Succession Planning: How It Works, Steps to Take

Succession planning involves choosing and training employees to replace company leaders when they depart. In some cases, for privately held businesses, it can include planning for a potential transfer in ownership in case the owner retires, dies or steps away from the company.

The details of any one succession plan can shift depending on the company’s overall goals. For example, a family-owned business may have top jobs earmarked for relatives. But, for most businesses, succession planning means finding good leaders who can take over when current leaders leave. Succession planning is an ongoing process that’s critical for any important leadership role, not just the CEO.

Not getting it right can be costly. A 2021 article in the Harvard Business Review analyzed what succession looked like at 1,500 top public companies. It found that issues, including promoting employees without properly preparing them and hiring external leaders who were poor fits for the job, cost nearly $1 trillion per year.

Steps to take for succession planning

One way to approach succession planning would be to mirror a typical hiring process: When the need for a successor arises, interview candidates and make a selection.

But that’s not an effective method, according to James Vardaman, a professor of management at the University of Memphis and a succession consultant for small and medium-sized businesses. “A good succession plan develops talent in general,” he says. “It's not just about finding the next person to be in this job or that job.”

Effective succession plans often include the following steps:

• Review key roles. Take stock of the leadership positions in your company where a departure would have a significant impact on business.

• Align on requirements. List out the traits needed in the key role. Vardaman says this list should go beyond the functional job requirements found on the average job posting and should also include soft skills, personality traits or other indicators you think are important.

• Identify potential successors internally. Look throughout the organization to identify potential leaders. Remember that performance in a functional role doesn’t always predict leadership potential.

• Provide development opportunities for potential successors. Instead of a traditional interview process, Vardaman recommends assembling a team of possible successor candidates and giving them a project to work on that’s significant to the entire company, something that affects every part of the business.

• Consider insurance. Many businesses purchase key person insurance to cover their most valuable, essential employees. The death benefit from the insurance policy can assist with business costs and bridge the gap during the replacement period.

Tips for planning

Take your time choosing a successor

The urge to make a succession plan leads some businesses to move too quickly, naming a successor before the position opens.

“Tapping an heir apparent can be really bad for the morale of the organization,” Vardaman says. “And it really isn't good for the heir apparent either.” Doing this can lead to resentment, complacency and, ultimately, retention issues.

Choosing an heir apparent can also limit a business’s ability to adapt to circumstances that might change between naming the would-be successor and the time at which that person actually assumes the role.

Don’t rely too much on current job performance

In the TV comedy “The Office,” the character Michael Scott bumbles through his role as office manager, displaying behavior that would make any HR department shudder.

Vardaman says this illustrates the most common mistake he sees businesses make when succession planning — choosing a leader based on performance in a functional role. For Scott, the skills that made him successful in sales didn’t translate well when he moved into a leadership role.

“Organizations too often just say, ‘You know, this person's the best at their job, so they're the natural person to come in,’” Vardaman says.

Adapt the planning process to your business needs

For example, a small company with just a few employees might have to adopt a pared-down version of succession planning.

A business run by a family may also require a slightly different approach. For example, the role of CEO might be reserved for a child or other relative. This presents unique challenges, like managing the expectations of non-family members in the company and addressing any intra-family issues that could arise.

Planning for a transfer of ownership

Besides having someone to step in when needed, succession planning can include the transfer of business ownership, along with the transfer of responsibilities.

If the beneficiaries of a key owner aren’t suited to own and run the business, the current owner can sell the business, which can include setting up a buy-sell agreement with any co-owners of the business to buy out one another’s share in the event of disability, bankruptcy, retirement or death.

A business owner’s interest is considered an asset, which means it will likely need to pass through probate. However, using an irrevocable trust — such as a grantor retained annuity trust (or a GRAT) or an irrevocable life insurance trust (or an ILIT) — can ease the complexity surrounding these situations:

• A GRAT can remove future appreciation of the business from the owner’s estate. This minimizes gift and estate taxes when transferring assets to heirs. 

• An ILIT can own a life insurance policy for the business owner. With the trust as owner, it separates the death benefit proceeds from the business owner’s personal estate, possibly minimizing any estate tax hit. The ILIT also provides the business owner’s heirs with more immediate liquidity or access to funds to cover business expenses until a suitable buyer for the business interest can be found.

» MORE: Should you set up an irrevocable trust?

As a business owner, personal and business affairs are often intertwined. Consulting with estate planning attorneys as well as tax and financial advisors ahead of time can help you find the right solution to ensure that your personal and business succession plan will be in order and arranged in a manner that achieves your ultimate goals.

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