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The Purpose of Early Business Succession Planning
As an entrepreneur, the focus is typically on developing a business model, planning financing, and generating returns from the very beginning. Ideally, both legal and tax considerations are taken into account, both when choosing the company’s legal form and during day-to-day operations. In contrast, the question of a potential future “exit” from the company is often given little or no attention. Yet this aspect deserves consideration right from the start. After all, the issue at hand is what happens to the company once it has been successfully built up and managed. If an orderly succession fails, the risk is not only the loss of assets and jobs but also, not least, the destruction of the entrepreneur’s life’s work.
The scenarios are diverse, so different aspects regarding succession planning should be considered depending on the individual case. Some of the key considerations that must be addressed for partnerships as well as limited liability companies (GmbH) are outlined below:
1. What exit or succession options does the entrepreneur have?
As an option for eventual withdrawal, the entrepreneur typically considers selling their interest or transferring it (without compensation) within the family, particularly to their children through anticipated succession or inheritance. If there are other shareholders in the company in addition to the entrepreneur, the dissolution of the company (provided this is permitted by law or the articles of association) in exchange for a buyout payment is also frequently an option; the amount of this payment is determined by law or the articles of association (typically the market value of the company attributable to the shareholder’s stake).
Against this backdrop, it is of considerable importance for reliable planning and the drafting of the articles of association whether the entrepreneur acts as the sole shareholder of the company or whether it is a multi-shareholder company. In the latter case, the scope for tailoring individual provisions regarding withdrawal or succession is generally more limited if the law or the articles of association contain provisions that restrict the entrepreneur’s freedom to terminate the company, sell their interest, or even liquidate the company. Therefore, when drafting the articles of association, it is best to ensure—at an early stage, ideally right from the very beginning, to ensure that appropriate provisions—in line with the entrepreneur’s wishes—are included to enable the desired succession plan, so as not to be reliant on the goodwill of the co-shareholders later on when implementing the individual succession plan. This applies not least to the option of transferring the ownership interest, as desired, to family members—typically the children—during the entrepreneur’s lifetime through anticipated succession. In many cases, the law, articles of association, or shareholder agreements between shareholders provide for approval requirements in favor of the remaining shareholders with regard to the transfer of shares by a shareholder (so-called transfer restriction clauses), in order to protect them from the entry of new, particularly undesirable, shareholders. Restrictions on the transfer of shares can be explicitly regulated in articles of association, as well as limited or, if necessary, waived. For example, it is conceivable to exempt certain transfers—such as those to one’s own children—from such a consent requirement, so that the business owner is always permitted to make such a transfer.
To enable a shareholder wishing to sell their interest to “exit” the company without necessarily exposing the remaining shareholders to a new co-shareholder, compromise solutions are also available. For example, the right of a shareholder wishing to sell to transfer their shares to a third party can be regulated, provided that the co-shareholders have been granted a right of first refusal in advance. If the preemptive rights are not fully exercised, the shareholder wishing to sell may be granted the right to sell their shares to the third party as planned. This right can, in turn, be restricted—for example, such that the sale to the third party is permitted only if the remaining shareholders are granted the right to co-sell their shares to that third party under the same terms (known as a “right of co-sale”). It is also conceivable to include provisions in favor of the shareholder wishing to sell, whereby the remaining shareholders may be obligated—at the request of a co-shareholder or a majority of shareholders and subject to specific conditions—to sell their shares together with those of the other shareholders wishing to sell (so-called “obligation to co-sell”). The rationale behind this is that a potential purchaser is often interested only in acquiring all shares, and thus the sale can be ensured at the request of the relevant shareholders or a majority of shareholders.
The scope for structuring the articles of association tends to be broad for both partnerships and limited liability companies (GmbH), so the above considerations are intended merely to provide food for thought. However, such considerations should be thought through early on—ideally at the time of formation—so that a contractual provision desired in a specific case does not later fail due to a veto by the co-shareholders.
If the entrepreneur acts as the sole shareholder, he generally has the option to determine on an ad hoc basis when and how he will exit the company or which transfers he wishes to implement—whether within the family or through the sale of the business to third parties. In this scenario, there is often a risk of repeatedly postponing succession planning, only to find that no suitable arrangements have been made in the event of (sudden) death, or that tax-efficient transfers via anticipated succession during one’s lifetime have been missed. Last but not least, proper succession planning—including the necessary legal and tax advice—takes time, so early planning is strongly recommended in this context as well.
