Luca Sena, the second-generation owner of Panorama Ristorante and the Penn’s View Hotel in Philadelphia’s trendy Old City neighborhood, emigrated with his family from Italy as a youngster in 1967. For more than two decades in their native country, Luca’s father, Carlo, had worked as a chef. In 1975, Carlo finally took a chance on starting a restaurant in Philadelphia. That restaurant, La Famiglia, prospered, and soon Carlo bought a second restaurant—Panorama—and the hotel. Carlo ultimately sold La Famiglia to relatives and began concentrating on his new properties. Luca worked alongside him in the restaurant and hotel business.
By 1997, Luca Sena was ready to take the reins. But he harbored no expectations that the company would simply be handed to him. He hired a professional appraiser to determine a fair purchase price for the business.
Although the appraiser valued the property at around $1 million, a lawyer suggested adding a cushion and paying 10% more. Luca, who has five brothers and sisters who don’t work at Panorama or the hotel, followed the legal advice. “This way no one can say that I stole the business from my father and cheated anyone out of an inheritance,” explains Luca, now 54. To finance the purchase, the son took a second mortgage on his house and borrowed from a bank. He paid some cash to his father and then made a series of annual payments.
While Luca Sena’s eagerness to pay extra may be unusual, his desire to buy the business outright is hardly unique. In many families, the most effective way to transfer ownership from one generation to the next is to have the successors buy the business rather than receive it as a gift. Sales benefit all parties involved, family business advisers say. In a well-planned sale, they note, the successors gain clear control of the company on a fixed date. By contrast, a gifting program may take years to complete. For parents who have put most of their assets into the business, a sale provides cash that can be diversified for a retirement nest egg.
Perhaps most important, a sale teaches adult children to recognize the hard work of their parents. Someone who is given the keys to the family business may not appreciate the value of the gift. “A sale diminishes the likelihood that a business will be taken for granted,” says Scott E. Friedman, a managing partner at the law firm of Lippes Mathias Wexler Friedman LLP in Buffalo, N.Y., who consults with family businesses.
Today, Luca Sena’s company includes other real estate as well as Panorama Ristorante and the Penn’s View Hotel. The enterprise generates $6 million in annual revenues. In the next decade, Luca hopes to sell the business to his oldest son, who like Luca’s father is named Carlo and who now serves as general manager.
“Carlo knows that he will not be given the business,” says Luca, who speaks in a firm voice with the accent of his native Italy. “Everybody should earn what they get.”
“I have been working in the business since I was five,” says the younger Carlo Sena, 32, “but I won’t feel that I own it until I buy it outright.”
Some successors borrow from banks to finance the purchase of the business. Often parents help with the financing, either by co-signing bank loans or by making the loans themselves. The next-generation owner pays some cash initially and then spreads payments over a period of years. If the business generates plenty of cash flow, the new owner may easily make payments from operating income. In ideal circumstances, the deal will provide income for the parents while still leaving the business with enough cash flow to meet expenses and pay for expansion.
If the family cannot finance the deal, friends may be willing to participate. Another option is to form an ESOP (employee stock ownership plan), which can borrow money and purchase part of the business for employees.
In 1989, Dave McDonald purchased McDonald’s Meats in Clear Lake, Minn., from his father, Richard. The father took a note, allowing the son to make annual payments over 15 years. When Dave wanted to expand his production of smoked meat and jerky, he borrowed again from his father. “Rather than going through the hassles of dealing with the bank, we kept everything in the family,” says Dave, 48, who still heads the business, which generates $2 million in annual sales.
A crucial element in any sale is determining a fair valuation for the business. Some families may be inclined to set the valuation on the low side. This holds down the capital gains taxes that sellers may face. But low-ball prices could create jealousy from relatives who don’t join in the purchase, says attorney Scott Friedman. Suppose a business is worth $1 million, and there are two sons, one who enters the company and the other who does not. To avoid gains taxes, the family values the business at $100,000. The parents leave the business to the entrepreneurial son and equivalent cash to the other. At the end of the day, one son controls a $1 million business, while the other sibling has $100,000 in cash. “If you don’t assign a fair value, you defeat the whole idea of treating each child equitably,” cautions Friedman.
To avoid hard feelings, advisers urge families to meet and agree on fair prices. Many businesses sell for multiples of earnings, such as three to six times EBIDA (earnings before interest, depreciation and amortization). Fixing the exact price is something of an art, but there should be a connection to prices of comparable businesses. Appraisers typically pay close attention to the current cash flows and the outlook for future growth. A small clothing shop, for example, may command a lower multiple than a fast-growing technology company.
