Succession planning for family business owners is one of the most talked-about areas of financial planning — but it is often poorly executed or even overlooked altogether.
The reason for the disconnect? Many people fail to recognize that families and businesses are run very differently. Families generally take care of each other based on individual family members’ needs — not by how “successful” each family member is — whereas owners or employees of a business are largely judged on successful results. These often-opposing forces can give rise to many potential missteps in the transfer of ownership and control of a business to family members — and the process can be even more complicated when you factor in the nuances of family relationships.
It’s one reason why so many family businesses ultimately fail in succeeding generations. According to The Family Business Institute, only 30 percent of family-owned businesses survive the transition from the first to the second generation; only 12 percent are still viable into the third generation; and only three percent make it to the fourth generation or beyond.
Let’s be clear on what we mean by “succession planning”: the term can mean different things to different people, but it ultimately involves planning for the eventual transition of the control and ownership of a business due to the incapacity, death or retirement of the business owner. Many commentators tend to focus on retirement, but it’s also crucial to have a plan that accounts for the death or incapacity of the business owner; these events are much more likely to cause chaos in the business than the owner’s retirement. As a result, succession planning should be seen as more of a “continuity plan” for the business and family wealth rather than an end point for the owner at retirement.
There are many different issues family business owners must consider when developing their succession plans. The goals that parents, children and other key management may have for the business can sometimes be very different, and at times, even conflict. For example, when selling the business to children, an owner may need to depend on the payments from the sale of their business for their retirement income and financial security. On the other hand, the owner’s children may want to purchase the business at a reduced price, as compensation for a potentially low salary earned while previously working for their parents. Relationships between family members can be strained if conflicting needs or interests aren’t handled or planned for properly. A successful transition between family members depends on honest, upfront communication early in the planning process, yet those conversations don’t always happen until conflict has occurred.
To help facilitate healthy communication and transparency, owners should enlist the help of skilled business advisors with experience in family transitions; these individuals have seen good and bad business successions, and can help owners address issues early on in the process. In addition to consulting with professionals — including financial advisors, accountants and legal advisors — owners should also consider the following questions regarding their future and the future of their business:
- When will you be ready to voluntarily let go? Business owners often perceive succession planning as a threat to their control; many owners believe they can and should remain in charge as long as they are alive. But in many cases, that outcome isn’t realistic. For one, a business may not sell when the owner is ready; and moreover, there’s a good chance the owner will lose control of the business through incapacity or infirmities of aging, if not through retirement.
Assuming that the owner voluntarily retires, the question becomes: when will the owner be ready to give up control of the business? And assuming that the business stays in the family, when will the owner be ready to accept all decisions made by the successor child or children, even when they don’t agree? Once the owner decides when to give up control of the business, he or she can reasonably assess the following:
- Whether their children are capable of taking over the company
- Whether there is sufficient cash flow to support the sale of the business to their children
- Whether the business will need to be sold to a third party
To be successful, the succession planning process should be initiated and guided by the business owner; otherwise, he or she may feel forced to confront issues they would prefer to avoid, which may not lead to open and honest discussion.
- Do you have children who are capable of running the company? It’s important to remember that the family business is often the owner’s life work; therefore, it may be difficult for them to imagine not running the business and trusting that someone else can operate it as well as they did.
Family business owners need to honestly ask themselves whether their child or children can run the company properly. In some cases, parents know their children too well to be objective about this decision; after all, they have seen all of the silly mistakes their children have made growing up. At the end of the day, the owner should approach the decision as a business owner first and as a parent second. Preparing potential successors also requires ample training and communication — transferring management responsibilities to a child who is not engaged or unable to operate the business competently and make sale payments can put the future of the business and the owner at risk. Since they likely have an inherent bias toward their children, seeking input from non-family management and other advisors may be critical for the owner to make this decision wisely.
On the other hand, the owner’s child or children may have no interest in running the business at all. Dividing ownership between children who have no role in the business with those that will assume the primary management roles can lead to disaster for the children’s relationships with each other. Parents can use their estate planning documents or life insurance to reallocate how their assets should be transferred to the children who are not involved in the business so that all of their children are treated as fairly as possible.
- Who can run the company today for the owner if the need arises? This question is often overlooked by many commentators and planners: if the owner becomes incapacitated or dies unexpectedly today, is there a plan in place to keep the company operating as smoothly as possible? If not, this can be problematic to the success of the owner’s continuation plan. In cases where there are other owners within the business, a buy-sell agreement can be helpful in covering next steps in the event of an owner’s death or incapacity. If there is only one owner of the business, then the owner, the owner’s spouse and the management team need to have a plan in place for such occasions, and make sure that the arrangements are regularly reviewed and updated. Of course, it’s imperative for the owner to have an estate plan that formally authorizes another person to step in and take control of the company in the event of his or her death or incapacity.
- What level of financial security does the owner need from the sale of the business? Since the family business often represents the vast majority of family wealth, the owner may be dependent on the sale of the business to maintain his or her current lifestyle. With appropriate financial planning, the owner can determine how much cash they need from the sale of the business to maintain the lifestyle they desire.
This is also the time to enlist the help of an experienced business appraiser. In many cases, business owners have unrealistic expectations about the value and potential salability of their business. In our experience, very few businesses sell for the price the owner is expecting. Whether the business sells to family members or to an outside party, an appraiser can provide a realistic expectation on the value of a business, which is necessary to assess an owner’s retirement needs or to establish a value for a gift if a “bargain” purchase is provided to family members.
- What will the business look like in the future? While most of the questions above are relevant to the owner or their children, this question focuses on the future health of the business itself: how viable is the business over the next five, 10, 15 and 20 years? How much capital will be needed to expand and grow the business? Do the children and/or management team have the ability to manage the growth of the business? Conversely, is this a business with limited growth opportunities for the future? If the answer to the latter is ‘yes’, does the owner really want to transfer a declining business to their children? In this case, it might make sense for the owner to sell the business to a third party now to maximize the family’s wealth for the long term.
Communication is the key to making any transition work. Parents, children and other members of the management team need to discuss the hard issues and not make assumptions about what is expected to occur. They have to honestly discuss their respective needs, expectations and fears. They need to try to agree on shared values and goals to be achieved. If all of the parties are being open and honest with each other, then the likelihood of a successful transition is greatly improved.
Co-authored by Dean Stange, J.D., CFP® | Principal, Senior Financial Advisor, Wipfli Hewins Investment Advisors, LLC
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