Family Business Succession

“But Dad, you didn’t tell me I had to be at work by 8 a.m.! By the way, is six weeks vacation too much? Oh, and did I mention that my car allowance needs to be at least $1,500 per month? And just to be clear, I don’t think my brother and sister should work in the business.”

Many business owners would like to pass their business to the next generation. They would also like to make sure they have adequate funds to enjoy their retirement years. This concern, along with demands similar to those in the first paragraph, are some of the reasons that the parents oftentimes end up selling to an unrelated third party. Transferring the business to the next generation only works if that generation has the desire to carry on the business. The heirs may want to sell the business as much as the parents. They may realize that the optimum value can be obtained while the parents are there to transition to a new buyer. The heirs may also not want to risk the fortunes of the business and their financial future on the untested management of the next generation.

Passing businesses to the next generation, however, is done successfully on a regular basis. Getting there involves overcoming a lot of obstacles. A lack of planning, poor communication, and insufficient “cash” are three critical obstacles. If there is no “cash,” then something else has to be added to the formula to get the results that the parents and the children seek to obtain. This article will address these issues by focusing on two key aspects of business succession planning: 1) Parallel planning for both the family and the business in succession matters; and 2) Corporate legal tools that can create a workable formula for the transfer of the business to future generations.

Family Business Continuity Tools in Business Succession

Around the world, these words resonate with business owners: “Wealth doesn’t last beyond three generations.” This is the most succinct statement of a fear that can hang like a dark cloud over the otherwise remarkable success of many entrepreneurs and their families. Whether it is an operating business or portfolio of invested assets that is passed along to heirs, the “three generation rule” can apply. But it is not a law of nature or some other incontestable force to which all must yield. Many families have successfully passed along thriving businesses for many generations, in the process creating new wealth and carrying on the legacy of the founder.

The difference between success and failure is often due to planning on both the business and family fronts. This parallel planning process should be holistic in nature, including family decision making, ownership preparation, leadership development, sound financial planning, and legal structures that allow for the growth of both family and business. Principally, five elements are needed for successful succession of a family business.

• Business Strategy Plan. If a business has been treated as a “cash cow” and deprived of reinvestment and strategic realignment at critical points, it may need to be sold while there is value remaining before it reaches the point of failure. It is critical that a family-run business is properly nurtured to make sure there is a successful business to transfer to the next generation. Making the strategic commitment to build toward succession should be done well in advance. This commitment should be reflected in a statement of management philosophy and long-term goals that create a compelling “Vision Statement” for the business. This vision can inform all elements of the strategy of the business and shape plans to invest in its future.

• Governance. In order to accomplish the goals set forth in the Vision Statement, a governance strategy should be implemented that represents the interests of all owners. Adult children are often willing to let their mother or father make all the decisions regarding the business they founded even after there has been significant gifting or other forms of share distribution to make the children the actual owners of the enterprise. However, when Mom or Dad leave the business, this deference in decision making is generally not extended to a sibling, cousin, aunt, or uncle. In addition, the senior generation may not be willing to completely turn over decision making to their successors if their lifestyle in retirement depends upon a regular payment from the profits of the business. Providing for an independent retirement for the senior generation is a key to successful transitions in decision making and governance.

• Creating the Right Family Dynamics. Sending the right messages is critical to the succession plan. Positive action should be taken early in the process to orchestrate and encourage the participation of future generations both as managers and owners of the business. On the other hand, parents should be open to alternative career choices and opportunities for their children to consider and not try to force them to go into the business. It is difficult to inspire children to want to be part of the family business if the only knowledge they have is based upon overhearing discussions of the day’s business problems around the dinner table. Nor does aspiring to lead the family business seem to make much sense to the next generation if Mom or Dad never plans to retire. These and other messages, sometimes subtle and sometimes not, can derail the best financial, legal, and business planning. A statement of vision and values for the family and business can prove to be a positive message that will inspire generations to come.

• Family Values and Cohesiveness. Creating a separate vision statement that builds family commitment and readiness for succession is also critical. This statement should be developed around the core family values that have made the family successful and that can become a lasting pattern for success in the future. Core values of a family inform the development of a philosophy about why it is important to retain ownership of a business in the family.  From this philosophy, comes the Family Vision Statement, which can become a guiding beacon for success in the future.

• Great Plans and Even Greater Communication. Plans that provide for the development of effective owners, whether active in the business or not, can provide for the “patient capital” that will allow a business and family to prosper for many generations. These plans will serve as guides for the effective financial and legal planning necessary to implement a succession plan. The best laid plans, however, will fail if not properly communicated to all the family members. Therein lies the greatest value of the planning process—the building and continuation of strong family relationships. It may be wise to enlist the help of  a mature, experienced family business consultant, who can provide the buffer and the clarity that are essential in the communication process to promote family harmony and achieve a successful business transition.

Corporate Tools Available in Business Succession Planning

There are many corporate/business law planning alternatives that can serve as the “frame” upon which to build and execute a successful family business succession structure. The following is a brief explanation of some of the “tools” that can be used to create the frame that will best suit the structure of each business succession.

• Voting and Non-Voting Stock. Children not involved in the business can be given non-voting stock so that the active owners can control the business operations. Certain actions taken by the active owners (and controlling board members or managers) could require a “super majority” vote. The non-active owners can control key decisions by being able to participate in a “super majority” vote on such matters as: 1) salaries of key employees (family members particularly); 2) issuance of additional ownership interests; 3) encumbrance of a significant portion of company assets; 4) material asset acquisitions; and 5) sale of a material portion of the company or its assets. Family harmony can be threatened if one group of heirs feels they have too little say in what is being done with their “patient capital.”

