No business can sustain its market position, let alone grow, if its capital base is dramatically diluted each time the mantle of ownership shifts from one generation to the next. The perception of many senior owners that they must fully “harvest” their equity at the time of succession thus poses a serious threat to the continuity of the family business.
Unfortunately, family businesses are sold every day for such harvesting. Part of the problem is that the senior leaders often have little sense of their financial goals and needs in retirement. While they are highly competent at reading balance sheets and business budgets, they and their spouses have never bothered to keep track of their personal spending. In short, they don’t know what it is to prepare a household for life on an investment portfolio.
There is another, even more critical reason that the succession process all too often breaks down: When sorting out the options for transfer of the business, the senior generation’s equity is usually quantified in terms of “fair market value.”
Certainly, doing responsible planning requires some measure of fair market value, if for no other reason than this is the benchmark the Internal Revenue Service uses. But it is only a benchmark, not an absolute truth. Fair market value is in the eye of the beholder. What one buyer may pay per share for 51 percent of the company’s stock may be far higher than the same buyer would pay per share for 10 percent. What a competitor might pay for the company may differ substantially from what a venture capital firm might offer.
Unless the owner-manager is willing to sell the majority of the company in an arm’s length transaction, the true fair market value of that stock can never be known. But who cares except the IRS anyway? If everyone wants to keep the business in the family, what is required is planning that works for both the family and the corporation.
A better, more realistic formula for financing the transfer of a business would give the highest priority to determining the needs of the retiring owner and his or her spouse, and the ability of the business to pay for those needs without risking its future growth and viability. Our firm has found that stimulating discussion of these two yardsticks helps clients to clarify their goals, attach numbers to them, and decide whether the transfer is feasible. Before explaining how the process works, let’s look at a simple example of the problem, which is truly unique to family businesses.
The horns of a dilemma
Dad started a modest business that has now become a substantial enterprise. As with most entrepreneurs, he and Mom poured everything they had into the business. The years have been filled with financial risk, long hours, and unflagging commitment to the enterprise. Today the business is successful, and at least on paper Dad and Mom would be thought of by outsiders as wealthy.
A closer examination would reveal, however, that they are still on the credit line at the bank. Dad’s compensation, including “informal perks” run through the business, has not changed dramatically over the last decade. No richly funded retirement package waits in the wings. And perhaps most distressing of all, the product life cycle in their industry has never been shorter and they must grow in order to retain market share.
As if all this were not enough, both the business and the family have put a great deal of effort into selecting Dad’s heir-apparent: his daughter. She is very bright, has an MBA from an outstanding Midwestern university, is well respected in the corporation and its industry, and, most important, is absolutely dedicated to the family enterprise as her life’s work. Everyone, including her two siblings, who are not involved in the business, is excited about where the company is going under her leadership.
Recently, Mom has begun to lobby for that long-promised retirement home in Arizona. While Dad is not ready to retire completely, he is proud of his daughter and eager to begin turning the reins over to her. He and his board concur that it is high time they began planning how his and his wife’s stock will be sold to his successor.
Reality check! Dad has the business appraised and discovers that (again, on paper) he and his wife are truly among the well-to-do. Daughter begins doing spreadsheets on her personal cash flow and soon discovers she does not begin to make enough to buy out Dad and Mom; in fact, her chances of buying out her parents get worse as the company continues to grow and the stock appreciates in value.
The family lawyer suggests a redemption of Dad and Mom’s stock by the business, but the banker does not particularly like this idea unless the buyout is over a long period of time and Dad stays on the corporate credit line until the transaction is complete. This option would leave Mom without the funds for the Arizona home any time soon, and would put a tremendous debt burden on the company just when it needs to tool up for the next product cycle.
In short, Dad and Mom have a tiger by the tail. The business provides a nice living for them day to day, but how do they ever get out? And what about the business? It has grown to a position of leadership in its industry, developed the next generation of stable, talented managers, and demonstrated its ability to cope with a quickly changing marketplace. The enterprise has never been stronger, but it needs capital to sustain this growth and prepare for the highly competitive years ahead.
Whose value is fair?
To an outsider, the answer might be easy: It’s time to sell. But to many family businesses, this is not a viable option. The answer for them is not to sell, but to rethink the problem.
