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Is Your Family Business A Sitting Duck?

Careful succession planning will ensure a smooth transition.

By David L. Risdon

For a number of years, small-business and family-farm lobbies have been rallying for the repeal of estate taxes. The complaint is that with the estate tax so high, the family business or farm needs to be sold just to pay the tax bill. In 2000, an estate tax repeal sailed through Congress, only to be vetoed by President Bill Clinton. With the election of George Bush and the Republicans taking control of Congress, “death tax” abolition advocates were encouraged. As the economy faltered, however, the primary focus of President Bush's tax-reduction plan became cuts that would provide a more immediate stimulus to the economy.

The $1.35 trillion tax cut passed by Congress over this past Memorial Day weekend did not abolish the estate tax. It did, however, provide for an estate tax reduction—with some relief immediately—and the balance phased in over the next few years. The legislation provides for the elimination of the estate tax by 2010. As a result, there continues to be some discussion regarding how reduced estate taxes—combined with effective estate planning—will help more families hold on to their small to mid-sized businesses.

But what about ensuring the value of the business when it is passed on to a new owner? This is one of the primary issues that must be considered in effective succession planning.

All in the family
Keeping the family business in the family can be an important objective. Even if you are a business owner planning to pass your family company on to your heirs, you need to consider your options carefully.

In many cases, business owners find that heirs, even though they may be well-educated and capable, simply are not enthusiastic about running a business they have “grown up” with. An alternative is to bring in “professional” management to take the helm of the company as the owner moves into retirement. In certain situations, such a strategy may work perfectly. Some business owners, however, may feel it is risky to entrust the health and well being of their business to an “outsider.” Business owners who fail to put in place a viable succession plan are opening the door to competitors who will not hesitate to undermine the viability—and eventually the value—of the family business. If you don't have an heir who is capable of running your business, and you're not comfortable with immediately entrusting the future of your business to a nonfamily member, how do you prevent your family business from becoming a sitting duck?

There are several alternative strategies to consider that will enable a business owner to transition a business while preserving control and company value. These are the transition sale, the partial buyout and the full buyout.

The transition sale
A transition sale provides a way for a business owner to comfortably transition away from a business, while at the same time preserving the business' value. Such a sale could take many forms but essentially would encompass:

  • An initial transaction, whereby a substantial percentage of the business (anywhere from 40 percent to 100 percent) is sold to a third party.
  • An agreement whereby the owner continues to manage the business for some time (typically three to five years) and is offered incentives as the business experiences continued success.

Sales of mid-sized businesses often end up taking this form because buyers want previous owners to continue to manage the business until the new owner is comfortable that a capable team is in place. Many business owners, however, are under the impression that they will be “working for some MBA at the head office.” Or they fear that they will be ousted within a few months once the business is acquired. You must remember that when owners sell a business, they can negotiate the terms of the sale. Those terms can include specifics to ensure owners they will remain involved in the business for years. This knowledge gives them confidence that they can smoothly and successfully transition into a “post-ownership” mode.

Business owners without viable succession plans are opening the door to competitors.

The partial buyout
Suppose a business owner sells 40 percent of his or her company, valued at $10 million, for $4 million in cash. The business forms a board of directors and the buyer is represented on the board. The business owner holds the majority of the common stock of the business and continues to manage the company. The buyer has an option to buy out the remaining 60 percent of the company's common shares — held by the business owner — at the greater of $6 million or a valuation that is based upon a specified multiple of the company's annual cash flow. The business owner has the right to “put” his or her 60 percent share of the business to the buyer — using the aforementioned valuation methodology — any time after five years from the date of the initial transaction.

In this scenario, the buyer invests an additional $1 million in the business to fund future growth. The form of this investment is nonvoting preferred stock. If future performance of the business suffers to the extent that the timely payment of the preferred dividends can't be made, the preferred shares become voting, giving the buyer a majority control of the business.

This deal structure offers substantial incentives to the business owner to remain involved and excited about growing the business. It also provides the business owner with the comfort of knowing he or she can gracefully transition out of that business when it is the appropriate time. Lastly, the structure protects the buyer if the business fails to perform up to expectations. If the preferred dividend payments are not made, the buyer can take control of the business.

The full buyout
In the case of a full buyout, the business owner sells 100 percent of the business, valued at $10 million, for $8 million in cash and an “earn-out” based on future profits. These should be worth anywhere between $2 million and $4 million over the next three years. The former business owner signs a three-year employment and noncompetition agreement with the company.

Under the terms of the employment agreement, the former business owner receives a salary, performance bonus payments and reasonable perquisites. He continues to manage the day-to-day operations of the business.

The business forms a board of directors and the former business owner has a seat on the board. If the former business owner is terminated, he would receive the balance of the compensation due under the employment agreement, along with the remaining earn-out payments due. These are based upon the future performance of the business.

Like the partial buyout, this deal structure provides substantial incentives to the former business owner to remain involved and excited about growing the business. He also gets a three-year period to transition out of the business.

In addition, this structure offers some protection—through the profit “hurdles” that must be met before the earn-out payments are made—to the buyer if the business fails to perform up to expectations.

Careful planning is key
Estate planning for succession of a family business can be complex. Although the examples described in this article have been simplified, they offer good alternatives to a family business owner who is seeking to transition from the business while preserving its value.

Although tax strategies are clearly important, one of the most critical issues often overlooked in the estate-planning process is the question of who will be running the family business once the owner is no longer at the helm. With careful planning, no family business has to be a sitting duck.

David L. Risdon is a managing director at Consilium Partners, a Boston-based investment banking firm, which offers M&A advisory and capital raising services to mid-sized businesses. He can be reached at dlr@cpboston.com.

 


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