afford — both financially and emotionally — to buy the business?

If the candidate says, “Good grief, it will take me 10 years to fully buy you out and pay off the note,” you are probably looking at a candidate who is not really ready to own and finance an asset the size of your business.

3. Make sure that you have the right person. Dishonesty and character flaws are far less likely to shoot down an internal deal than a lack of communication about goals and objectives. Merely asking an internal candidate whether he or she is interested in being your eventual successor isn’t a big-enough question. Each party must discuss in depth what being a successor means personally.

Thorough communication will help avoid many of the pitfalls of internal succession, and is especially important in determining if a successor candidate is a poor match.

In the wise words of a client whose internal succession plan fell apart and who hasn’t yet found that right person, “Succession planning seems a bit like marriage: it takes commitment, open and honest communication, give and take on both sides, respect and support for one another’s goals. In our particular case, I can now look back and see the breakdown in each of these different areas.”

Rebecca Pomering is the chief executive of Moss Adams Wealth Advisors LLC and a former practice management consultant to independent advisory firms.

For archived columns, go to investmentnews.com/successionplanning.