2. What happens if the business owner dies suddenly?
Even in the event of the entrepreneur’s death, clear consideration must be given to who should take over or inherit the business or the ownership interest in the business. Once this has been determined, contractual provisions must be put in place to ensure that the law—or any provisions in the articles of association that deviate from it—allow for the desired outcome.
The statutory provisions governing succession in the event of death—which apply unless the articles of association provide otherwise—vary depending on the legal form of the company. Amendments to the articles of association are typically necessary. These provisions should also be agreed upon by the shareholders at an early stage—ideally at the very beginning of the company—to avoid having to rely on the cooperation of a co-shareholder at a later date, when the relationships among the shareholders may have changed. In general, it is also advisable to establish such arrangements early on to ensure planning certainty in the event of death. In addition to the provisions under corporate law, the provisions of inheritance law must always be taken into account, as a conflict may arise between the two (particularly in relation to the entrepreneur’s testamentary dispositions, such as a will or an inheritance contract). As a general rule, it should always be assumed that succession provisions under corporate law take precedence over those under inheritance law in the event of a shareholder’s death, so that when drafting testamentary dispositions, special attention must be paid to ensuring that such dispositions do not conflict with the corporate law provisions or render the implementation of the testamentary disposition legally impossible.
Last but not least, when establishing succession arrangements (in the event of death), a comprehensive assessment of the financial interests of the business owner and his or her family must always be conducted. In this context, it is essential to ensure that the remaining family members are adequately provided for. Consideration must also be given to the inheritance claims of family members who are not named in the will (spouse, children), who may be entitled to a statutory share of the estate against the heirs. Here, too, it is therefore always advisable to seek in-depth legal (and tax) advice at an early stage, ideally taking into account the interests of the other family members.
3. Transfer During the Entrepreneur’s Lifetime?
Provided that the business owner is entitled and able to transfer his business or his company shares under statutory or articles-of-association provisions, he will often already be considering, during his lifetime, a sale to third parties or a transfer to family members, usually one or more of his or her children—by way of anticipated succession. This goes hand in hand with his or her overall life planning and the question of when and to what extent he or she wishes to hand over the business. Transferring ownership within the family during the entrepreneur’s lifetime offers the advantage that the entrepreneur can coordinate succession planning within the family in advance and subsequently mentor the successors. It may also be advisable for tax reasons, for example, if one wishes to take advantage of tax exemptions when transferring ownership to children. Any subsequent appreciation in the value of the ownership interest then accrues to the successor and, to that extent—unlike if the transfer were to take place only after the appreciation—is not subject to the gift or estate tax that might otherwise apply.
Particularly in the case of a transfer within the family, the question arises as to whether and to what extent the business owner continues to rely on a financial stake in or income from the business, and to what extent he or she wishes to retain the ability to exert influence, at least for a certain period of time. In this regard, there are a variety of options available for individual succession planning. One option, for example, is for the business owner to reserve a so-called “usufruct of income” as part of the (gratuitous) transfer to the children, through which he continues to participate in the company’s income to the extent specifically stipulated. It is also conceivable that the entrepreneur retains a small stake in the company and, through his voting rights and appropriately defined approval requirements, continues to exert a certain degree of influence over the company’s direction. Regardless of his status as a shareholder, he may also remain connected to the company as a managing director (possibly with extensive decision-making authority) or as a member of an advisory body (advisory board, supervisory board). These and other options require a thorough, holistic assessment and consultation. Here, too, the interests of the other family members—as well as any future inheritance claims to which they may be entitled (in particular, claims to a compulsory share and supplementary compulsory share)—must be taken into account.
The legal structure must always be accompanied by tax advice, since, in addition to gift and estate tax exemptions, tax relief provisions may apply to a significant extent under certain conditions—particularly in the case of the transfer of a business during the owner’s lifetime or upon death—which can substantially reduce or even eliminate the successor’s tax burden. In-depth tax advice is strongly recommended in this context.
Entrepreneurs should therefore address the issue of succession and the necessary structuring of their articles of incorporation and wills as early as possible to avoid jeopardizing the success of the business and family cohesion, and to prevent unforeseen obstacles.
