Business Survival for Families-Part I

You may be surprised to learn that 90 percent of businesses are family owned. Only 30 percent of family businesses survive to the next generation of family members and only 15 percent survive to the third generation. The reason? Illiquidity and estate taxes are one reason but in far too many cases, family dynamics make a sale or liquidation the preferred or only choice. If you own your own business and would like to see it passed on to one or more of your children, developing a proactive strategy is essential. This is most challenging when an owner has children who work in the business (active) as well as children who do not (inactive). Here are three possible solutions:
  1. Transfer the business to your children equally. This will guarantee all children are treated fairly on the front end but can create problems depending on whether the children are active or inactive in the business. For example, if you have four children and two are active in managing the business and two are inactive, then their view of the business plan can be very different. The inactive owners are often most interested in immediate and ongoing cash flow and can disrupt business operations with their demands. If your primary goal is to maintain business continuity, consider recapitalizing the business ownership into voting shares and non-voting shares. Give the voting shares to the active owners and non-voting shares to the non-active owners.
  2. Transfer the business to the children working in the business and other assets of equal value to your remaining children. The biggest problem with this strategy is determining the true value of the business. This can be resolved by having a formal business valuation completed. If there are insufficient non-business assets, you can either create a promissory note from the business to be given to the inactive children or you can buy life insurance on your life sufficient to ‘equalize’ the estate distribution and have that insurance payable to the inactive children.
  3. Transfer business to all of the children equally and include redemption provisions. This is sometimes referred to as a put and call strategy and typically includes provisions to protect both the active and inactive children. The redemption feature acts as a built-in exit strategy that can be triggered by certain events or around certain expiration dates. For example, the non-active children can elect to sell (‘put’) their interests up until an expiration date; funding provided by the company and paid over a number of years. To protect the children running the business, once the non-active children’s redemption period has expired, the active children have the right to purchase (‘call’) the inactive children’s interests.   This strategy allows the children a time period to see how the relationships of their competing interests will work and a way to either cash out or gain control of the business based on fair market value.
The lesson here is the importance of pre-planning so that the relationships among your children as well as your business have the greatest chance of thriving. Next week, I’ll continue the discussion of business succession planning and the key elements of effective buy-sell agreements.