Unlike its publicly traded cousins, this business and its owners do not gauge their success by the market value of their stock. Mom and Dad did not build this business just for the money. They love it, just as their adult children who now run it have come to love it, and they want to see it continued. For family business owners like Dad and Mom, there are more meaningful measures of success, such as long-term profits and good day-to-day livings for themselves and their employees. So why is its IRS-defined fair market value—what a mythical “ready and willing buyer” will pay for the business—the only measure of what this business is worth to the family?
Using fair market value as the benchmark to set the price for Dad and Mom’s stock may lead to unrealistic expectations on the part of the seniors, as well as serious doubts about whether the transfer is even feasible. Perhaps a better way to determine the worth of the business and to facilitate the transfer is to assess “need” and “ability to pay.” This new approach is designed to help the senior generation prepare and provide a respectful opportunity for the family to discuss the coming change.
The concept of “need” begins with a very private conversation between Dad and Mom about how much is enough. Need is not a cookie jar into which the senior generation can reach and pull out whatever it wants, whenever it wants. Planning is critical for the business, and it cannot be drained of cash periodically by its former owners. Planning is equally critical for the senior-generation owners.
To determine their needs, the business couple must define their goals beyond succession and put together a budget. Many consider that an unpleasant task. Whether at the personal or company level, budgeting seems to evoke negative thoughts such as: “It feels as if I don’t have enough, so I guess I better budget,” or, “I’m not smart enough to watch what I spend, so I have to budget.”
Budgeting, however, gives the retiring couple an opportunity to sift through today’s needs and do a little creative thinking about what tomorrow’s needs will look like. Such planning can be empowering, for it helps senior leaders prove to themselves that a successful ownership transition can really happen.
When needs are balanced by the company’s ability to pay, flexibility is possible. Without flexibility, the successor generation may have to pay much more, both monetarily in higher transfer costs such as gift and estate taxes, and in terms of the pressure and scrutiny under which they will operate. If the senior generation is forced to remain in financial control, the successors will be unable to learn from their own mistakes—as their parents did when they assumed leadership responsibility.
(All too often, the enormous load that estate tax places on so many businesses drives the planning. The basic premise here, however, is that through good planning you can limit not only the debt burden on your company, but also the amount that passes at death between the generations. Ultimately, good tax planning allows your family to avoid dilution of the estate. Like good succession planning, it requires a coordination of the interests of both the business and the family, and enough time to allow those plans to work.)
The needs and ability-to-pay formula has one other significant advantage. As we will see, the company’s future prospects are a vital ingredient in its worth and its ability to provide a continuing income to both the senior and successor generations. This is much more empowering than the fair-market-value yardstick, which gives only a static view of the company’s current worth and provides little insight into its capacity for growth.
Steps in defining need
One good way to start talking about the economics of succession is to begin with the needs of the business. In our firm, we find that this provides a “reality check” for the retiring owners that sets some boundaries on their determination of their own needs. Next, we define a process whereby the senior owners can quantify the cash demands of their lifestyle. The goal is to come up with an annual or monthly figure of their costs, along with a date on which they will turn over leadership (we try to avoid the loaded word “retire”).
Generally, our firm uses a five-step process to help the senior generation define its needs.
First, we discuss the economic needs of the business in broad terms, without coming up with numbers. The discussion focuses on the company’s market share, how it has changed over the years, what is needed to sustain (or re-energize) its growth. This review includes such considerations as the status of personal guarantees, the company’s debt burden, and its need for working capital to stay technologically current in its industry.
Second, we help the seniors identify their economic goals for their family and community, with particular emphasis on their children and grandchildren. Again, the discussion at this stage deals with these goals in broad terms, avoiding specifics. This is the point at which the parents discuss “fairness” in division of assets among their heirs. We get a peek at how they feel about treating their offspring equally (ensuring that they understand the difference between equal and fair) and what the parents wish their legacy to be. We may learn about their dreams for, say, the education of their grandchildren or for community stewardship, as well as their concerns for an aged parent, a favorite niece, or even an old and trusted friend.
Third, we introduce the idea of planning for retirement with a budget-driven model. The model starts with estimates of current living expenses using a comprehensive budget worksheet. This is often quite revealing. We then move on to helping the clients define what they must accumulate outside the business to sustain that lifestyle after succession.
To do this well, the seniors must have permission to think just about themselves for a little while. So many have lived such responsible lives for so long that they often struggle to articulate what they personally want out of the transition. For example, it is helpful for them to talk about what their ideal job would be after succession; where they dream of living or traveling; what they’ve always wanted to do but have never had time for; and how often they’d like to be in contact with the business.
