The generational transition of a family-owned business is rarely a clean and simple process, and not all businesses succeed. Only about one in three family businesses are expected to survive the founder’s generation, and even fewer, an estimated 12%, will make it through to the third generation (PwC 2019 US Family Business Survey).
Succession planning improves those chances by setting down in legally binding documents how ownership will transfer. It also identifies successors, develops future leaders and potentially protects talented key employees. The decisions you make for succession planning must be strong enough to stand up in court yet allow for changes that time may bring to the business and the family.
Beyond Taxes
Much of business succession planning focuses on estate planning and structuring business succession to minimize transfer taxes. And certainly, these are important factors to consider in succession planning as many a family business has had to be sold to provide the estate with liquidity and pay excessive estate taxes that could have been reduced to a manageable level had proper estate planning been performed.
If you stop there, though, you’ve got only a portion of a plan. There are other important nontax issues that contribute to successful business succession plans.
- Naming successor(s) and other key players in the business’s success to run the business.
- Determining a methodology and structure for transferring control.
- Establishing retirement income for the family owner, who often has significant net worth embedded in the business, and unlocking this wealth for the owner’s retirement funding.
- Providing for a smooth and controlled transition.
- Considering family dynamics versus business priorities and realities. Squabbles and lawsuits between family members aren’t uncommon in an unplanned business transition. The more complex the family dynamics, the greater the need for a plan and mechanism for executing unbiased succession decisions.
- Clarifying career paths for family members with the appropriate skills and training. While a business owner may love their children equally, those children may not be equally up to the task of taking over the family business. Selecting who’s best to lead the family business on the retirement or death of the owner can be a difficult and thorny issue but is likely the best path for preventing nasty family in-fighting and lawsuits.
- Minimizing liquidity demands that could undermine the viability of the business at the time ownership is transferred.
- Considering key employees, the loss of whom would make transitioning the business from one generation to the next difficult. As the head of the family business approaches retirement, key employees may feel insecure in their future and begin to consider other employment opportunities. When one or more key employees are integral to the success of the business, a good succession plan should consider how to reduce their anxiety and perhaps include them in the plan, whether by part ownership opportunities or economic incentives.
- Providing for contingencies and revisions to the plan, with periodic reviews to ensure it’s still valid. Times change. So does the law, family dynamics and business value. A business succession plan done five years ago may be out of date. There any many issues and events beyond the business owner’s control that could derail succession in key positions. For example, a business owner could determine that Daughter #2 is best qualified to lead the business into the next generation and Daughter #2 may be on board with the plan. But several years later, Daughter #2 gets married, moves to another state and begins building her own career. The plan should be revisited to determine if Daughter #2 is realistically still interested in taking over the business. Reviewing the plan on a regular basis for these types of pivots will lead to the best result for the business and family members.
In most cases, family business owners don’t have the luxury of waiting until they want to retire to put the succession plan in place. Risks in waiting include: an untimely death or disability of the owner; adult children and/or key employees becoming impatient with the lack of planning and stress in the unknown, driving them to take other employment opportunities and spreading family stress and discord; and, inability to finance a sudden buy-out of the business.
Real Life Example
So, what does a successful family business transfer look like? Years ago, I was approached by an electrician (owner) who had successfully built up a local electrical business that employed about eight electricians, including his son and another electrician that he considered to be a key employee and who the owner treated as a second son. The owner was in his mid-50s and wanted the two young men to begin taking more responsibility in managing and operating the business as well as start the process of buying the owner. The owner wanted to maintain control during this process, with the hope that in about 10 years, the young men could fully take over the business. The business operated as a corporation, and the owner owned all of the outstanding shares of common stock in the business.
With this set of parameters in mind, we reorganized the corporation’s common stock structure into two classes: voting and non-voting. At the end of each year, the owner granted each of the young men an option to purchase a certain number of shares of the non-voting common stock. The timing of the option would typically coincide with year-end bonuses so that the primary source of funds to pay the exercise price for the option shares was the bonus money. This essentially allowed the young men to fund the option exercise price separate from “out-of-pocket” costs, reducing their financial burden and making the buy-out more palatable. Under the stock provisions, when the two young men acquired two-thirds of the outstanding shares from the owner, their non-voting shares would automatically convert to voting shares, the timing of which would correspond with the timing of the owner’s retirement and the young men assuming control of the company.
Key Factors for Success
This plan kicked in well before the owner’s target retirement date and wouldn’t have been possible had the owner waited until he was nearing retirement. The sophisticated exit design unfolded over years and touched on many key factors in successful succession plans by providing: (1) flexibility for the owner to decide each year how many shares he wanted to option to the two young men; (2) a manageable buy-out of the owner’s controlling interest over a long period of time while minimizing the liquidity demands on the business and young buyers; (3) funds to the father for his retirement for reinvestment and diversified holdings; (4) the two young buyers with some certainty regarding their future in the business and a growing economic stake; (5) for a viable business with minimum liquidity demands and competent leadership (6) a smooth and controlled transition, seamless both internally for staff and externally with customers; and, (7) the owner’s management control of the company during the transition process.
A succession plan for a family business that isn’t expected to be transferred to next-gen family members will look quite different. An owner might take advantage of opportunities to transfer the business to one or more key employees, including through an employee stock ownership plan or outright sale to a third party, especially if the sale is precipitated by the untimely death or disability of the owner. This includes hiring and training competent management; formalizing operating procedures to aid the future buyer; and, putting in place life and disability insurance in the event of an unexpected death or disability for liquidity during the process of locating and negotiating a sale of the business.
David A. Thayer, esq., is a business and corporate finance attorney, and former CPA, that focuses on making deals as he helps clients achieve their business dreams. He can be reached at [email protected].
