Over the past year, I have been working with a number of business owners who would like to transfer their businesses to their next generation. Yet, fewer than a third of family-owned businesses survive into the second generation, 12 percent to the third, and only 3 percent to the fourth generation.
In many cases, the poor survival rate is simply a reflection of economics. Not all businesses are destined to survive. In some cases, however, otherwise successful family-owned businesses fail simply because they had no plan for business continuation. By employing advisers to help them develop a plan, these businesses have an opportunity to thrive throughout the generations.
There are a myriad of challenges in transferring a family-owned business. This is why no one professional discipline (law, accounting, tax, wealth planning, exit planning consultants) has become the profession of choice for business owners seeking exit planning advice. Because of the disparate issues that must be grappled with in business-continuation planning, an owner needs the help from all of the professional disciplines named above.
For a successful business transfer, three major strategies must be in place.
- Both the business owner and the business itself must survive financially;
- The owner must have a transfer plan in place before exiting the business; and,
- The exit plan must be adequately funded.
To successfully transfer the company, the transfer plan cannot carry financial provisions that strap both the children and the business to the extent that the business cannot survive. Similarly, if the transfer plan financially devastates the owner and family, the transfer plan is a failure.
Several steps need to be taking well in advance of executing the transfer of the business. First, when the business owner decides to create a transfer plan, it is important that the books and records (typically five years of income statements, balance sheets and cash flow statements) are “clean” and follow reporting standards similar to publicly traded companies.
Next, an outside, third-party valuation firm should be engaged to provide an independent valuation of the business. The valuation of a family-owned business is not simply a task of updating the company’s financials. There are several adjustments that are commonly necessary. For example, a valuation adjustment is needed to reflect excess compensation if the owner is receiving compensation above market standards. Another adjustment is warranted if the owner is not paying market leasing rates for a building that person owns but has put that real estate in a separate LLC, to house the business. Similar adjustments may apply to benefits, travel, company cars, boats, airplanes, country club dues and other discretionary expenses.
Typical analytic methodologies used in a professionally produced valuation include the market approach, the income approach and the asset approach.
Even though the goal is to transfer the business internally, a truly independent valuation is a key step in the transfer planning process. Some reasons include:
- If any kind of financing will be involved in the transfer plan, the financing entity will likely demand an accurate valuation. The valuation may not only be an issue for underwriting the loan, it may also determine the source of the loan and interest rate charged. Whether the loan comes from a commercial bank or nontraditional financing sources such as mezzanine lenders or private equity firms, most will require an independent valuation.
- Federal income, gift and estate taxes may require a defensible independent valuation. For example, estate tax challenges from the IRS under IRS code 2704, Discount for Lack of Marketability (DLOM), can be overcome with a valid independent valuation.
An accurate valuation of a going concern is typically dependent on both a look back and look forward of earnings. The intent of the business analysis is to acquire an accurate valuation of assets and a reasonable assessment of future earnings and goodwill.
Another major consideration for business owners thinking about transferring their businesses to their children is what I call the “Family Dynamics Analysis.” Throughout my career I have consistently heard from business owners about “how close their families are.” But often, this “closeness” falls apart when transfer issues are discussed among family members.
For most family-owned businesses, these are the major family dynamics that should be considered
- Control. Who’s in charge, in both the family and the business?
- Equity. How will family members be treated equitably when they have different positions in the business?
- Jealously and loyalty. What are the family and business politics?
- Conflicts and disruptions. What situation could cause confrontations, and how can they be avoided or resolved?
Finally, funding the transfer plan is critical to the success of the ongoing business for the children. The plan may be based on maximizing value or minimizing taxes but has to include maximizing flexibility to address economic downturns, unanticipated events and capital needs for future growth.
Since most owners can work through maximizing value or minimizing taxes through their professional advisers, I want to address the need for “flexibility” in the exit plan for both the owner and the children. For example, a wait-and-see buy-sell is a common technique in which the agreement among owners provides that the corporation has the first option to redeem the exiting shareholder’s stock; the other shareholders have the second option to purchase remaining shares; and, to the extent any shares remain unsold, the company must redeem those shares. This gives the family the flexibility to determine which course of sale will minimize taxes.
Regardless of the general information that I have provided in this article, all business owners considering transferring their businesses to their children should seek the professional advice of counsel on all matters pertaining to legal, tax, accounting or exit planning to avoid the pitfalls inherent in family transfers.
Gary Miller is the CEO of GEM Strategy Management, Inc., an M&A consulting firm, advising middle-market private business owners prepare to raise capital, sell their businesses or buy companies. He is a sought-after business consultant and speaker on M&A issues, strategic business planning, business valuations, exit planning, family transfers, what buyers are looking for in acquisitions and how to prepare for due diligence. He can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com.
