The generational transition of a family-owned business is rarely a clean and simple process, and not all businesses succeed. Learn about how to increase the odds by addressing key factors for family business survival.
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.
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@example.com.
THIS INFORMATION IS NOT INTENDED AS LEGAL ADVICE. SEEK SPECIFIC LEGAL ADVICE BEFORE ACTING.