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Transitioning Strategies For Family-Owned Businesses
How To Think About A Wealth Plan That Takes Care Of The Family
By Robert Legan
Learn more about Robert by visiting his bio page.
Family-owned businesses provide many wonderful opportunities and some unique challenges. Many business founders pour their heart and soul into their business for years and enjoy the fruits of watching it grow. But as time goes on, they begin to think about retirement.
For family-owned businesses, especially those families where children are involved in the business, the retirement of the business founder can be a real conundrum. There are so many issues to sort through. Some of these issues are financial or business-related. But other issues are unique to family-planning and caring for loved ones.
If you or someone you know is facing this moment in life, here are some key considerations to help make the best possible decision.
Johnny is 55 with a manufacturing business that has done well. Johnny would like to retire soon but has some concerns for his family. He has a son named Billy who works in the business and has expressed an interest in one-day taking it over, although he also has expressed interest in starting his own new business. If Billy starts a new business, he would need financial support at the beginning.
Jenny is Johnny’s daughter and she is a school teacher. She is a wonderful daughter, yet she’s unmarried and does not have strong prospects to become a high-income earner. Her need for income for life is a key concern in Johnny’s mind.
Johnny has an important decision to make that is both a business decision and a family decision. Should he sell the business to a third-party and reap a windfall or should he transition the business to Billy? Which decision is best for Johnny? Which decision is best for his family?
There are no right or wrong answers here. These decisions can be very challenging and require a great deal of thought. To help sort through both options, let’s look at the impact of either decision on all three stakeholders.
What happens if Johnny sells the business?
Johnny’s need for retirement income is clearly addressed in this scenario. However, for the first time in his life, Johnny will have significant liquidity. Johnny will need a plan to help preserve and grow his portfolio to take care of his family. He will also need a great estate plan because much of the wealth will one day transfer to his heirs, Billy and Jenny. Prior to executing the transaction, Johnny should develop an estate plan to ensure that his assets are properly structured to mitigate potential estate taxes.
However, this scenario also substantially increases risk to Billy who will not inherit the business. This means Billy would need to start his own business and this would require Johnny to put a portion of his windfall at risk on a new, unproven venture.
What happens if Johnny transitions the business?
Johnny’s need for retirement income is not so clear in this model. If he transitions the business to Billy and Billy leads it successfully for many years, Johnny’s retirement is secure. However, if Billy falters and the business loses value, then Johnny’s retirement income is put at substantial risk.
The business may not be able to pay Johnny the earn-out he desires. Also, if he and Billy decided later to sell the business after it has slumped for some time, it will produce far less income than when its earnings were at their peak.
Johnny may consider playing a strategic role in the company to help increase the likelihood of the company’s success. In conjunction with a full or partial transfer of the business, Johnny will need a well thought out business succession and estate plan. The plans should address the major issues, including but not limited to, the type of transfer (gift versus sale), the amount of control and value transferred, the new company structure, and estate and cashflow projections.
What happens to Billy if Johnny sells the business?
In this scenario Billy would be free to start his own business and may even draw seed capital from his father’s liquidity event. However, Billy would be engaging in a venture of unproven financial merit. There is greater risk, both to Billy’s life-long earning potential and to Johnny’s seed capital, in this scenario as compared to Billy taking over the business.
What happens to Billy if Johnny transitions the business?
In this scenario, Billy walks into a known entity – the business in which he is already an executive. Billy would also have his father to guide him at critical moments and when important decisions need to be made.
Billy’s life-long earning potential is more secure in this path versus if he starts up a new business. However, Billy may not enjoy the experience of taking over an existing business as much as he would enjoy starting a new business. If he does not bring the same level of passion and commitment to his father’s business, then he may not see the same rewards as his father saw.
What happens to Jenny if Johnny sells the business?
In this scenario, Jenny’s need for life-long income and support are probably well secured. But for this to happen, Jenny and Johnny would need to be in alignment on the best way to preserve her portion of the inheritance from Johnny’s liquidity event.
Jenny would need to work closely with a financial advisor who could help her build a growth-oriented portfolio that yields enough income to support her while not putting the principal at too much risk. This would be a fine balancing act that would need careful analysis.
What happens to Jenny if Johnny transitions the business?
In this scenario, Jenny’s need for life-long income is less certain. While her father’s earn-out would lend substantially to the inheritance she would receive from him, if the earn-out is put at risk through business under-performance, she could face dire outcomes.
In this scenario, Jenny’s source of life-long income is directly tied to her brother’s ability to lead the business profitably into the future. Johnny is placing much of his daughter’s financial future in the hands of her brother. Billy would definitely need to be aware of and committed to this level of obligation.
One option that Johnny might consider is transferring the business cash-flows and assets to Billy while transferring the real estate the business owns to Jenny. In this scenario, Jenny could earn life-long income from renting the real estate and have a large asset on-hand if she ever needed emergency income.
As you can see, there are many options to consider and many details to take into account. Each of the scenarios above could be modeled to understand the potential financial outcomes for each family member. In my experience, this approach gives business owners comfort because they can see the financial implications of each decision.
None of the financial models, however, take into account the emotional weight that a business-owner will ultimately feel as they face decisions that have a long-term impact on the people they love most. This is where open and honest communication between family members, based on hard data, can protect the integrity of these relationships.
This is also where a partner can be of great value. When decisions become emotionally charged, as is so often the case with family members, it is helpful to have a third-party perform analyses and recommendations for differing outcomes.
While this may not make the decisions any easier, it will allow business owners to make informed decisions. If you or someone you know is grappling with issues similar to these, I would appreciate the opportunity to help them sort through options and make the best possible decisions for their family.