Family Business Succession Planning: The Perils of Pay and Dividends

Final installment in the series…

Transfers of business interests to the next generation create all sorts of thorny issues, but one of the very thorniest is money. Picture four siblings, Sam, Jane, John and Jim Sanford, who inherited all the shares of their family business, Privco, upon their father’s sudden death last summer. Each now owns 25% of the company. Sam, the oldest, is President of the company, Jane works for the company part time in the accounting department, John teaches seventh grade at a local junior high school, and Jim, who joined the company five years ago when he graduated from business school, is head of marketing.

This past December, Sam proposed to PrivCo’s newly-constituted board (which includes his siblings and two outsiders) that he should receive a healthy bonus and raise, citing his successful leadership of Privco during the recession. (Sam has been somewhat disgruntled that his salary is less than half the pay his father received when he was president of the company.) Sam also proposed that Privco minimize dividends to conserve cash needed to fund capital investments. Christmas dinner was uncomfortable – John grumbled that their father had wanted them to share the company’s profits equally and must be rolling in his grave to see Sam take a big payout while giving his siblings so little. Jane and John fretted that they wouldn’t be able to pay their children’s private school tuition, and Jim’s fiancée mumbled that Jim deserved the top job more than Sam did.

To avoid uncomfortable gatherings like the Sanfords’ Christmas dinner, family members need to understand the difference between compensation and distributions. Furthermore, the methods by which both compensation and dividends are determined need to be sensible, systematic and well-documented. Otherwise, family members may well see themselves as victims of a rigged system.

Family business shareholders need to understand that compensation is paid to managers in payment for their work on behalf of the company, while distributions or dividends are paid to owners as a return on their capital investment. An owner-manager like Sam (or Jane or Jim) is entitled to receive two steams of income from the company: compensation for doing the job, dividends or distributions on his ownership interest. (The Sanford kids’ father, Pete, an owner-manager, never had to face the issue of determining an appropriate compensation model, and probably didn’t think much about it when he asked his lawyer to draft his estate plan, or when he discussed his succession plan with the board of directors - assuming he had a board, and assuming he even raised the issue of succession with them before his death. Pete was the sole owner and manager of the business, and whether he pulled money out of the company in the form of salary, bonus or dividend was largely a question for his tax advisors.)

For the second generation Sanfords, the issues of compensation and distributions are much more complicated, and uncomfortably intertwined. First, whatever is paid to management isn’t available for distribution to shareholders, creating a zero-sum game. Coming up with an appropriate compensation program for the president of the company is a tough job for any board of directors, but particularly tough in a family context, where a sole owner-manager like Pete has set the bar by which the next generation consciously or unconsciously measures its own compensation. Sam in turn is responsible for setting compensation for PrivCo employees. Using market survey data or bringing in a compensation consultant to determine an appropriate compensation package can help to ensure the process is fair and justifiable.

Coming up with an appropriate dividend policy is also challenging. Successor managers who want to invest for growth may seek to cut or eliminate dividends, arguing that reinvestment now will boost future returns. Successor shareholders who don’t understand the role of patient capital or agree with the capital reinvestment plans may pressure management to distribute all or most of the company’s free cash flow. Sibling shareholders often downplay the role of management in generating profits and argue that family managers use their roles as insiders to boost manager compensation at the expense of dividends. Building trust among family stakeholders can be achieved by increasing manager accountability, educating shareholders about the role of equity capital in the company’s growth and long-term profitability, and developing policies at the board level that seek to balance shareholders’ desire for distributions with management’s plans for growth. A thoughtful strategic planning process, accepted by management and shareholders alike and implemented with rigor and discipline, can increase transparency and accountability, minimizing tension and distrust.

Business Succession Planning: What if the next generation isn't ready?

Part six in a series...

For families contemplating a transfer to the next generation, planning is more complicated when the next generation is young, untested, disinterested, or incapable. Typically, families focus on management succession, but ownership succession deserves consideration as well.

