When it comes to succession planning for a family business, delays can be costly.
When retirement time comes around, will control of your family operation pass smoothly to the next generation of managers? Or will unexpected bills — or squabbles among your children — force its dissolution and a sale of its assets at discount prices?
You may feel uncomfortable with these questions, but failure to address these issues can have serious financial consequences.
“In the worst-case scenario, the patriarch of a family business dies and leaves a business with no succession plan in place,” says Thomas A. Pedreira, an employment law attorney at Mikkelborg Broz Wells & Fryer, Seattle. “The result is a fire sale to raise cash, and very often liabilities imposed on the family.”
Why the lack of planning? A lot has to do with psychology. “Many times people just don't want to deal with the topic of succession,” says Vic Alexander, chief manager at KraftCPAs, a Nashville-based accounting firm and family business advisory. “It's kind of like people who will not prepare their wills until late in their lives.”
Delay can prove costly because many businesses lose significant value when the founder dies and a quick decision must be made about disposing of the business assets. A big bill for estate taxes, for example, can force a fire-sale transaction just to raise sufficient cash to pay the government.
So-called “buy-sell agreements” can present problems, too. The term refers to a contract everyone has signed, calling for the business to buy out the surviving spouse of any owner who dies. The idea here is that the remaining owners don't want to end up working with a spouse without business skill.
While such agreements are excellent ideas, the required buyout has to be funded in some way. “Many companies use insurance to fund these agreements,” Alexander says. And what if the insurance is inadequate? Once again, your heirs may end up selling the business at a big discount just to fund the buyout.
Of the many reasons for delaying estate planning, uncertainty is one of the biggest.
“Often, families aren't sure how they will deal with succession in terms of who will take over,” Alexander says. “Founders often hope children will come into the business, but aren't really sure the children will be interested when they get older. And then — will they be capable?” Not knowing the answers leads to a kind of freezing in place, and that delays critical decisions.
But, uncertainty is no reason to delay a succession plan. “A good plan will include options in the form of A, B and C,” Alexander explains. “Maybe option A is to leave the business to a specified child. The plan will call for certain parameters to be reached for that to occur. If those parameters aren't reached, then the plan calls for a move to option B, which might be the public sale of the company.”
Those parameters usually involve education and competence. “Sometimes, children feel entitled to a leadership position in business just because they bear the family name,” Alexander says. “You need to make sure the second generation is properly trained and can perform the required duties of the job.”
Unfortunately, too often, people feel compelled to treat children equally. That's understandable, but Alexander says it's not always best for the business. Unintended consequences can result.
Alexander cites an example where a client planned to divide the business equally among five children. “That would have been a mistake. You can't run a business by consensus,” he says. The more logical approach would be to sell the business to the child with the greatest managerial skill and interest, then divide up the sale price to the other children.
The individual with the greatest skill may not be the eldest. That also can create confusion.
“There's still a bias, even in this day and age, to give a majority share of the business to the eldest son,” says William J. Rothwell, Pennsylvania State University professor of human resource development. “That can lead to family conflict upon the death of the founding entrepreneur that leads to liquidating the business so that all the children are given equal shares.”
Sometimes difficulties arise for a much different reason: The founders feel that because they started and built the company, they want to sell it for as much money as they can get, excluding the children from any decision on keeping the business going.
That can create a morale problem, Alexander warns. Not only might the children get upset, but employees will surely learn of such plans no matter how secretive managers are. The result is the business can lose its best employees to competitors. Once again, that means the business will lose value.
“One solution in such situations is to set up an employee stock ownership plan (ESOP),” Alexander says. “This is a great tool for people who want to exit their businesses.” Under such plans, the founders receive cash for their ownership and the employees receive shares of stock in the company. It's a win-win situation for everyone.
There's something common to both the above scenarios: Lack of sufficient communication between the generations.
“The key to avoiding many family business problems is to talk with the children prior to the founder's death,” Rothwell says. Problem is, many parents don't do so in order to avoid conflict. The result is children suing each other. “Family conflicts can be among the most bitter,” he adds.
Conversations must cover more than just managerial change, Rothwell adds. “You also have legal issues to straighten out, in terms of wills and estates and business transfer. And, there are the accounting and taxation issues that have to do with the relative benefits of selling the business before death, transferring it before death, or passing it on after death. Often, there are tax advantages to doing it one way or another.”
If it all sounds confusing, a thriving community of family business specialists is ready to help. “Don't refuse to seek out advice,” Pedreira urges. “You may think you know how to do it better, but until you hear others you won't get where you want to be.”
Pedreira recommends a structured source of objective advice. “Any family-held business with a vision toward succession should have a board of advisors,” he says. “The board provides input on the running of the business from people you trust and who have no vested interest in getting something out of their decisions.”
It's good for the board to have a mix of professionals: a lawyer, a banker, an accountant, an MBA. Consider adding someone in the same industry but who isn't a competitor to the company.
“Boards of advisors often meet quarterly, but the frequency is up to the business owners. One item that should be continually on the agenda, though, is succession.
A little prior planning could keep things from going south. “Only 15% of family businesses survive to the third generation,” Rothwell says. “So the chief danger of letting the topic go unaddressed is to risk a liquidation of the business.”
Phillip M. Perry is a New York-based writer specializing in management and legal issues.
As you plan managerial succession for your family business, helpful information is available on the Internet:
www.estateplanninglinks.com is the best portal to websites of succession planning information. Scores of links cover everything from consultants in the field to advice and published stories on taxation.
www.ffi.org (Family Firm Institute) is a great resource for finding consultants to help with the psychological and financial aspects of succession planning.