Transitioning a business to the next generation demands careful planning. Otherwise, the company may be doomed.
The tens of millions of family-owned businesses in this country form the backbone of the economy, accounting for more than 60 percent of the current U.S. workforce, by some estimates. According to the PwC 2019 Family Business Survey, 62 percent of family business leaders intend to pass the company on to the next generation. Yet only 18 percent say they have a robust succession plan.
Transitioning a business to the next generation demands careful planning. Otherwise, the company may be doomed. In many cases, not all the children end up working in the business, which means creativity is required when determining how to equitably distribute their inheritances. While successful outcomes are certainly possible, family business leaders’ efforts to give everyone their fair share do not always work out fairly. Some challenging scenarios include:
The business prospers. In one company, an individual child had taken control of the business several years prior, and the siblings were each provided a sum of money commensurate to their share. The company ended up thriving, but the siblings are in poor financial shape due to their own mismanagement. As a result, they resent the child who owns the business.
The business—but not everyone—suffers. This situation involves a manufacturing company that suffered financially from intense competition. The children who were not involved with the business received liquid funds, making them immune to the company’s troubles. The child who inherited the business would have been much better off receiving other assets in lieu of the company.
Conflicts arise between managers and investors. When some children occupy active management roles and others are passive investors, siblings can end up at odds with each other. The managers typically want to invest more in the company, while the others are primarily concerned with higher distributions.
Succession planning for family-owned companies is vital because it is far easier to address potential issues like these during the founding parent’s lifetime. There are a variety of important steps to take when developing a succession and estate-distribution plan in conjunction with a solid team of professionals, including legal, tax and financial advisors.
The first step is to make an honest appraisal of the next generation’s management skills. If the heirs are not able or willing to run the business when the founder retires or dies, it should be sold or professional management should be hired.
The second step is to determine the company’s fair market value and credibly forecast its future. This includes answering several questions, such as: Is the industry in decline? Are margins diminishing? Where are we in the economic cycle? (When valuations are high and cash is abundant, as is the case presently, it is usually a favorable time to sell a business.)
If the decision is made to keep the company, a plan of estate equalization has to be developed. Those heirs who are not interested in or capable of operating the business must be bought out or given company stock. If the idea is to buy them out entirely, a variety of approaches can be taken. For instance, there may be other estate assets to offset the business value. Some company owners will purchase life insurance owned by an irrevocable trust to eventually pay for the buyout. Another option is for the company to take on debt to make the payments.
No matter which strategy is chosen, it should entail thorough communication with the heirs. In many families, estate plans are a taboo topic, and we frequently encounter situations where the heirs are kept in the dark until the founder passes. However, there is great value to be gained and much peace to be preserved with enhanced communication. It is also essential to educate the heirs in financial matters, as most are ill-equipped to deal with the impact of sudden wealth. (Please see our article about managing sudden wealth on the worth.com website.)
Taking steps to coordinate a well-communicated, comprehensive family business succession plan can help ensure a company’s viability while protecting the founder’s children and employees well into the future.
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