Ensuring business succession in Mittelstand is legally sound

Intra-family succession, management buy-out or sale: which approach is best?

The choice of succession route is not merely a matter of preference, but has implications for the entire legal framework. There are three basic models to choose from.

In the case of an internal family succession, the business is transferred gradually to one or more children during the owner’s lifetime through anticipated succession. This preserves the identity of the business and allows the extensive inheritance tax reliefs for business assets to be utilised. Its legal core lies in coordinating the transfer, the will and the protection of siblings who are not taking over the business. A prerequisite is that a successor is available, suitable and willing. If any one of these three elements is missing, the pressure to find a family solution is more likely to cause harm than an open-minded look outside the family.

In a management buy-out (MBO), the business is sold to existing senior managers. This is the typical solution when an internal family arrangement is not possible, but the management knows the business well. The advantage is continuity: the handover takes place to trusted individuals, there is no ‘outsider’ at the helm, and there is little disruption for customers and staff.

The difficulty lies in the financing. Management does not usually raise the full purchase price, which is why the financing typically consists of bank loans, equity capital and a vendor loan from the outgoing owner. These components must be interlinked contractually – from the acquiring company through the purchase agreement to the security arrangements.

As a rule, a sale to an external buyer – be it a strategic competitor, a financial investor or an individual manager from outside the company (management buy-in) – maximises the purchase price but severs the family’s ties to the business. The sale proceeds as a traditional M&A process, involving a company purchase agreement, a list of warranties and indemnities. For owners without a successor and without a management team capable of taking over, this is often the only way to realise the value of their life’s work.

Decisions are often taken in stages: first, a serious attempt is made to find a family-based solution; then an MBO is considered as a fallback option; and finally, an external sale is pursued. It is important to lay the legal groundwork in such a way that a change of approach remains possible, rather than locking oneself into a structure at an early stage that accommodates only one scenario.

When should succession planning begin?

Planning should begin much earlier than many business owners assume. A lead time of five to ten years is advisable in order to make full use of the key tax, inheritance law and operational options available. It should be noted that several statutory deadlines only begin to run from the date of transfer and cannot be made up for later.

Under Section 16 in conjunction with Section 14 of the Inheritance and Gift Tax Act (ErbStG), the personal allowances for inheritance and gift tax can be utilised anew every ten years: €400,000 per child and €500,000 for the spouse. Those who begin the transfer at an early stage can structure it in several instalments and thus utilise the allowances twice, rather than allowing them to lapse in a single instance upon inheritance. The holding periods for the business assets exemption are five and seven years respectively. These periods must run uninterrupted following the transfer for the tax exemption to remain in force. Furthermore, the supplementary claim to a compulsory share by disinherited relatives is only fully phased out over a period of ten years, in accordance with Section 2325 of the German Civil Code (BGB).

These periods begin upon the transfer. Anyone who acts only shortly before their planned retirement or upon inheritance will no longer be able to make full use of them. There is also an equally important operational factor: a successor must grow into the role, taking on responsibility, building relationships and developing decision-making capabilities. This role cannot be transferred solely by means of a contract. A phased handover of management, voting rights and shares therefore combines tax planning with a controlled operational succession.

How do articles of association and a will work together to ensure succession?

This is one of the most common and costly sources of error. Where the transfer of company shares upon death is concerned, company law takes precedence over inheritance law. A will that contravenes the articles of association is invalid. Anyone who names a child as the business successor in their will, but whom the articles of association do not permit to be a partner, has failed to make any arrangements and has set the stage for a conflict.

In the case of partnerships, the succession clauses in the articles of association govern the transfer. In the absence of specific provisions, a deceased general partner is excluded from the partnership and the partnership continues amongst the remaining partners. For limited partners, however, section 177 of the German Commercial Code (HGB) provides for the partnership to continue with the heirs. The articles of association may, however, steer this outcome in different directions.

A continuation clause maintains the partnership exclusively amongst the remaining partners, whilst the heirs receive a right to compensation in lieu of a shareholding. Under a simple succession clause, on the other hand, all heirs assume the status of partners in proportion to their shares of the estate. If only a specific group of persons is to succeed, for example a single child or professionally qualified descendants, a qualified succession clause is required. An admission clause works differently: it does not automatically transfer the share, but grants a named person the right to join the company. The situation is different for a limited liability company (GmbH). Under Section 15 of the German Limited Liability Companies Act (GmbHG), a share is freely inheritable and initially forms part of the estate or, where there are several heirs, the community of heirs. However, the articles of association may stipulate, through redemption and assignment clauses, that the share of undesirable heirs is to be redeemed in return for compensation or assigned to the preferred successor. The will and the articles of association must provide for the same outcome; otherwise, they will conflict with one another.

Compensation clauses are a separate point for consideration. A compensation payment under the articles of association that is significantly below the market value may relieve the burden on the successor taking over the business, but it can trigger tax consequences and affect the calculation of the statutory share of the estate. Such clauses should not be taken directly from a model contract, but should be carefully calculated.

What role does the statutory share play in the handover?

