The major reason why family businesses fail to transition between generations is dysfunctional family dynamics, not taxes. In September of 1997 (when taxes were much higher than they are now), the Journal of Business Venturing published a survey of family business owners about the factors for the breakdown of family business transitions. The study, and findings published in article “Correlates of Success in Family Business Transitions” reported 60% of the respondents said that the relationships among the family members were the reasons a business did not transition. They cited a lack of communication, trust and affinity among family members. 25% of the respondents replied that transition failure was the result of the second generation not being adequately prepared to assume ownership and control. In only ten percent of the cases a lack of tax planning was indicated as the cause of the failure. Lack of organizational structures, such as boards of directors, was never indicated as a cause for the failure of a business to transition.
Five Key Business Transition Questions for Families to Ask
In planning for a business transition, one should ask:
- Who will succeed to the ownership if the owner were to die or become disabled within the next five years?
- How would the transfer of ownership and future management occur?
- Who will share in the growth of the business?
- When and how would future business growth be shifted to others?
- Who will operate and control the company?
Remember ICE in Family Business Succession
In family business succession planning, there are three elements in the discussion, with the acronym “ICE”
I is for Income. What are the current and future sources of income for the business owner and spouse? Is cash being drawn out of the business in the form of salary? If the business owner were to die or become disabled, could a spouse draw cash out of the business? How will the non-active family members receive income from the business? In the form of dividends such as received from preferred stock? In the form of S Corporation distributions? In the form of real estate owned by a family limited partnership?
Only when a business owner, spouse and family members are assured a steady stream of income will the discussion about succession continue. Income can be assured through contractual arrangements such as employment agreements, bonuses, deferred compensation, consulting and director’s fees, in addition to stock appreciation rights.
C is for Control. Who will control the day-to-day operations of the business? Control can be affected through stock ownership such as voting and non-voting common shares or preferred shares. Contractual arrangements can set forth the control of the business through articles of incorporation, codes of regulations, by-laws, voting trusts, close corporation agreements and buy-sell agreements.
E: Equity Ownership
E is for Equity Ownership. Who will have and benefit from the equity ownership of the business? When, if ever, will the value of the ownership be realized?
Sub-Plans for Every Business Succession
A business succession plan should have three sub-plans:
- Financial Succession Plan – the manner in which stock or other financial interests are transferred inside or outside the family.
- Organizational Succession Plan – Who will assume the role of CEO, of President, of Treasurer? At which times –death, disability, retirement? Who will serve on the Board of Directors?
- Operational Succession Plan – will the successors be trained in operating the business? By whom? Over what periods of time? Could a “Business Skills” Trust serve as a means of educating younger generations in the operation of the business?
By discussing these issues with, and reaching a consensus among family members, a business owner will greatly increase the chances that the family business will successfully transition between generations.
James G. Dickinson, a shareholder at Cavitch, Familo & Durkin focuses on business law including corporate succession planning and tax planning. For more information about setting up a successful succession plan for your business contact Jim for more information.