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.