For a small business, it may be too expensive to pay an outside appraiser. But if the business is complex, it may be necessary to hire an accountant or business appraiser. “You should hire an objective person who is not associated with the company,” says Ann Dugan, assistant dean of the Katz Graduate School of Business at the University of Pittsburgh. “If you hire the father’s long-time accountant, some people my feel that the final price isn’t fair to everyone.”
To set a price for McDonald’s Meats, the family held a meeting that included the purchaser and relatives who were not going into the business. An outside appraiser provided a value for the land and building. The family itself agreed to value all equipment at half the replacement price. “If a saw was worth $10,000 new, and it was still in decent shape, we figured it would be worth $5,000 at an auction,” recalls Dave McDonald.
For all the virtues of selling businesses to children, there may be cases in which parents have good reasons to gift their companies. Say parents own a small candy store, and two sons have long labored faithfully in the business, helping to build it. Now the parents are ready to retire, and they can live on savings. To avoid capital gains taxes —and reward their dedicated offspring—they might simply give the store to the sons.
In some cases, families may want to combine gifting with a sale. A married couple can give $22,000 a year in assets to each child without facing any gift taxes. Any gifts are removed from the taxable estate and will not face inheritance taxes. By using gifts along with a partial sale, parents can lower tax bills and still give their children the discipline that comes with making a purchase. In some cases, families can sweeten the package by providing parents with annual income in the form of consulting fees. “If a non-family member buys the company, the owners may insist on as much cash as possible,” says Dean Fowler, a family business adviser in Brookfield, Wis. “But if the transaction involves parents and children, then everyone may be willing to do what benefits the family most.”
One Wisconsin owner of a tool and die maker faced a particular challenge because he had eight children, Fowler reports. Uncertain whether any of the youngsters would go into the business, the father gifted each of the children non-voting stock in the company. That left control in the parents’ hands. Then two sons decided to take over. Their first step was to buy the non-voting stock from their siblings. Then they bought the voting stock from their father. The new owners paid for the voting shares over a period of years using cash flow from the company.
Fowler notes that many family transactions fail because they are poorly planned. In some instances, the parents simply don’t act soon enough. Some senior-generation leaders wait until they are in their 80s before considering giving up control. By then, the putative successors are thinking about retiring and are unwilling to take over a demanding acquisition. In other instances, the parents sell but insist that the company provide the older generation with annual income and cover medical costs. This can be a big drain on the business and leave it with too little cash to meet competitive pressures.
Consultants recommend that parents begin casual conversations about a sale when the children are in their 20s. There should be clear discussion about who can work in the business and how those individuals can rise to leadership.
By the time the younger generation hits 35, serious discussions about a transition and sale should take place. “You don’t want to wait until late in the game to tell children that they are required to buy the business,” says attorney Scott Friedman. “If the young people have not been thinking about the need to finance the acquisition, they may be stuck with other commitments.”
In most cases, parents start the process, talking about the transition and meeting with accountants. Some parents don’t even consult with their children before making key decisions. But consultant Dean Fowler says deals work best when the next-generation members take action themselves. “In the really successful companies, the successors take the initiative to investigate what it would take to buy out the parents,” he says. “The children develop a plan and present it to the parents, rather than waiting for the parents to make the decision. It helps when the successor generation gets involved in shaping the company’s strategy so that the business moves along with the children’s competencies and passions.”
To ensure a successful outcome, experts recommend that parents and children begin educating themselves about the process years in advance. By reading books and attending seminars, they can begin to get basic knowledge about how to finance and execute what may be a complicated transaction. Family members should call on advisers and perhaps employees who can explain accounting and tax issues. “When you sit down at the table to negotiate the final deal,” says Friedman, “you don’t want to be naïve beginners who don’t know the first thing about one of the most important deals of your life.”
The transition process is just starting for Dawn Fuchs, president of Weavertown Environmental Group, an environmental cleanup company in Carnegie, Pa. Dawn, 39, is thinking how to take over from her father Donald, 64, who is now CEO. From the outset, it is clear that gifting will not play a major role. With $28 million in sales and 190 employees, the company is sizable enough that gifts could generate substantial inheritance taxes, so the business must be sold. That will take serious planning, Dawn says. She says she expects to work methodically to execute the transition in the next five years. A key goal is to make sure that the lines of authority remain clear, with Dawn as CEO. In addition, she says, there must be some effort to compensate a sister who is not actively involved in the business. “Our most important goal is to keep the family intact,” says Dawn. “We have seen a number of families where there are bitter fights and people wind up not speaking.”
To avoid such unhappy results, Dawn and her family members must spend many hours in planning over several years. With careful preparation, they can improve the odds that the business will continue thriving and all family members will be satisfied with the final deal.
Stan Luxenberg is a business writer based in New York City.