Family Business Succession Planning: Why Now?

This post begins a series on transferring ownership of family businesses to the next generation. Along the way we will think about the following issues:
• Transfer now or later?
• To family managers only or all members of the next generation?
• Outright or in trust?
• By sale or gift?
• Governance after the transfer – the importance of an effective board
• What if the next generation isn’t ready?
• Clarifying the returns to owners and managers: structuring an appropriate compensation system post-transfer.

Transfer now or later?
For most family businesses, the better answer is “Now”. Why?

Hit by a bus? Now what? One of the biggest risks to a privately-held business’s continued success is the sudden death or incapacity of an owner/manager. Without the boss around, employees lose focus, or worse, panic. Customers, fearing an interruption in supply or decline in quality, seek other suppliers and buy less. Vendors may cut back credit terms; banks may call the business’s loans. On the other hand, if ownership has been transferred (or a funded buy-sell agreement exists), an effective board of directors is in place, and there is a clear management succession plan, then the successors can step into their new roles quickly, stakeholders will be reassured, and day-to-day operations can be restored.

Death and taxes. The business owner who waits to transfer shares at death puts the business at significant risk – planning for a catastrophic event on an unknowable future date can be perilous. Remember that 9 months following the date of death, the estate will owe a 45% tax on the amount by which the value of the owner’s assets – including the shares – exceeds $3.5 million (assuming no major change in the estate tax exemption comes out of Congress). If provision has not been made to ensure there is enough liquidity available to the estate to pay the taxes – whether via a buy-sell agreement, insurance trust, or creation of a fully liquid side fund – the business may have to be sold to pay the taxes. Transferring the shares to the surviving spouse at death, either outright or in a QTIP trust, will defer the tax liability, but can create unexpected control and cash flow issues, particularly if the surviving spouse is not involved in or supportive of the business. By transferring the shares during lifetime, the owner can insulate the business from the estate tax liability.

Valuation opportunities. The current recession has created unprecedented opportunities to transfer ownership of a business cost-effectively. Business valuations are unusually low right now, both because of business-specific issues (for most businesses, sales, profits and cash flow are well off previous highs) and larger economic issues (fire sales of risky assets in the wake of the banking implosion mean that the stock prices of public companies most often used by valuation firms as comparables are also well off previous highs). As a result of these trends, the economic and tax costs of transferring shares within families are unusually low. Families should be aware that the window of opportunity may be closing as the recession ends and business conditions improve.

But how am I going to pay the bills? Perhaps the biggest reason owner managers don’t transfer businesses to the next generation is that they depend on income from the business for living expenses. Thoughtful planning can avoid or minimize this problem. First, the owner doesn’t have to give the business to the next generation - the business can be sold on an installment basis, creating a steady stream of income for the selling owner without saddling the new owners with an unmanageable financial obligation. Second, the selling owner can continue to be employed by the business in an executive or advisory capacity, or can enter into a non-compete agreement that ensures a second stream of income. The selling owner can purchase a life insurance policy – or better yet, create an irrevocable life insurance trust (ILIT) –to provide for his or her surviving spouse. If the owner simply cannot afford to transfer all of his or her shares, another option might be to spin off the business’s real estate into a separate entity, and keep the real estate while selling the operating business. The real estate entity would then rent the real estate back to the business, generating an additional income stream. This option permits the owner to accomplish the transfer of the operating business while still keeping a significant financial interest. (We’ll revisit this option when we discuss who should own the business, and how to deal with control issues.)

And what will I do? Beyond financial concerns, some founding owners consciously or unconsciously dread transferring control to the next generation because they fear losing their identity. There is no simple solution to this problem, and all stakeholders need to be aware that transferring a business is not just a financial transaction. Families struggling with this issue may want to bring in a consultant/therapist well –versed in family-business dynamics to assist them through the transition. Generally, succession is most likely to be successful when an owner chooses to transfer his or her shares and is an active participant in a thoughtfully-planned succession process.

Next week: Who should own the business – only family managers or all members of the next generation?