In our previous post, we examined the process behind successful ownership transfers to family. You may recall from that article that there are six key ingredients to successful ownership transfers to family:
- The BEI Seven Step Exit Planning Process™
- Parental Financial Security
- Ownership Based on Merit, not Emotion
- Fairness to All Children
- A Capable Successor, Prepared Business, and Ready Owner
- A Back-Up Plan
In this article, we’ll examine the remaining five elements and explain why each is important for owners who want to pursue an ownership transfer to family.
Parental Financial Security
In Exit Planning, there is nothing more important than financial security for the exiting business owner. By definition, an Exit Plan is successful only if it allows a business owner to exit with financial security.
We’ve talked about the importance of financial security before, but it’s especially crucial to consider within the context of an ownership transfer to family. That’s because transfers to family rarely allow owners to exit their businesses with the full sale price upfront. Family members—more specifically, children—almost never have the liquid funds necessary to pay exiting owners for their share of ownership. While it may seem that transferring the business to family precludes financial security, that’s not at all the case.
It’s easy for owners to view financial security and transferring the business to family as mutually exclusive. However, it’s common for owners to achieve both with the right kind of planning. Typically, owners achieve financial security through a transfer to family by implementing strong incentive plans for key employees and retaining voting shares of ownership until they are completely cashed out. With help from proper advisors, business owners can achieve financial security and transfer to family within a reasonable time frame.
Ownership Based on Merit, not Emotion
Exit Planning is an emotional exercise. Without proper planning, owners can fall into the trap of transferring ownership to a family member who either doesn’t really want it or can’t really handle the responsibility. Even worse, some owners let themselves be persuaded by family members to go against their own interests as they exit their businesses. To address these risks, business owners should transfer ownership based on merit. Installing performance standards is a proven way to judge potential successors on merit.
Owners should consider installing performance standards that do the following:
- Motivate and reward employees to increase enterprise value and cash flow over time.
- Award cash bonuses to non-family key employees / Ownership to family key employees.
- Design performance standards that further the parent’s goals and objectives.
- Can determine allocation of ownership among children.
When a family member (i.e., child) reaches these performance standards, it does four key things:
- Demonstrates the child’s ability to operate the business successfully.
- Allows the child to earn ownership using the same standards that non-family members use to earn cash.
- Shows that the part of the parents’ estate the child receives by gift or inheritance should not include the business interest owned or promised to him/her.
- Establishes that the child’s ownership has been earned, not simply given to him/her.
Determining the specifics of the performance standards can be complex, which is why owners should consider consulting with an advisor to help.
Fairness to All Children
Treating all children fairly is a common struggle for owners. When some children are active in the business while others are not, determining what is fair can be especially difficult. That’s because business-active children and non-business-active children typically display two different mind-sets:
Business-active children believe that because they’ve worked in the business and helped grow it, they should receive ownership in addition to a share of their parent’s estate. They view the business and the estate as two separate entities. They often point out that they took a big risk by agreeing to succeed their business-owning parent and shouldn’t have to share the benefits that came from that risk with siblings who didn’t submit themselves to the risk of running the business.
On the other hand, non-business-active children believe that they should implicitly have a share of the business-owning parent’s estate, which includes the business. To them, the business is a part of the estate, rather than a separate entity. They often prefer liquid assets over an illiquid family business because if they were to receive ownership, they would have to take on responsibilities they don’t want for benefits they don’t see. In a situation in which a non-business-active child receives a share of ownership, it’s usually impossible for them to sell that share to anyone other than a business-active sibling, who often doesn’t have the liquid cash to buy the non-business-active child out.
These are just a few of the issues that arise in an ownership transfer to family in terms of fairness. The only way to address these issues is to attack them straight on. Knowing what each child would consider “fair” gives owners a baseline upon which to act. With help from Exit Planning Advisors, business owners can walk the tightrope between being fair to children who aren’t active in the business and properly transferring ownership to business-active children while recognizing the work they’ve done to build the business’ value.
A Capable Successor, Prepared Business, and Ready Owner
It may seem obvious that owners need a capable successor to run their businesses. However, when transferring to family, blood bonds can cloud judgment. For a family successor to be deemed capable, he or she must do at least five things regularly:
- Drive business growth.
- Anticipate and respond to outside threats (e.g., new competition).
- Navigate during economic downturns.
- Exercise leadership.
- Manage the management.
If the successor cannot do these things, they’ll likely fail to maintain the cash flow necessary to fund the exiting owner’s post-exit lifestyle.
Likewise, the business must be prepared for the owner’s exit. This means that the business must have Value Drivers installed and functioning well before the owner exits the business. This does two things: First, it allows for a smoother ownership transition. Since Value Drivers increase a business’ operational efficiency, the successor can hit the ground running, allowing the business (and cash flow) to grow and thus fund the exiting owner’s post-exit lifestyle. Second, because Value Drivers are things that all buyers look for in a business, having them installed before the owner is ready to exit gives the owner a built-in back-up plan should something unexpected happen to the owner’s chosen successor.
Finally, the business owner must be ready for post-exit life. This includes having an idea for what to do with all the available time a business exit provides. While this portion is usually covered by the first Step of The BEI Seven Step Exit Planning Process, it’s crucial for owners to clarify their goals with their Exit Planning Advisors to assure that they can be attained and will be fulfilling after the owner exits.
Even when owners fulfill the first five ingredients of a successful ownership transfer to family, they must be prepared to pivot if necessary. There are countless things that can go unexpectedly in a transfer to family: The owner might die before the transfer is complete. The business might to too valuable for a family member to buy out, even over many years. The owner’s successor could have a change of heart about ownership, could desire to run the business in ways that make the owner regret transferring ownership, or could face personal issues (e.g., divorce, death of a child) that make it impossible to run the business.
This is why it’s important for owners to prepare their businesses for a third-party sale concurrently. When done right, planning for a third-party sale and a transfer to family often dovetails, giving owners flexibility to pivot when necessary.
Preparing for a successful ownership transfer to family must be all-encompassing, and it can be difficult (and sometimes, impossible) to do alone. But with the right process, ingredients, and advisor help, business owners can achieve their goals by transferring to a family member.