In our March issue, Boating Industry profiled how to plan your exit strategy and the different pathways for transition. Below is a preview of this article, highlighting how to begin the process of generational succession planning. For more details on transition, see our March issue.
Family businesses have many struggles, but none so intricate as planning for a generational transition of ownership. Some 70 percent of family-owned businesses fail or are sold before the second generation gets a chance to take over, according to the Harvard Business Review. Those numbers only get slimmer as you move through the generations.
Estate planning is very important for a family business, but life planning is even more so; while it is important for an owner to plan for the event of their death, the more likely event is that they live.
“Lifetime planning is going to deal with at what point do the business owners transfer their ownership in the business to family members, key employees or an external sale, and how does that impact the individual’s role with the business, in terms of level of involvement and their controlling interest with the business,” said Don Bielen, director of business advisory services at The Rainier Group, Inc. “A detailed lifetime transition plan deals with how the ownership should be transitioned, how all the operations are handed off to the next generation, and ultimately at what point you transfer the controlling interest to the succeeding shareholders.”
The lifetime transition plan is going to look at tax implications; skills and capabilities; the passions, goals and interests of the next generation. The plan should do everything possible to align those respective elements, all while at the same time determining how to meet the financial security requirements of the exiting shareholders and keeping the business healthy.
“One key tool that we believe is critical in that lifetime transition planning process [is a] detailed financial analyses of the business, its value, its cash flow, and the pre-cash available to fund an internal transition, relative to the individual’s personal needs, considering all their assets and all their income sources: business income, real estate income, distributions for retirement accounts, earnings from investment accounts, and then determining how to meet those requirements relative to the transition and the growth perpetuating the family business,” said Bielen.
Owners who want to pass their business on to a family member need to begin planning at least 10 years in advance to ensure the success of the transfer, according to David Spader of Spader Business Management. This gives business owners time to work with the family member purchasing the business and determine if that person fits the motivational profile.
“There are several different methodologies we use and tools we can use to do that, and what we’re finding more and more so is that there are many in the [next] generation that don’t [have that motivation], and the sooner we can identify that they’re not ready or that there’s a significant question about whether they want to be the next owner, the better, because again the further out we do that, we can ask the right questions and make sure people are prepared for it,” said Spader.
In one case, Spader was working with a dealership that had an adult child who was confident he wanted to be the next owner. They began a coaching conversation for a period of three years to discuss all that was involved in owning the dealership and what the role actually looks like.
That adult child came out three years later with a better picture of what it meant to be an owner and felt confident knowing he did not want it at all. As this individual was a strong performer in the dealership, any sane person who does eventually buy the business will keep him on the staff where he can work in a role he enjoys.
“That was really helpful for his parents, because they then knew [it was] off the table,” said Spader. “Because they were looking 10 to 12 years out, we had that two to three years to make that determination without a lot of pressure.”
How to execute succession
If a family member is interested and does fit the profile, it is time to look at all of the gritty details of succession. There are three different values for the business to consider: the fair market value of a business, based on its earnings and equity; sustainable value, which is the value the owner needs to realize to meet their financial security requirements post-sale; and the transition value, which is what the business can afford in terms of financing an internal transaction.
“With a family transition, you look at what mom and dad need for financial security, what the business is worth from a fair market standpoint, but also what value that the business can actually fund, because the second generation often times has inadequate resources to fund an internal purchase,” said Bielen. “It’s a balance between mom and dad's financial security, again what the business can afford and then also what the next generation potentially brings to the table.”
One wrinkle that can arise in succession planning is the inability of an existing generation to let go. On the financial side, the outgoing generation will at times continue to exert influence and control until they have no financial responsibilities.
“As long as they depend on rent or cash from the business to fund their retirement, it’s going to be very difficult for them to let go of control, and they shouldn’t necessarily let go of control either if they still have a majority of the risk,” said Spader. “So the goal should be to get them off of those and make the business independent as quickly as possible. Another way to say that is they need to be at a point where they don’t need any income from the dealership to retire the way they want to.”
The need for open avenues of communication and trust is particularly important for family succession. While the financial, tax and legal ramifications are important to consider, they are not often what will impact a transition.
“That is the primary reason why most family business transitions – 70 percent-plus – fail, because of the breakdown of trust and communications through that process,” said Bielen. “I strongly encourage an individual to use a business transition succession planning expert that works as a facilitator with the attorneys, the accountants, the family counselors, the insurance individuals, to facilitate and manage this process, because it is truly a process that requires expertise, skills and experience to effectively work with family businesses and its owners.”
(Find a list of experts in our March issue.)