Transition tribulations: exiting a family-owned business
July 2018 | FEATURE | RISK MANAGEMENT
Financier Worldwide Magazine
July 2018 Issue
When the owner of a family business decides to call it a day in order to enjoy the fruits of his or her labour, the transfer of ownership can be a challenging process. What is more, in the US in particular, transitions of this nature are becoming ever more common.
Indeed, as highlighted in JC Jones and Associates LLC’s white paper, ‘Exit Planning for the Family Owned Business Owner’, more than 70 percent of privately owned businesses in the US will change hands in the next 20 years. At an estimated $10 trillion, it is the largest intergenerational transfer of wealth in history.
In terms of today’s retirement-minded family business owners, what is required is a well-conceived exit plan, one that sets clear and realistic objectives. “An exit plan is a strategic process detailing the financial, operational, management and ownership changes that will take place as leadership is transitioned,” states the report. “A well-thought-out plan is required to meet the personal goals and timeframes of owners and to monetise their business.”
When the decision to depart a business is taken, there are myriad exit or succession planning (the primary emphasis of which is family) strategies to be considered and a multitude of questions to be answered. What will happen to the business when the owner moves on? Should the business be sold? Will the owner’s children want to carry on with the business, and, if so, is there a successor ready to assume the leadership? How can a maximum return from the business be ensured? These are just some of the key issues.
In many instances, a family business owner may have no choice but to pursue exit rather than succession, as there is no next-generation family member ready, willing or able to take the helm. That said, for those owners who do have the option of transferring ownership elsewhere in the family, statistics are not encouraging.
Stephen Pascarella, owner of Pascarella and Gill, PC, notes that less than one-third of family-owned businesses survive the transition from first generation ownership to second. According to Mr Pascarella, three main challenges are likely to arise. First, transferring when parents are not financially ready. This is a premature move which could be devastating to retirement planning and financial security, as retirement funding may draw from the business, impeding possible growth. Second, transferring to children who do not know how to run a business. Many business owners forget that new owners, most often their children, must possess the skills to run a business. Finally, attempting to give everyone equal shares. When multiple family members are involved, dividing a business equally may not be in the owner’s best interests. For business owners, it is crucial to remember that management and ownership are two separate issues.
Exit and succession strategies
When a business owner decides to make an exit and there are children employed in the business, a layer of complexity is added to the planning process. According to John Dini, president of MPN Inc, in this scenario there are three relationships between family members at work.
First, there is the blood relationship between parent and child. Second, there is the management relationship, not only where a child reports to a parent but when a child is, at least nominally, in charge of siblings or even the children of siblings. Third, there are the ownership relationships. Does ownership pass according to the blood relationship or in proportion to the management responsibility? Are children who are not working in the business included in ownership? What rights do they have to determine the course of the business? In today’s extended families, where these questions frequently encompass step-children and in-laws, it is a complicated business.
“A family successor should be ready, willing and able to run the company,” says Mr Dini. “However, if he or she is not, all may not be lost. There are a number of succession plans where employees who are key to successful operations are included in ownership or otherwise financially motivated to spend a lifetime within the business. There are numerous incentive plans, including stock appreciation rights, phantom equity or other forms of deferred remuneration that can compensate a critical employee based on company value, without actually issuing ownership.”
For Nadine Kammerlander, professor of family business at WHU – Otto Beisheim School of Management, the main challenge is to find the ‘right’ next owner and at the right time. “Family business owners often start thinking about their exit at too late a juncture and often have unrealistic expectations,” she suggests. “Moreover, they often underestimate the difficulties of finding an individual to take over a firm, overestimate the future potential of the firm as well as its value due to emotional attachment, neglect legal, regulatory or tax issues that might impede the sale, and can be reluctant to cede control.”
Whether it is a matter of unrealistic expectation, misplaced emotion or wasteful procrastination, the likely outcome is that the sale will not proceed as smoothly as intended, with the business owner forced to restart the process more than once. “When considering suitable strategies, family business owners first need to decide whether they want to pass on ownership and management to the same individuals or split them, for instance by giving the ownership shares to the children and hiring an external chief executive.”