Family business owners often envision a graceful handoff from senior management to the next generation – a bit like the performance of the winning team in an Olympic relay race. But what happens if the next generation isn’t ready? One option is to appoint interim management. When I - young lawyer without manufacturing experience - took over as president of our family business, we hired as VP of Manufacturing a retired executive well known in our industry. Roy worked with me for a number of years, offering wise counsel on manufacturing-related issues. Similarly, a trusted non-family executive may be appointed to serve as President and CEO while the next generation earns its stripes. What’s important in these situations is that the family clearly lays out the non-family executive’s role - placeholder, mentor – and that he is well compensated. Few situations can deteriorate faster than a company run by an aspiring non-family executive who is suddenly and without warning or explanation replaced by a family member. Furthermore, the next generation family executive needs to understand that the path to the top job is not necessarily preordained, and that his success will depend in large part on his absorbing as much knowledge and wisdom as possible during the non-family executive’s tenure.

In some cases, a non-family executive has successfully run a family-owned business for many years, even generations, without any family members on the management team. In these situations, there may have been no next generation family member who was interested in or capable of running the company, or the company may have grown to such a size and complexity that it was unrealistic that a family member would have the world-class skill-set required to handle the job. Whenever a family business is run by non-family executives, it is critical that the family exercise its oversight responsibilities – whether as directors or shareholders – with focus and commitment, to ensure that the family’s values and vision continue to guide business planning, and that strategic planning and budgeting reflect the family’s need for distributions and liquidity.

What if no one in the next generation is capable of serving as a director or even a responsible shareholder, whether because of age, incapacity or lack of interest? For some families, it may be time to consider selling the business, particularly if the interests and focus of G2 and G3 are on other worthwhile ventures or activities. For other families, a transfer in trust can provide for ongoing stewardship of business assets for the benefit of the family. The essential element for a trust that will own an operating business is selecting a trustee with the right skill-set. On the business side, the trustee needs to have at least basic business knowledge: a working understanding of business operations, strategy and governance, the ability to read financial statements and reports. On the personal side, the trustee should understand the grantor’s intent, have strong interpersonal skills and have sufficient contact with the beneficiaries to understand their needs. The best trustee will bring useful perspective and experience to the family and the business, and, leading by example, will serve as a mentor and model for the next generation.

Governance after the transfer - the importance of an effective board

Part 5 in a series…

Soon after I began to work for our family business, I attended my first board meeting. Board members were my dad (the Chairman and CEO), our accountant, our lawyer, and a local businessman. My dad read his prepared report, there was some quiet and polite discussion, and the meeting was adjourned for lunch.

You may sense from my summary description that I, young and aspiring lawyer-turned-business leader, found this board structure and process less than ideal. True. But first, let’s start with what was right:

1. There was a board! Many controlling owners – particularly, first-generation entrepreneurs – don’t have a board of directors. These owner-managers make strategic business decisions on their own, believing that a board would interfere or meddle in their business.
2. The board included an independent director. The local businessman in question brought important experience and perspective: he too ran a manufacturing company in a construction-related industry, he was a half-generation older than my father and had weathered more storms, and he was also on the board of the Company’s bank.
3. The board received a report in advance of meetings, including quarterly financials and a letter from the CEO discussing the Company’s performance and strategic issues. Copies went to the Company’s banker and to the trustees of the shareholder trusts.
4. There was an opportunity for open discussion of performance and strategy.

When I stepped up to the role of President and took over board meetings, I had two primary objectives:

1. To increase the number of independent directors, in order to gain access to greater outside perspective. I was painfully aware that I had no formal training in manufacturing, finance or sales (or much else other than law, for that matter) and wanted experienced sounding boards going forward.
2. To increase discussion. I would come to realize that my father’s board reports had synthesized a great deal of information, but they expressed only one point of view and source of information. I felt board members needed a broader perspective on the issues facing the Company. I expanded the board book to include reports from treasurer and heads of manufacturing, sales and marketing, worked to frame the issues more clearly, and included specific strategic questions on the agenda.

