Most family business owners expect their thriving enterprises to transfer to the younger generation with minimal fuss and bother. Reality, though, can be far different. Absent a carefully designed plan, misunderstandings and disputes can turn any business transition into a costly train wreck.
Parents must analyze the skills and proclivities of their children before assigning future management roles. While such assessments can help smooth the transition, even the best of such plans needs the support of legal documents that ensure power flows to the right people and sufficient cash is available to make everything happen on cue.
Setting terms
Often the most important transition document is the so-called "buy-sell agreement," which specifies how ownership will be allocated and how the sale of shares will be funded. "A buy-sell agreement is crucial to a smooth ownership transition for a family business," says Gregory Herman-Giddens, a board certified specialist in estate planning at the law firm of TrustCounsel, Chapel Hill, N.C. "It allows for one or more of the children who are active in the business to buy out a parent who retires or dies."
Buy-sell agreements typically cover an array of issues that go beyond the basic transfer of ownership upon the death or retirement of the original owners. They also typically cover how ownership will transfer when one of the children exits the business, either through death, disability or even a decision to go into another like of work. Will the business itself, as an independent entity, buy up the shares of the departing individual? Or will the remaining siblings as individuals have the right to buy up the shares?
Here are some other issues that buy-sell agreements often cover: What if one of the siblings desires to sell shares to an outside third party? Must the siblings be offered the shares first? How much time do they have to reach a decision? And what if a child wishes to withdraw capital from the business? How much money can one individual owner take out, over what period of time, and how much prior notice must be given to the other owners?
These agreements also often specify the methods by which internal disputes are resolved. Some issues will lend themselves to arbitration or third party mediation. For those which can be resolved by voting, the agreement will specify who has the power to vote and whether a simple majority or super majority is called for.
Buy-sell agreements can be real life savers in sticky situations. For example, they can obviate unexpected shifts in power to unqualified individuals. "Often one member of the second generation receives share of ownership, then gets divorced," notes John J. Scroggin, a partner at the estate planning law firm of Scroggin & Company, Roswell, Ga. "That individual's former spouse now owns the equity. Unreasonable demands can follow, and that can be a thorn in the side of the family."
The solution, says Scroggin, is to draw up clauses in buy-sell agreements that anticipate common and costly events such as divorce or unexpected death. To do this the document should mandate a "call right" on shares that are gifted to children. The "call right" is a provision that empowers remaining family members to buy out the shares of a non-family spouse who may survive the divorce or death of a family member who was in an ownership position.
Avoiding Problems
Successful buy-sell agreements include provisions that anticipate and obviate common problems. Here are some tips from Scroggin, who has studied the hidden pitfalls of family business transitions:
- Non-compete agreements
Suppose one family member wants to exit the business but asks for some compensation in return. The buy-sell agreement may include a clause that specifies the value the individual will be paid for his or her shares. That sounds fine on the surface, but it can backfire if the individual then goes out and starts a business pursuing the same customers.
"If an individual is paid a lot of money for their share of the business, but nothing stops the person from competing for the very business that was purchased, why should the amount paid be any more than the value of the hard assets?" poses Scroggin.
The way to avoid this pitfall, says Scroggin, is to include a "non-compete provision" that prohibits the departing family member from engaging in a similar business for a set period of time. The agreement can also specify that the departing owner may not solicit the organization's current customers or vendors, or utilize any of its trade secrets.
- Tax implications
"Never provide for a business transition without having a tax expert review the documents and the plan," says Scroggin. "Proper planning can substantially reduce the tax cost of the transaction." In many cases, for example, the sale of the business to family members can create substantially more taxes than a gift.
- Funding
It's important to set up vehicles for funding the buyout. Often life insurance provides funds for buying the shares of an owner who has died. And if the owner is retiring, there can be provisions for installment payments over time.
- Exit strategy
Suppose one child wants to leave the business after some time passes. How much will that individual be paid for his or her shares? This should be spelled out in a legal document that you can think of as a kind of pre-nuptial for business owners. "Two people who own a business together are even more likely to divorce than a husband or wife," says Scroggin. "There should be an agreement that defines their relationship and obligations and describes how they can exit the relationship."
Starting early
Before legal documents are drawn up, the proclivities and skills of new generation members must be assessed. The process should start with individual interviews, assessing the goals of each family member. Then goals should be incorporated into documents that ensure the smooth process of business and wealth transfer.
Many family business owners hesitate to draw up transition plans because of the current uncertainty in tax laws. Such hesitation is not necessary, says Herman-Giddens. "A qualified attorney can create a flexible plan that anticipates many different tax scenarios. So put a plan in place now and have some peace of mind that you and your family are protected. You can always update your plan in a year or two."
Indeed, delay can be costly. "Don't wait until one of the owners is sick or gets ready to retire," says Herman-Giddens. "There can be an unexpected incapacity or death at any time."
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