Contents   * Search Website    * Products   * Retirement Plans   * Services   * Carrier Links   * Newsletters   * Contact Us Customers Only   * HNI E-Mail   NEW $1 billion Medicare Gap pumps up insurance costs Special Features * Glossary of Terms * Can You Afford to   Retire? Hot Topics * Family Business -    What to Pass Along to    the Next Generation * Qualified Sick Pay    Plans * Carving Your Way to    Success - Group Term    Life

Hot Topic Family Business Wisdom What to Pass Along to the Next Generation There’s an old American adage that goes, "Nine tenths of wisdom consists in being wise in time." Nowhere is the meaning more serious than in planning family business succession. The traditional dream of entrepreneurs is to watch both the business they have grown and the family they have raised merge in a new generation of ownership. But the statistics are well-known—only one-third of all family business make it to the second generation, only one in seven to the third. And the breakdowns include some pretty gory family stories chronicled for everyone to read. What is wisdom that makes one dream succeed while another slips into nightmare? And what is the mystery of being wise in time? Both are easy to identify and difficult to manage. First Rule of Family Business Wisdom—achieving it is not a one-person job. Succession planning for family businesses involves close coordination among legal, accounting, finance, and risk experts who serve on the decision team and equally close communication among family members and management. Second Rule—the enemy of being-wise-in-time is plan-and-forget-about-it. Just as business plans run on three-to-five year horizons with periodic review and adjustment, succession plans cannot be initiated and then ignored. Three to five years can create revolutions within families and between partners, not to mention swings in the value of the business. There is a good probability that a plan which has not been reviewed within the year will be veering off course a few degrees and a few years after that expands the arc dramatically.

The watershed issue for family business succession would seem to be deciding whether the business should stay in the family or not. But that question can almost never be given a definitive answer, because reason and emotion are so often in conflict in family business situations.

Take the founder who is obsessed by continuing family ownership of the business. He or she could no more consider letting go of it than he could letting go of one of the children. That is what the business has become—a family member. Is it possible for such people to consider that it might actually be more advantageous for everyone involved that the business be sold? For example, try these what-if’s.

• What if the success of the business is tied too tightly to the unique abilities or knowledge of the founder?

• What if necessary additional growth will be difficult to finance?

• What if competition is very strong and products and services may become obsolete without new technological capabilities?

• What if there is no family member who can take over management of the company?

• What if no one on the current management team has been groomed for the particular leadership such a transition requires.?

• What if there would not be sufficient profits to support the founder’s children’s families as it has supported the founder’s own family and withdrawing additional money from the business would be crippling?

• What if critical management and financial decisions among owners may be stalled as one faction wants to distribute profits while another wants to reinvest?

• What if submerged intra-family personality problems could surface after the founder’s death to the detriment of the business?

• What if personal burnout for the founder is on the horizon, but he or she can’t see it?

• What if the family is tempted to continue the business only as a monument to the founder, not realizing that monuments do not pay the bills?

Now, what about the entrepreneurs who see their businesses not as family history but as a pot at the end of the rainbow? Would they recognize that conditions could be more compelling not to sell a business? The what-if’s include . . .

• What if the business is successful and providing family revenues greater than what might be gained by sale?

• What if increasing profits are likely because of favorable markets or new developments in products, technology, management, etc?

• What if good leadership is in place, either from within the family, or from within the management, with a good relationship with non-active family owners?

• What if the selling environment is not favorable, and prices of similar businesses are depressed?

• What if the increase in the value of the business during the founder’s life is subject to income tax if the business is sold prior to the founder’s death? If the founder is the sole stockholder and the business is continued after his or her death, income taxes do not have to be paid on the increased value of the property, because the income tax basis of the stock is stepped up to the fair market value at the owner’s death.

Either way, retain or sell, business succession planning wisdom must eliminate or at least reduce the possibility of financial, management, or family obstacles to intrude on the progress to the ultimate destination for the business. That goal requires both a well-conceived fixed plan—a succession plan for the smoothest and least costly transfer or a sale plan to maximize return—and the flexibility to deal with inevitable contingencies.

Let’s assume that family retention of the business is the ultimate desire and that none of the negative conditions listed above argue against such a plan. There are seven distinct issues that must be addressed and from which wisdom will emerge.

Many entrepreneurs rely on instinct in their decision-making—a very clear picture of the future that they never doubt and never lose sight of. So, it can come as a disturbing surprise for them to learn that their goals for business succession contain contradictory elements and significant missing pieces. Unless they allow their advisors the freedom to isolate all the objectives and work through them one-by-one that clear picture will never be sustained. For example, clear, quantifiable objectives should be set to . . .

• Maintain voting control of the business and sufficient salary income in the event of a disabling accident or illness.