This “dreaming” is critical. Without it, the economic analysis will be fatally flawed. For unless the seniors believe that the succession plan works for them personally, it will never get done.
The next step is the “sharpening and polishing” phase. Once the clients have done their dreaming and lifestyle research, we help them extrapolate a picture of tomorrow. Financially, this will result in the monetary figure they need to support their post-succession lifestyle, with enough left over to meet their planning goals. Emotionally, this will be a picture of what their role in the business will be after succession. What is necessary in this phase is for people, who for years may have felt that succession planning was simply impossible, to develop a sense of the doable—to believe they can overcome whatever obstacles are confronted and achieve their goals.
The final step in the process is to attach numbers to the needs determined by the seniors. Whatever model is employed, the end result should be a figure that represents how much they must set aside to: maintain the lifestyle they have worked so hard to achieve; attain the desired level of personal economic freedom; be able to leave the business confidently; have sufficient resources to meet their special family and community needs.
The company’s ability to pay
Moving to the other side of the succession equation, the issue becomes: “Can the business afford to meet the needs of the retiring owners?” The ability to pay is based on the future, not the past. While historical data is important, basing ability to pay entirely on the past violates the principle that the corporation is the engine that will make future prosperity possible. It also violates the principle of stewardship, which suggests that each generation has an obligation to ensure that the business remains viable and grows, so that it provides for both old and new generations. In a sense the business is like a forest; unless the harvesting is selective, the forest will be lost.
The true value of a company to a family, and hence its ability to pay, depends upon three ingredients.
First is the ability to foster what we call “innovative development.” To be a modern, innovative organization, a company today has to be able to develop new products or services, and to create new processes that support that development. Innovative development can involve new tooling, new products, new operations, new uses for current products, new incentives for sales forces and assembly workers, new space—in short, new approaches that, when necessary, lead to reinventing the business.
Most of our clients are not focused on innovation. They have built their companies by capitalizing on a highly valued work ethic, a commitment to customer service, and an intuitive wisdom that has allowed them to make quick decisions to solve problems before they spin out of control. Saying that many are not particularly innovative does not diminish in any way the value of their unique skills and experience. Today as never before, however, technology and innovation are critical to the long-term success and even survival of family firms.
Second, the company’s long-term health depends upon its capacity to attract and hold talented and motivated people. There is a great deal of competition in the marketplace today for good employees—both family and non-family—who can lead organizations through dramatic changes. Attracting and keeping such people requires planning as well as money.
All too often, succession comes at the same time that the company is struggling to change from an entrepreneurial enterprise into a managerial, professional organization. One of the hallmarks of many successful clients is that they run “lean and mean” and are proud of it. This is certainly not all bad—even the public sector is trying hard to get back to basics. But for many family companies, this is more than a business strategy. It is part of their culture, driven by the owner-manager’s need for control.
However, many of these businesses have simply grown beyond the ability of one man or woman to make all the decisions. In addition, members of the next generation are usually moving toward multiple sibling or cousin leadership. A serious element of distrust will pervade the organization if they are unwilling to subject management to the discipline of professional governance in the form of a well-functioning, impartial board of directors.
Third, to sustain growth, the company needs access to sufficient capital to maintain technical competitiveness and adequately staff the organization. Most of our clients have a history of capital use that falls at one end or the other of a continuum. For many family companies whose owners grew up during the Great Depression, debt is an evil to be avoided at all costs; their emotional resistance to the use of debt financing remains powerful. At the other extreme are businesses for which everything is leveraged and always has been, and shareholder personal guarantees are virtually a way of life. These companies, while not at all frightened by the prospect of debt, often have little or no cash reserves, plan very little, and believe with real conviction that anything is possible if one has the guts to try it.
To make things work on both sides of the succession equation, the seniors must address not only the corporation’s ability to pay, but also their own unwillingness to slow down and eliminate personal, debt-financed “deals.” In estimating future levels of growth, the owners should recognize that this is not “go-go time.” The period of succession planning is a time to consolidate, to strengthen fundamentals, and to give the principals in both generations breathing room to let it all happen. While no-growth is probably a killer, it is important to keep growth under control and let key stakeholders know that this is exactly what is planned, so they do not interpret a slowdown in the rate of growth as a fundamental weakening of the business.
