As part of our discussion of issues related to the transfer of family-run businesses, let’s turn to the issue of merit. We’ll look first at how merit plays a role in transferring ownership to a child active in the business as well as the role it plays in how “fair” the child (or children) not assuming ownership perceives that transfer to be.
Let’s consider two common family business scenarios:
Scenario 1: Ideal and Rare. These owners had the foresight to avoid the inherent difficulty of having multiple children but only one company: They had only one child. Further, that child is capable, ambitious, and wants ownership. Transferring a business to this only child makes sense and isn’t that difficult to accomplish.
Scenario 2: Real and Common. Owners have one business but more than one child. This situation commonly plays out in one of three ways:
- All children are active in the business. In this case, the predominant issue is determining how multiple children will share the control and ownership of one company.
- One child (or several) is active in the business and one (or several) is not. How does an owner give the business (or at least the controlling interest) to the active child(ren) provided they merit it, while being fair to everyone else?
- Every child, active or not, gets an equal share of the business as well as all other assets.
Performance standards vary from business to business, but, at a minimum, they should:
- Be communicated clearly.
- Be written.
- Be attainable.
- Be tied closely to increasing business value or cash flow.
- Describe exactly which attributes and what performance are expected from any key employee seeking ownership. The result, if attained, is the parent's security.
These standards control the incremental awards of ownership over a multi-year (typically 5- to 10-year) time span. As standards are met, a child earns, and is awarded, ownership via stock bonus, gift, or purchase.
Merit as Measured by Performance Standards
Whether selling a business to key employees or transferring to it children, we generally recommend that successors earn ownership or, in the case of employees, earn the cash to fund the buyout. Performance standards not only govern a successor’s ability to earn ownership but also motivate (and reward) management and key employees for increasing enterprise value and cash flow over time. If employees meet the owner-set performance standard, they generally receive a cash bonus. Similarly, if a child meets an owner/parent-set performance standard, the child is rewarded with ownership in the business.
Performance standards can be designed in many ways to reward children with ownership or to allocate ownership among active children. For example, if one child is president of the company or a division, a performance standard (for the award of a stock bonus, for example) might relate to the company (or division) reaching a revenue or market-share target, cash flow level, industry benchmark, or other goal. Each child who achieves the performance standard set for him or her receives an award of ownership.
Performance Standards and Business Ownership
Hank Weatherby, a business and Exit Planning attorney in Connecticut, tells the story of the owner who brought his son and daughter into the business when his company was worth about $2.5 million. Due to the son’s efforts, the company increased in value to $40 million. The son benefited from his value-building efforts in two ways. First, his annual salary increased to over $1 million. Second, the value of his ownership of the company and the new subsidiary increased in value from about $600,000 to nearly $10 million, with over $6 million of it available to him and totally excluded from his estate for estate tax purposes.
The owner’s daughter worked as the company’s accountant at a salary of $125,000 per year. She was not contributing to the increase in the company’s value, so rather than award her ownership outright or continue to increase her salary, her father gifted her, in trust, a small amount of ownership.
When we asked Hank about whether the glaring disparity in both salary and ownership had poisoned the sibling or parent/child relationships, Hank was surprised. "Bad blood? Not at all." Hank recalls that, "Early on, dad told both kids how he planned to transfer the business and about the performance standards he set. Both knew the rules of the game going in and neither had any complaints."
We devoted an entire article to the importance of communication in family transfers, and the case above is great affirmation. Both children had the opportunity to “seize the ring.” One accepted the challenge (with great results) and the other decided to remain active but less involved in the business, but both were satisfied with the result of their choices.
Performance Standards and Cash Flow
If the owner chooses to use performance standards based on cash flow increases or other key performance indicators (such as net revenue), another benefit is that as their child meets the standard, he or she creates additional cash. This cash can be distributed to the parents and used to invest in non-business assets. Consequently, the parents will be able to leave the business sooner, or leave as originally intended, with more money. They can also transfer excess cash to non-business owning children.
Performance Standards and Successor Ability
One of the valuable byproducts of performance standards is that a child who meets or exceeds them effectively demonstrates her ability to operate the business successfully. Another is that the business-active child can earn ownership under the same conditions as would a non-child key employee earn a cash award.
Performance Standards and All Children's Perception of "Fair"
Objective measurements of the business-active child’s contribution to the business buttress that child’s likely position that his or her parents’ estate (apportioned by gift or inheritance) should not include his or her business interest (whether owned or promised) because he or she has earned it. Performance standards also take the wind out of the sails of non-business-active children who may demand that offsetting assets be transferred to them in an amount equal to the “gift” of ownership to the business-active child. When children not involved in the company see that their sibling is only receiving ownership in return for his or her blood, sweat, and tears, and understands that mom and dad will give them other (and more liquid) assets through their estates, the potential for family discord diminishes significantly.
Simply discussing the issue of meriting ownership vs. giving ownership to a child helps clarify goals and aspirations for parent/owners, their business-active children, and non-business-active children. Once clarified and communicated, the parent’s goals can drive the design of ownership transition, which is, after all, the central aim of Exit Planning.
In next week’s article, we’ll tackle the issue of fairness in family-business transfers.