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The Five Biggest Mistakes People Make When Transferring A Family Business To The Next Generation
How You Can Avoid These Costly Mistakes
By Robert Legan
Learn more about Robert by visiting his bio page.
I’ve seen many families over the years grow successful companies that provide a great quality of life for the ones they love. Whitnell, in fact, was born out of a family business and still holds true to these roots. Serving families is an important part of our heritage and mission.
While family businesses provide tremendous benefits, they also present challenges. One of the biggest challenges comes into play when a senior family member, often the primary equity holder and sometimes the founder, decides to retire. If the founder’s children have shown interest in the business, the founder often wants to transfer the business to them. This should be simple, right? I mean, the family owns the business. So it should be a straightforward private transaction, right?
Actually nothing could be further from the truth. Transferring a family business from one generation to the next comes with challenging financial and personal issues. In fact, due to family dynamics, this single event could destroy the very fabric of the family if it is not handled well. I would like to illustrate the five biggest mistakes I see people make during a transfer so you can avoid them.
The five big mistakes
Here are five mistakes I often see families make when they transfer a business to the next generation:
- Not having a plan
- Not building the right team
- Not anticipating the tax implications
- Not balancing control with equity
- Not formalizing a succession plan
Not having a plan
Most people who sell a privately owned business to a third party underestimate the amount of time it takes to complete this process. Most entrepreneurs are great at running businesses, but are not prepared to address the complexities of selling a business. Some common steps that they go through often include these:
- Having the business professionally appraised by an independent third-party
- Completing the due-diligence process to ensure the business is unencumbered for sale
- Negotiating the fair market value of the equity and how and when it will be transferred
- Negotiating the earn-out process for the stakeholders so they have an exit that maintains the stability of the business
- Drafting all agreed upon points into a set of legal documents
So if you transfer a private business to the next generation, rather than sell it to a third party, you can avoid all of this work, right? Can’t you just say to your loved one, show up for work on Monday and take over where I left off? The short answer: no. Why?
Transferring a business to the next generation requires a delicate balance between taking care of your children, while ensuring that you and your spouse can enjoy a comfortable retirement. Common considerations include:
- How much equity can I afford to gift (give away) to my children, while ensuring my spouse and I enjoy a comfortable retirement?
- How can I sell a portion of the equity to my children when they don’t have cash to pay for it today?
- How can I mitigate potential taxes associated with transferring my business?
A sound plan needs to take into account all of the considerations of a third-party sale while also addressing your family’s financial needs. Without a plan in place, it is very easy to overlook important details that could produce problems down the road.
Not building the right team
Many family business leaders believe that they can rely on individuals who helped them run the business to successfully transfer the business. Usually this assumption is wrong.
The process of transferring a family business to the next generation will require a team of experts in various disciplines. That team could include the following professionals:
- Family business planner to shepherd the process
- Financial advisor
- Business valuation expert
- Business CFO/Controller
Each of these professionals brings a distinct skill-set and perspective to the process.
Not anticipating the tax implications
The transfer of equity between family members raises some very significant tax concerns. Many family business owners are unaware of potential tax consequences of gifting equity to family members. If the equity is transferred without due consideration for tax concerns, the tax consequences could be very significant.
There are several important considerations in these situations. The lifetime cap on exclusionary gifting is $5.34 million dollars, which means that an individual could gift up to this amount without incurring gift taxes. Any amount gifted above this threshold would be subject to gift taxes which may significantly erode the value of the equity.
In addition, a professional business valuation may allow you to take “discounts” for tax purposes, which may allow you to transfer more equity under the exclusion. Each situation is unique and requires careful analysis of the tax outcomes.
Not balancing control with equity
Many entrepreneurs want to transfer the value of their business to the next generation while still maintaining some level of decision-rights to keep the business on course over time. Other business owners know that certain children are ready to run the business and make good decisions while other children are not ready. Even so, those children need financial support.
There are techniques that may allow you to separate decision-rights from equity, value from voting. But many business owners do not realize that they have these options. So they often opt to transfer the equity to a trusted, stable child and task them with caring for siblings. This runs the risk of complicating relationships between children and eroding the fabric of the family.
Not formalizing a succession plan
Most parents will tell you that each child is unique and gifted in their own way. Some children have the education, acumen and ability to step into leadership roles in a family business. Some children can be solid contributors, but not leaders. Other children may not want to be in the business at all. What happens if there are leadership roles that need to be filled, but your children are not equipped in that area?
This is where you need a succession plan. Most family businesses fall woefully short in this area. The founder of a business is often a uniquely gifted individual whose experience and skills are hard to replace. Many family businesses have trusted long-term employees whose contributions have been critical to their success. How do you transfer control to these individuals and what does the operating plan look like?
If you don’t have answers to these questions, your business may be at risk. The succession plan is a critical component to ensuring the business is successful for the next several generations.
How to avoid these mistakes
These five mistakes are all avoidable, with the right plan and team. A family business should be a source of comfort, stability and even identity for a family. But the transfer of a business to the next generation could be a boom or a bust. If you or someone you know could benefit from our knowledge in this area, I would welcome the conversation.
The information contained in this article is provided for informational purposes only. No illustration or content in it should be construed as a substitute for informed professional tax, legal, and/or financial advice.