Did I achieve my objectives? Mostly. I did enlist several more outside directors, from diverse industries and with diverse expertise. (But in my search for greater subject-matter expertise, I discounted the value of the broad experiential wisdom that the local business leader had brought to my dad’s board.) Discussion did increase, particularly as I learned to frame the questions better. My board gave me moral support, a safe sounding board, access to skillsets and experience I otherwise would not have had.

For a successor just taking over management of a family business, I can offer the following suggestions:

1. You need a board. Enlist a group of outsiders with relevant experience who are willing to devote the time to meetings and the necessary preparation. Big names aren’t necessarily the best board members, particularly if they come with big egos.
2. Prepare for meetings by creating a board book. Send it out at least a week in advance. Creating the board book may be the single most important task you take on each quarter. Putting together the reports and agendas forces you to step back from the day-to-day stuff and focus on the bigger strategic issues facing your business.
3. Make sure you include at least one constructive critic who is willing to speak up. Finding independent directors isn’t enough – to be really valuable, an independent director needs to be willing to voice observations and concerns that will make you, the business leader, uncomfortable and defensive. Recognize that this advice and perspective is more valuable than all the pats on the back combined.
4. Encourage discussion. Think hard about your biggest strategic dilemmas, greatest fears. Board meetings shouldn’t focus on what’s going right, but rather what’s going wrong, or might go wrong. Excuses are useless – frame the issue, outline your response, and ask for feedback and recommendations.

I’ve focused on the value a good board can bring to a successor manager, but the board is even more important to next generation shareholders, particularly if they aren’t actively involved in the business. A good board will hold management accountable and push for better performance. A good board can also provide a critical balance point between the interests and needs of family shareholders, and the interests and needs of management (a topic I’ll take on in coming weeks…)

Family Business Succession Planning: By Gift or By Sale?

Part 4 in a series…

As with last week’s topic, my experiences with my family’s manufacturing business inform my thinking here. Unlike last week’s topic, no ambivalence – I believe it’s better for a family member who will take over management of the business to buy (or earn via bonus) a controlling interest in the business, rather than to receive it as a gift. Particularly when the founder/senior generation manager is still living and at least somewhat active, a sale clarifies the next generation manager’s rights and obligations and gives her* skin in the game.

Often, a gift of interests in a business comes unexpectedly, with little or no explanation or education – the senior generation implemented an estate planning transaction at some point in the past which has now come to pass, whether because of the completion of a period of time (as with a GRAT or CLAT) or because of an event (the death of the grantor). The gift can create a sort of paralysis in the recipient: is it really mine? What do I do now? What is expected of me? The gift can heighten family-business conflicts: If I vote the shares differently from the way the senior generation would have voted them, am I being disloyal to the family? Will I touch off a major family blow up? Do I owe the senior generation something in return?

By contrast, a next generation manager who buys an interest in the business has negotiated the terms of the purchase and has willingly entered into the transaction, with eyes wide open. She has made an investment, a commitment. Assuming the purchase price represents fair value, her obligation to the senior generation is clear, and as a result she can make family-business decisions putting appropriate weight on both sides of the calculus, without fearing that she somehow owes “more”.

I said at the outset that I feel it’s better for a next generation manager to buy a controlling interest, rather than receive it as a gift. Is the answer different when the next generation will not play a management role? Perhaps. For some families, collective ownership is an appropriate (and successful) model: the family provides patient capital, ensuring financial stability for the business, receiving dividends in return. The business is the family’s legacy, embodying its values and vision. An attitude of stewardship prevails. The notion that the transfer of ownership is a gift from one generation to the next makes sense in this context.

But, the stewardship model may not always be effective, at least not without a significant ongoing investment of time, attention and energy by the stewarding shareholders. Several generations down the line, patient capital can become dormant capital. Stewardship can become a habit, rather than a choice, actively embraced. The family may come to depend on dividends and vote against capital investments that might cut into dividends, possibly crippling future growth.

Regardless of how the interests are transferred, shareholder education – and open communication about the purposes, timing, terms and consequences of the transfer – are critical for long-term family and business success.

*Him, her, them – please substitute number and gender of your choice.