Fred Silvestri’s window manufacturing operation in Battle Creek, Michigan, has grown steadily over the last 10 years. Fred knows his oldest son, Stan, company vice-president, will eventually take over day-to-day operations. But neither Fred’s daughter, Susan, an elementary school teacher, nor his other son, Carl, a building contractor, are employed in the business, and they have no desire to join full time.
Fred has already had several meetings with his lawyers to discuss the eventual transfer of the family business to his three grown children. However, in addition to an estate plan, Fred would like to provide current income to the family members not employed by the firm, using techniques that will also improve the business.
Like many owners, Fred, our fictitious founder, has family members who lead active lives yet are not active in the business—either because there is no room for them, they do not have the right skills, or they have other interests. Nonetheless, they need not be limited to the role of passive benefactors of the business.
There are several creative techniques owners like Fred can use to transfer current benefits and improve the business. These include transferring ownership of real estate used by the business, consulting arrangements, establishing a feeder business, and setting up a venture fund. The first two require little ongoing management and entail only moderate risk. The others require more investigation and ongoing oversight, and involve greater risk.
Real estate
Often family businesses lease real estate from third parties. A basic technique owners like Fred can consider is to establish a separate entity to own real estate and lease it back to the family business. This is a frequently available but often unused opportunity.
In this arrangement, nonactive family members such as Susan and Carl can own the new real estate entity. This technique is most applicable to businesses that currently occupy leased space, or will require more space for expansion. It is well suited to light manufacturing and assembly companies that use simple buildings, and those that use traditional office space. Of course, the real estate can house other tenants that would pay rent as well.
The key is to generate the financing needed to purchase the real estate. The company can buy the real estate and transfer ownership to Susan and Carl. Or the company can be a guarantor of a bank loan to Susan and Carl, who could then purchase the real estate themselves. A lender may require personal guarantees from Fred if the building is a single-purpose facility with the business as sole tenant. Susan and Carl also could be given a loan directly by the business, or by senior family members.
The rent paid to the real estate entity can provide a steady cash flow to the nonactive family members. There is also another benefit: the conversion of a family business expense—rent—to family equity in the real estate as the mortgage is reduced. Furthermore, although real estate values have fluctuated over the last few years, appreciation of property value and rents is likely over the long term.
Of course, before real estate is acquired, a comparative analysis should be made of the after-tax effect of ownership versus leasing. Consideration should also be given to issues such as future space requirements and the opportunity cost when capital is devoted to real estate ownership instead of investment in the business.
The choice of entities that could own the real estate and lease it to the business include nominee trusts, which are mere titleholders controlled by the beneficiaries, to grantor trusts or limited partnerships, which have centralized management that controls the distribution of cash flow and disposition of the property. Legal and accounting advisors should be consulted on these issues. Depending on the circumstances, the acquisition and leasing of real estate may be a one-time event or the foundation of a separate ongoing family business.
Consulting arrangements
Consulting arrangements can be used to generate income for family members who are not on the payroll but have the skills and experience to make a contribution. Their work can be limited to one-time projects or brief but ongoing interactions.
Typically, consulting falls into traditional financial and management categories. However, if owners think creatively and widely, they can usually find a way to match company needs with the skills of nonactive family members.
For example, with her teaching background, Fred’s daughter, Susan, could probably perform employee training. Fred’s son, Carl, who has a contracting background, could be retained to perform plant and property repairs and maintenance. There are many other common business tasks that can be accomplished on a consulting basis, but often aren’t, such as interior decorating, plant refurbishing, equipment installations, landscaping, brochure design, manual writing, software creation, publicity, promotion, and advertising.
Consulting arrangements can be extremely flexible. The consultations can be conducted by telephone or in person. A formal engagement letter, which sets forth such terms as compensation, a timeline for the work, and performance standards, is the basic mechanism for implementing a consulting arrangement, and helping to establish it as a legitimate business expense.
Feeder business
Another way to create part-time work for inactive relatives and add value to the family firm is to organize a separate business that will sell goods or services currently purchased from third parties to the primary business. This technique is particularly appropriate for manufacturing firms, which consume many raw materials and parts, but it can also apply to any company that uses a large quantity of a given item, such as paper, solvents, packaging materials, even general cleaning supplies.
In the beginning, it is best to set up the feeder business as a distributor or broker which simply supplies an item purchased in large quantities by the family business. Consideration must be given to the resources, abilities, and goals of the family.
Because involvement in a manufacturing operation is a major undertaking, it is simpler to structure the feeder unit as a sales or distribution business. Family members may start up the new business or may choose instead to make an equity investment in an existing business. The feeder business can benefit the primary business by supplying products at lower prices than are currently being paid, while providing compensation and/or dividends and capital gains to the nonactive family members.
If the feeder business is small, the nonactive family members might need to spend only a modest amount of time a week running it. The primary business could provide clerical support and other basic services. The nonactive family members could fund the feeder business themselves, or with a loan from the family or primary business. A family limited partnership could be formed to own it, too.
With the family business as its initial customer, the feeder business should quickly become profitable. In time it could begin to sell to other clients. Eventually, it could become a significant source of revenue. At this stage, it could be re-formed as a joint venture with the primary family business, or professional managers can be hired, so the nonactive family members do not have to devote too much time to operations as the feeder business grows.
As with consulting arrangements, some creative thinking can greatly expand the possibilities for new businesses that take advantage of the special skills, interests, and personalities of family members who may not fit in the primary business. For example, if Fred’s window business uses a lot of wood frames, Carl, the contractor, could start a mill business that hews the raw wood that Fred would buy. Or Carl could run a business that assembles frame segments or entire frames. If Fred employs enough shift workers in his factory, Susan, the elementary school teacher, could start an on-site day care center. The day care center could also accept children from the rest of the community.
A critical step in implementing a feeder business is the preparation of a business plan as soon as a potential opportunity is identified. The business plan forces critical analysis of the benefits and risks of the opportunity, and brings order and discipline to the process of structuring the new entity. Properly utilized, this exercise tests the new venture against the harsh realities of the marketplace. Determining whether the new business makes sense is also an important tool in resolving potential family issues, such as the roles the different family members might play and the allocation of the benefits of the venture.
Venture funds
Business owners who have confidence, experience, ready cash, and a stomach for high risk can form a venture fund that over time invests in a portfolio of companies. In the long run, a venture fund can substantially enhance family wealth, and create many employment and ownership opportunities for family members not active in the primary business.
Owners should not consider a venture fund unless they are adept at evaluating the operating as well as investment aspects of another business. Also, this technique is only suggested when a family company has substantial capital and can devote a portion to high-risk, high-return opportunities.
A venture fund is most worthwhile when a family business can acquire temporarily depressed or undercapitalized businesses in which they have exhibited a particular expertise. For example, Fred could take a major interest—or take over—a framing operation, a glass cutting shop, or a window contracting business. All of these could provide Carl with work in addition to ownership. Ultimately, the enhanced businesses can be sold or taken public.
Family members who have no way of actively participating in such businesses, such as Susan, can still become investors and thereby share in the potential for substantial appreciation. Of course, the traditional concerns of any venture involvement must be considered, such as control, strength of management, and an exit mechanism to provide liquidity of the investment. Unless Fred, or the other family members, take a majority interest, they will not have much control. An alternative is for Fred or the family members to get the word out that they are willing to become investors in others’ ventures. There are many venture capitalists who are interested in joint investments.
Joel I. Cherwin is a business attorney with the Boston law firm of Cherwin & Glickman, where he advises family businesses.