Succession Success

Proper planning when passing your family business’s reins to the next generation can help ensure a smooth transition.

By George N. Saliba, Managing Editor On Dec 18, 2017

Drafting a will, purchasing life insurance, or experiencing the passing of an elderly parent may each – in their own way – remind us of our mortality. While we all wish to lead long, healthy lives, considering retiring from one’s family-owned business and turning the reins over to adult children is yet another thought about aging – and a factor experts say often causes business owners to delay succession planning.

Procrastination surrounds succession planning for additional reasons, including, but not limited to: the owner not wanting to “lose power” while he or she is not entirely retired and still has “one foot” in the business; family-dynamic-based debates about which adult child, if there is more than one, should lead the business; and/or adult children who have ensconced themselves in other careers and are, therefore, uninterested in taking over the family business (in such cases, a business owner may choose to procure an outside buyer).

Jason Pourakis, partner and practice leader for entrepreneurial services group in New Jersey at the accounting firm of Mazars USA, says, “In terms of succession, it should be a much longer process than what it normally is: The light switch goes off [when] somebody gets injured or sick, and we need to do something. We try to address the topic earlier on, when we start to [think]: Maybe [the owner] should retire or give up more responsibility. We want to push the actual thought of transition or succession.”

In the case of multiple adult siblings who are involved in the family business, succession planning may be a hornet’s nest of in-fighting and rivalry, depending on broader family dynamics. What if one adult child is more suited to run the business than another child, and both children sincerely wish to do so? Overall, even if there is no fighting, who will assume different positions within the company?

Scott T. Bumbernick, manager at the accounting firm of Smolin Lupin & Co., says, “I kind of play the intermediary: ‘Okay. How are we going to resolve this?’ With an unbiased, third party involved, [people] say, ‘Look. This is what they are saying; this is why they are saying it.’ It keeps the emotion out of [the equation]. Because if it is just the family, some have their own dynamics they are trying to fight through.”

William Hughes, partner at the accounting firm of Grassi & Co., says, “There are instances when the family members may not be the best people to take over. I have a client with an extremely competent [non-family-member] CEO who is actually better than the family member. The family member will be active and has stock ownership in the company, while the CEO has a very minority stock ownership. But, the CEO is a much stronger person to lead the company in the future, and the father understands that. That’s a tough one, for him.”

Succession planning may often also encounter ownership dilution issues: When the business was first started, it might have supported the needs of only a few families, but as the genealogical tree spreads outward, multiple, related families – with new spouses, cousins and grandchildren – can strain the business’s resources.

Pourakis says, “There is [often] a lot of infighting in terms of the share of profits and overall compensation. To stem that, [we say]: In every generation, if you are in the business, you are in the business. If you are out, then you are out. We will then normalize the estate.”

He adds, “We will use the patriarch example: He has an estate that is worth $10 million. The value of the business is in that estate, and it is worth $5 million. We take a hard look at which children are going to remain in the business and make sure that they get their proportional share of the business. Then, if you have any children outside of the business, we would equalize the estate based on the value of the business, with liquid assets.”

As a separate issue, small business owners may be accustomed to affluent lifestyles, which the business must continue to support in the owner’s retirement, even though he or she is no longer actively involved in the company and has, by definition, ceased to add value to it. This scenario can often be prevented via proper planning, prior to the owner’s retirement.

In a case when a family-owned business learns that the adult children are, in fact, not taking over the business due to their own, aforementioned independent career ambitions – and an outside buyer must be found – early planning is essential for maximizing the business’s value.

Gerald Shanker, CPA, partner, KRS CPAs LLC, says, “One common problem I see, especially when the seller is the person who started the business or has inherited the business, is that they usually think the business is more valuable than it really is. When [an outsider] buys a business, [he or she] does not really care about the history, what happened, or who founded it – and they don’t pay anyone extra because they started it.”

He adds, “A business buyer is purchasing future income and cash flow. A fair market value buyer, as opposed to a strategic buyer, is evaluating all the places where he or she can invest his or her money, and the risk: how much they expect to receive in the future from that investment, and the risk that that amount might not be received. They weigh the risk – and the potential return – in evaluating how much they will pay for the business. Again, they don’t really care what has happened in the past.”

While accountants are not psychologists, their demonstrable expertise can, at times, help reveal the true value of a business to its owner (above); and, as mentioned, act as an objective third party to perhaps defuse sibling rivalry.

In each scenario, steps can be taken years before the “passing of the torch” to ensure the business’s future viability. When selling to an outside buyer, Pourakis says, “If there isn’t going to be succession, but we need to do something to sell, I like to start backwards: ‘What do we need, net of taxes, that is going to satisfy our client’s retirement?’ This is a number at ‘X’ amount of interest and appreciation each year. Then, we need to determine what [business] sale number would be needed to get to that net number.

“It is another one of those honest discussions, where [the owner] may be at $100 million, but, knowing even multiples and the value of the company, [learns] that it is only [worth] $50 million. It is just using numbers. From there, similar to succession, it is not [flipping] a light switch. The focus then is to say: ‘Okay. Let’s put a three-year plan in place to drive EBITDA. You need to truly focus 100 percent on the EBITDA multiple, what our perceived value will be, and then take steps to get to drive that EBITDA number up, over a three- or five-year period, prior to sale.” Pourakis reiterates that this will make the business more attractive to prospective buyers.

In a broader, more panoramic view, at the 25th Annual New Jersey Family Business of the Year Awards Luncheon, recently held at the Crystal Plaza in Livingston, Al Titone, NJ district director at the US Small Business Administration, revealed that “… [Only] 30 percent [of family-owned businesses] make it to the second generation. Ten percent make it to the third generation. That’s amazing. And that sounds a little bleak, doesn’t it? Guess what? It is about two to three times what the average small, non-family-run business gets. So, actually, you are way ahead of the curve.”

According to Titone, these survival dynamics arise not only from many of the very issues discussed on these pages, but, additionally, work/life balance and its relationship to “burnout” – and the ability for the companies to cope with change. Titone concluded, “A smart family business keeps its edge by bringing in that second or third generation.”

As with any endeavor, the fascinating excitement a business founder originally experienced may fade over time, unless he or she has become enthusiastically, career-long engulfed in the quest for continuous mastery surrounding the business’s products or services in a changing marketplace. With succession planning, at least some owners may do well to heed a proverb which advises: “If you must play, decide on three things at the start: the rules of the game, the stakes, and the quitting time.”

 

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