One of the assumptions of this model is that the senior generation will be willing to accept limits on the harvesting of its equity and pass its stock to the next generation at the lowest cost consistent with its needs. The currency the successor generation is using to pay for this equity shift is its willingness to restrain its own economic demands on the business during the period of transition. Trust becomes a critical part of the equation, and trust is best fed and nurtured with the aid of a well thought out strategic plan. The plan should contain agreed-upon targets for need payments to the retiring seniors, the timing of gifts of shares, and well-understood benchmarks to ensure the continued fiscal health of the enterprise.
Looking at fundamentals
More often than not, the owners and their successors are surprised to learn from this process that the business does have the ability to pay. Even when companies are a little soft on the ability side, many of them can grow into a solution if the planning is started early enough. The real trouble occurs when this process is delayed too long and there simply is not enough time for the seniors to harvest sufficient resources without crippling the company with debt or forcing it into quick-fixes.
When the equation truly cannot be balanced, it is probably time to sell. But even this result is preferable to the clash of economic needs and feelings of entitlement that occur when the parties do not address the issues. The family may well discover by going through this process that the seniors’ needs outstrip the company’s ability to pay or can be satisfied only by full harvesting of the equity buildup. Still, it is better to uncover these realities through a respectful, inclusive planning process than to ignore them until members of the next generation get tired of waiting or the business is sold in a panic because of a senior leader’s ill health.
While the harvesting model presented here was designed as a planning tool and not a valuation device, it may be a start toward a better way of arriving at the fair market value of a private concern. Today the IRS guidelines on the valuation of private companies attempt to equate these enterprises with their publicly traded cousins. This has, of course, given rise to the method of appraising private companies in which “dividend-paying capacity” is determined through a series of simplistic profit-and-loss and balance sheet adjustments, with the results then matched against public company “comparables.” While this provides a rough yardstick in some cases, particularly when appropriate discounts are allowed for lack of marketability and minority interests, it is still overly simplistic and fraught with error.
Rather than looking just for surpluses on the company’s financial statements, for the purpose of determining dividend-paying capacity, we have attempted to dig a deeper trough that gets to some of the fundamentals of long-term success more accurately than a simple focus on short-term compensation and cash. With the Dow Jones Industrial Average flirting with the 9,000 mark these days, it is questionable whether even the public markets are looking at these long-term variables. Because the financing of a succession transition is so vitally important to privately held businesses, however, it is critical that their planning be grounded in the fundamentals of long-term financial success.
Glenn R. Ayres, an attorney with Fredrickson & Byron in Minneapolis, has been counseling clients in business and estate planning for more than 20 years. He is also a professional-in-residence at the University of St. Thomas Institute for Family Business.
Preparing to formulate a budget
The following questions can help stimulate discussion of a business couple’s goals and financial needs in retirement. They also help to define the “homework” that needs to be done to come up with specific numbers.
- What assets do you have outside the business? What rate of return can you expect from your traditional investments?
- Where do you intend to live? Will you be buying a new home and what will you do with your current residence?
- What do you believe the rate of inflation will be during your retirement?
- What do you see as a target date for succession? What, if anything, would you like to do for the firm post-succession?
- If you don’t wish to retain a role in the company, will you still be working, and if so, at what? Have you discussed these decisions with your board of directors?
- Do you have children or others who depend on you for economic support?
- Do you have any special goals you would like to achieve for your community, and would you like to involve your family in meeting those goals? Have you discussed these topics with your family? —G.R.A.
Harvesting techniques
Often, after examining a retiring leader’s needs and the company’s ability to pay, it is determined that the equation can be balanced over time, but some strategizing is necessary to determine how and when the harvesting will take place. The following are just a few of the techniques that can help put additional resources in the hands of the senior generation:
- Increased compensation, geared for a specific transition period to profits or sales, in order to limit concerns about unreasonable compensation.
- Deferred compensation, perhaps even backed by a rabbi trust (which segregates the funds needed to make these defined payments from other corporate assets), to produce the confidence that the dollars will be there.
- Increased rents on real estate that is owned outside the business or on equipment used by the business.
- Compensation for consulting to the business after succession, or lump sum payments for non-compete covenants.
- Upgraded pension and retirement benefits, perhaps including a limited employee stock ownership plan.
- Changing the form of the business to an S corporation, to enhance short-term, direct corporate distributions to the senior shareholders.
- Repayment of old shareholder debt.
- Use of the senior generation’s underperforming assets to create a tax-absorbing charitable deduction.
- Creating passive income streams with equipment partnerships, royalty income, and directors’ fees.
- A buyback of the seniors’ last block of stock, as a final step to put the plan over the top. —G.R.A