In terms of selling the business, a family owner has several choices, such as bequeathing to a family member, an employee via management-buy-out (MBO), another individual previously unconnected with the firm, via management-buy-in (MBI), or a competitor. “These strategies vary across the dimensions of sales price, professional management and continuance of firm tradition,” adds Ms Kammerlander.
When it comes to assessing the value of a business there are a number of options to ensure valuation reflects both current worth and future potential. How this valuation is determined very much depends on the type of exit strategy the owner has chosen to pursue.
“While selling a business to a competitor will probably generate the highest value, it may lead to a loss of more than 25 percent of the business proceeds due to taxes and advisory fees,” says Mr Pascarella. “External transfers, such as a sale to a competitor or private equity group recapitalisation, use synergy value and investment value. In contrast, internal transfers, such as an employee stock ownership plan (ESOP) or gift or sale to family, use fair market value where discounts may apply.”
Choosing the exit option most conducive to maximising value is, therefore, critical, as is obtaining well-qualified and experienced assistance. “A qualified valuation professional will consider both historical and projected value,” affirms Mr Dini. “But in a family transfer other considerations often take precedence over fair market pricing. What are the retirement needs of the parents? Is the estate being ‘balanced’ between children active in the business and those who are not? Is stock being transferred via a more arms-length sale process? And is the focus more on tax-reduction strategies, such as gifting or trusts?”
The worth of a valuation expert is clear, but caution should be exercised when securing a specialist. “Given the importance and complexity of the process, experience and support is required,” agrees Ms Kammerlander. “However, there are a large number of so-called advisers that may lack the required competencies, experience and attitude. A careful selection is needed.”
Another issue is that owner-managed firms often lack proper documentation. “Such a lack of transparency makes it difficult for outsiders to recognise the real value of a firm and might lead to a lower-than-desired sale price,” adds Ms Kammerlander.
With the sale of a family business often the culmination of a lifetime’s work, departing owners want to make the right choices, avoid missteps, keep regret to a minimum, and reap the rewards of years of endeavour.
“Sometimes a business has served its purpose,” says Mr Dini. “If all the children have moved on and are successful in other pursuits, then the company should be sold to a third party. “Few owners are more unhappy than those forced to return to a family business out of a sense of obligation to their parents, regardless of any related financial success. Their misery might be exceeded only by those who spent a lifetime in the company, only to see it sold to strangers because parents thought it was the only way to monetise the fruits of their labour.”
It is important for owners to consider both financial and non-financial issues. As regards the former, owners need to start thinking about the manner of their exit sooner rather than later. The more time dedicated to the search for the ‘perfect’ successor, the more likely that search will be successful.
In terms of non-financial considerations, the owner needs to reflect upon his or her goals before entering the exit process. What is most important? Is it the sale price? Is it the continuation of the businesses’ name? “A clear answer to such questions helps the exiting owner to achieve a satisfactory solution,” believes Ms Kammerlander. “Communication with family and other stakeholders is also crucial. If a family business owner sells, unaware that his or her children were interested in taking over, there is a high potential for ongoing family conflicts.”
To make the transition from business owner to retiree as smooth as possible, Mr Pascarella’s advice is to follow a five-step process: (i) establish exit goals; (ii) measure financial and mental readiness; (iii) learn and choose the optimal exit option; (iv) understand the business value of the option chosen; and (v) execute the exit strategy plan to achieve exit goals.
Complex and emotional
Exiting a family business is clearly a complex and emotional undertaking – a process requiring careful advance planning and much resolve, especially when the business is the largest single asset in an estate.
Moreover, once the decision to depart has been taken, there should be no procrastination. “This can lead to disaster with a great deal of vicious, internecine squabbling,” warns Mr Dini. “If an owner wants his or her children to remain on speaking terms, they owe it to them to discuss and define what will happen as the business passes, or not, to the next generation.”
Ultimately though, family business owners want to harbour no regrets over the decisions they make when the time comes for them to pass over the reins and transition to the next stage of their lives.
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