• Ownership Preferences. In the case of a corporation, preferred stock may be used, and in the case of an LLC or partnership, preferences can be built into the operating or partnership agreement. These preferences can provide passive owners with priority returns from operations and a first priority upon liquidation or sale. These rights will give the inactive owner(s) security that the interest they started with upon transfer to their generation will not diminish in value and, if it does, the active owners will not get anything more than they will receive. There are many variations of how these preferences can work. These techniques can be referred to as “risk/reward locks.” The key is to incentivize management to run the business day-to-day in the best interest of all owners without undue interference by inactive owners.

• Separating the Business or its Assets. If the business can be separated into two or more operating units (and meet the IRS requirements for doing so without triggering onerous tax obligations), one or more separate operating units can be put into the hands of specified children and/or sold to an unrelated third party. It may also be possible to spin out some of the assets from the business that can then either be given directly to nonparticipating children or sold for the benefit of those children. There are a number of reorganization techniques that can be used to accomplish the family’s goals. A partial sale and succession plan may help solve any liquidity problem by generating cash that can be given to the parents, thereby reducing the risk that they will not be paid completely for all of their interest in the business sold to their heirs.

Care must be taken not to exacerbate or encourage family conflict with such structures. For instance, if one set of heirs has the voting control over an operating business and another group has voting control over the buildings, land, and other assets needed to operate the business, vastly different priorities may emerge over time. One group may depend upon a salary income from continued operation of the business, while others may want to sell underlying real estate or other assets so that the proceeds are available for use or reinvestment. There is also the almost certain principal that “equal” businesses operations, once separated, will not perform equally due to many factors outside of management’s control. This can leave one group of heirs significantly wealthier than the other over time and may result in a perceived lack of fairness.

• Trust with a Little and then with a Lot. An incremental approach to the succession of the business will give the parents the ability to see how the children handle limited ownership and responsibility before putting everything in their hands. One way to do this is by licensing certain technology, products, or services to another entity owned by the child. Failure to do all the things necessary to develop, sell, and create profits based on this license may be an indicator of future performance. If things do not go well, the parents may want to reconsider passing the business to children who prove not to be responsible owner/operators.

• Buy-Sell Agreements. Buy-sell agreements are very good tools to control ownership of a company between unrelated parties, but they can lead to some serious traps in family business succession planning. A buy-sell agreement is designed to keep ownership out of the hands of either someone you do not know, or someone you know and who you do not want to have as a co-owner/partner. Using a standard buy-sell agreement with family members will almost always result in unintended consequences, since a buy-sell agreement will typically not address the other 90 percent of the issues that should be addressed when transferring a business to family members. Careful analysis should be undertaken before providing rights and obligations to family members who, regardless of their current relationships, may not see eye to eye in the future. Forced redemptions of stock could cause business cash flow problems and the inability to sell could cause significant family financial conflicts and even litigation.

• Life Insurance. Life insurance funding can be useful if parents and children are both involved in the business; however, care should be taken in structuring the legal and beneficial ownership of those policies. If, following the death of one of the family members, a policy is transferred to another family member or owner, there could be a “transfer for value” and the future proceeds (minus any basis and future premiums) would be subject to ordinary income tax. A “transfer for value” occurs not just where there is compensation exchanging hands, but where there is a change in rights or obligations of the parties. For example, if there are three owners with policies on each of their lives held in an escrow or trust, when one owner dies, if the other two policies remain in place and continue to be held in trust, there will be a deemed “transfer for value” since there is a mutuality of obligation arising out of the agreement to continue the policies for the benefit of the surviving shareholders. If this sounds complicated, it is. Competent tax counsel should be employed to avoid these problems. Life insurance ownership can also be structured to minimize and/or to avoid future estate tax.

• Form of Entity. Careful consideration should be given to the form of entity in which a family business is held. Especially in the case of companies which an entrepreneur has built “from the ground up,” the entity type and its governance might be outdated or even downright problematic. Varying rights and obligations are attached to “C” corporations, “S” corporations, LLCs, and partnerships. LLC operating agreements and limited partnership agreements both provide an open design format with a great deal of latitude for addressing many of the management and ownership issues discussed above. LLCs and limited partnerships also may provide for better tax planning alternatives.

• Debt Instruments and Security. Since children may not have the “cash” to buy out their parents, the succession plan will generally include a debt instrument and usually something to secure that instrument. One common problem is that the business will usually have a primary lender so any indebtedness to the parents would have to be subordinated to the rights of that lender. Subordination substantially reduces the quality of any security provided by the children in the business. Protections can be built into the debt obligation to the parents by providing the parents with many of the positive and negative covenants contained in a bank financing with clear and definitive rights upon default. These protections may protect the parents by allowing them to regain control or make changes while the business still has significant value. Outside collateral could also be provided by the children, but not many parents are willing to take their child’s “house” if they default. The variations on loan documents and security instruments are almost infinite and should be created with the input of competent legal counsel and financial advisors.

In spite of all the potential issues and pitfalls, there are many situations where businesses have been successfully transferred to successive generations. It is very understandable, after all the hard work and risks taken by the parents to start and establish a successful business, that they would like to see their children continue their legacy. Parents who do want that legacy to continue should make sure they have all the necessary tools at their disposal, adopt a well-designed succession plan and undertake all the necessary steps required to implement that plan.