The compulsory share is the sticking point in almost every family succession where the business is passed on to one child and the siblings are to receive nothing. Under Section 2303 of the German Civil Code (BGB), descendants, the spouse and, in certain circumstances, the parents are entitled to a compulsory share amounting to half of their statutory share of the inheritance. This entitlement is to be paid in cash and is calculated on the basis of the full market value of the estate. The business is therefore not valued at book value, but at what it is actually worth.

In the case of a highly profitable business, the statutory share of a single child who is to be passed over may already reach a magnitude that the successor can only meet through high dividend payments, withdrawals from the business’s assets or additional financing. Consequently, a claim under inheritance law directly gives rise to a liquidity and continuity risk for the business.

Assets transferred during the testator’s lifetime are not disregarded in this context. Under Section 2325 of the German Civil Code (BGB), gifts are added to the estate. However, this claim loses significance over time: the gift is taken into account in full in the first year prior to the opening of the succession and thereafter reduced by one-tenth each year, until it is no longer taken into account at all after ten years. An important exception concerns the spouse. In the case of a gift between spouses, this period only begins upon the dissolution of the marriage – usually, therefore, upon death – meaning that the phasing out has practically no effect.

The most effective way to resolve the conflict in advance is a notarised waiver of the compulsory share under Section 2346 of the German Civil Code (BGB), which is usually made in return for a settlement during the donor’s lifetime. This waiver may be limited to the share in the business, so that the children relinquishing their claim retain a share in the private assets and merely waive their statutory share relating to the business. This is complemented by arrangements under matrimonial property law and a balanced distribution of the remaining assets. Anyone who compensates their siblings fairly, but outside the business, neutralises the destructive power of the compulsory share.

How can inheritance and gift tax on business assets be reduced?

Inheritance tax law offers significant tax relief for the transfer of productive business assets. The exemption rules set out in sections 13a and 13b of the Inheritance Tax Act (ErbStG) are the reason why a well-organised succession is often far more favourable from a tax perspective than an unplanned inheritance. The lawyer’s role is to structure the transfer so that the conditions for this exemption are met in the first place. The specific tax calculation is carried out in consultation with the tax adviser and forms part of estate and succession planning.

There are two models to choose from. Under the standard exemption, 85 per cent of eligible business assets is tax-free, provided the value acquired does not exceed 26 million euros. The conditions are a five-year holding period and compliance with the wage bill requirement: the total wages paid over a five-year period must not fall below 400 per cent of the initial wage bill. Businesses with up to five employees are exempt from the wage bill requirement. For businesses with six to ten employees, a reduced minimum wage bill of 250 per cent applies, and for those with eleven to 15 employees, 300 per cent.

Although the optional exemption makes 100 per cent tax-free, it requires a holding period of seven years, a total wage bill of 700 per cent over seven years, and a maximum of 20 per cent of the business assets to be classified as administrative assets.

To illustrate: for eligible business assets of 10 million euros, 8.5 million euros remain tax-free under the standard exemption. The tax rate applicable to the respective tax bracket is applied to the remaining 1.5 million euros after deduction of the allowances. This example is for illustrative purposes only and does not replace a calculation for an individual case.

Two points must be clarified in advance. Firstly, the 90 per cent test in accordance with Section 13b of the Inheritance Tax Act (ErbStG). If at least 90 per cent of the transferred assets consist of business assets – for example, let property, securities or surplus liquidity – the exemption is completely forfeited. New business assets that were only added to the business within two years prior to the transfer are not eligible for the exemption in any case.

Secondly, large acquisitions exceeding 26 million euros must be mentioned. In such cases, the acquirer may choose between the phasing-out model under Section 13c of the Inheritance Tax Act and the exemption needs test under Section 28a of the Inheritance Tax Act. Under the phased reduction model, the tax relief allowance decreases by one percentage point for every 750,000 euros above the threshold and is completely withdrawn at around 90 million euros. Under the means-test, the tax is waived to the extent that the acquirer is unable to pay it from their available assets. Both options require very precise planning of one’s financial circumstances.

Why does a family business need an advisory board?

An advisory board can help professionalise management, particularly during the most sensitive phase: the generational handover. In Mittelstand companies, it is not a legal requirement, but can be freely established as an optional body in the articles of association. Around 78 per cent of family businesses now have an advisory board, supervisory board or board of directors. The reason for this is practical: a well-staffed body brings in external expertise, mediates between the family branches and supports the successor until they are confidently in charge.

The spectrum ranges from a purely advisory board with no decision-making authority to a supervisory body with genuine powers, such as the appointment and dismissal of the managing director or the right to withhold approval for major investments. Which option is appropriate depends on the extent to which the family withdraws from day-to-day operations. If the family withdraws completely, the advisory board assumes strategic oversight of a company managed by external parties. If a family member remains involved in day-to-day operations, external members should constitute the majority to ensure the board remains independent.

It is crucial that this is clearly enshrined in the articles of association: the composition, appointment, duties and rights of the advisory board must be unambiguously regulated; otherwise, the result will be either a body lacking teeth or one that paralyses the managing director. If set up correctly, the advisory board acts as the institutional framework that maintains stability in the succession process beyond the handover date.