• Accumulate assets outside the business to diversify net worth and to build funds to support retirement lifestyle goals.

• Pass control of the family business into the right hands.

• Provide income for the surviving spouse and dependents who are not active in the business.

• Generate equitable non-business inheritances for inactive children.

• Minimize transfer costs and provide cash to avoid forced liquidation of estate assets.

Analysis of the business assets and liabilities, as well as the ownership structure make up most of the work the advisory team will perform. In addition, for the non-business assets and liabilities, strategies can be developed to equalize income and inheritance objectives for non-active family members.

However, analysis should be equally qualitative. For example, it is essential that owners familiarize the advisory team with the business—products, markets, operations, employees, etc. With this understanding they will be better equipped to anticipate changes that could occur when the founder leaves either expectedly or unexpectedly.

It is equally important for them to communicate with family members for whom the plan will evolve and with whom they will necessarily interact for some time to come. One of the common disruptions of family business succession planning is that the founder shields his or her advisors from the family. Instead the founder should encourage interchange so that the children and spouse learn how to work with advisors, what questions to ask, when to ask them.

Also, without knowing special circumstances within the family—for example, exceptional individual needs or multiple family situations or citizenship—elements of the succession and estate plan might not come together as intended.

Valuation will determine the price at which the business will change hands between a willing buyer and a willing seller, assuming neither is under any compulsion to sell or buy and both have reasonable knowledge of the relevant facts. In the case of succession planning, valuation provides the benchmark for estate tax liabilities and for determining the distribution of non-business assets for the fair and equal treatment of non-active children.

The founder’s concept of the company’s value is commonly distorted by his or her personal identification with it. Valuation for estate tax purposes requires an unbiased view—though not one devoid of intuitive skill. The role of a valuation specialist can be critical to the advisory team’s succession planning recommendations.

Commonly, entrepreneurial businesses began with joint participation of spouses. Sometimes this was a cost-saving necessity, but it also happens that each partner had specialized knowledge that contributed to the initial success.

That partnership may still be in place, or in time circumstances may have led to one spouse withdrawing from day-to-day business concerns. Withdrawal is seldom complete or final, and the spouse probably continues to act as a sounding board for strategic and management decisions. Even when there was no control or direct involvement in the business it is virtually certain there was a corresponding control and involvement with the family members around whom the plan will be constructed. In every case, the spouse’s involvement in the succession plan is essential.

For the sake of the succession plan, the founder’s grown children can be considered active or inactive in the business, based on whether they decided to work in the family business or pursue a career outside of it. Most owners make the same distinction, even if unconsciously, and they are generally determined that, because of the distinction, all effort must be made to treat all children equally in the plan.

A more productive mindset may be to make sure all children are treated fairly. Equal treatment means all children will have the same ownership percentage in the business and all other assets. Inactive children would have the same voting power and management voice as active members—a potentially disruptive effect from a well-intended idea, including such common results as . . .

• One faction wants to grow the business and reinvest profits. The other faction thinks of it as a mature business, avoiding unnecessary capital outlays.

• One faction sees salaries high, while dividends seem extraordinarily low. The other sees the very opposite.

• The need for consensus for reasons of family harmony causes delays in decision-making for business purposes. Opportunities are lost forever.

Fair treatment starts with the premise that children will not receive the exact same inheritance. The non-active children receive assets, usually in an acceptable ratio to the business asset, such as cash, non-business real estate, life insurance death benefits and real estate and equipment which is leased to the business. The ratio recognizes that the business asset usually represents a higher level of risk than the non-business assets and that the non-active children will have more investment flexibility with their inheritance.

For people under the age of 60 the risk of disability is much higher than the risk of death. And at such a time, the fact of disability can turn out to be a more catastrophic financial fact for the family than the fact of death. The succession plan must deal effectively with this contingency. Disability insurance will insure the income of the founder, as will a properly structured salary continuation plan. But the plan must also assure competent successor management in the event of permanent disability if the goal of retaining the business is to be achieved.

A formal retirement plan can strike most entrepreneurs as an anathema since they have no intention of leaving the helm. In their minds they will go from their desk to the funeral home on a stretcher.

But most entrepreneurs also value their independence highly, and such thinking leads to a dependence on the business for income. It makes more sense for the founder to build assets outside the business in order to achieve independent wealth retirement, which will also make succession planning and estate distribution considerably more effective.

Of course, the business succession plan will involve other layers of complexity. For example, life insurance can play a fundamental role a funding vehicle for various aspects of the plan. Also, there are sophisticated estate planning options for the business succession goals, including creation of family limited partnerships and charitable remainder trusts. But unless the decision team first addresses these seven issues fundamental to family business succession, and without a commitment to annual plan review, neither succession nor wisdom is not likely.

Courtesy of Partners Financial