Tips for transitioning your business to the next generation
Natalia Murphy, Senior Wealth Advisor
Successfully transitioning a family business to the next generation is, as the saying goes, easier said than done. The business owner must be farsighted and prepared to undertake a multi-year project requiring careful consideration of a myriad of business and family concerns, all while balancing potential estate planning and tax issues. Following are tips that you, as a business owner, may find helpful to plan for the succession and transition of your business to the next generation.
Evaluating the Long-Term Prospects for the Business
You’ve done well building your business and have succeeded in making it a profitable enterprise. As you contemplate transition of the business to the next generation of your family, it’s important to evaluate the long-term viability and profitability of the business. Is it highly likely that the business will continue to be profitable when your children succeed you? Consider these factors:
- How is the business positioned in the current market?
- What is the projected trajectory of the business?
- What are the current and foreseeable industry dynamics?
- Are there potential disruptions and other external threats?
If you are satisfied that the long-term prospects for the business look good, then it becomes entirely a question of preparing the next generation for the transition.
However, if changing market conditions or other factors portend a downturn for the business, then you’ll need to consider whether holding on to the business long-term may be contrary to the family’s interests. In some cases, it might make the most sense to sell the business to a third party and redeploy the capital in another way with better long-term prospects.
Preparing the Next Generation for Transition
At an appropriate time, the next generation should be allowed to acquire firsthand experience managing the family business. In this way, the future family business leaders gain invaluable skills and also have an opportunity to evaluate whether, and how closely, taking on leadership of the business matches their personal goals.
- A classic way to start the next generation’s journey within the family business is to find a first role for the child or children. This role should align with the child’s maturity and experience. The child can start in an entry level position and, over time, take on greater responsibility within the business.
- Another approach adopted by some families is to require the child to work outside of the family business for a period of years before joining it. Fortified by this independent experience, the child often is given greater responsibilities at the outset when joining the family business, and afforded opportunities to make independent decisions or even lead a division of the business.
In either case, the objective is to provide the child with sufficient exposure to different business divisions and operational roles within the family business. In this process, the child is going to need coaching and mentorship under your guidance to develop strong decision-making and leadership skills. Moreover, you will have an opportunity to impart to your child the values and culture that are important to you and which have helped to make your business a success.
Choosing a Successor and Communicating Your Decision to the Family
When you have more than one child contending for a leadership role in the family business, you will need to objectively evaluate which child (or children) has the requisite abilities to manage and lead the business. If you expect that your decision may lead to a conflict among the siblings, the best approach is to communicate your decision to each child separately and with complete frankness. By all means, make sure to avoid an element of surprise about who will succeed you. Such a surprise may cause friction among siblings and sometimes results in unwelcome litigation. Having frank discussions about succession well before you hand over the reins can get you the buy-in from all of your children and help ensure a smooth transition.
When deciding on a successor, you’ll also have to consider the child’s inclinations and personal aspirations. To be sure, not every child wants to build a life working for their parents’ business. For the succession to be successful, the key is to make sure there is an alignment between your goals for the business and the successor child’s personal and family goals.
In some cases, the business may have numerous family shareholders, each with their children, and there just aren’t enough opportunities to employ everyone concerned. Then it becomes important to provide equal access to leadership roles and select future leaders based on merit, per clearly developed policies and guidelines. Some families with numerous shareholders have institutionalized the education and development programs for next-generation leaders, as well as their merit-based selection process.
Ensuring a Smooth Transition Through Estate Planning and Governance
In furtherance of your succession plans, you’ll need to engage in estate and tax planning to achieve legal transfer of ownership. You’ll also need to choose who you would like to act as your agent if you ever become incapacitated, as well as to ensure the necessary documents are prepared.
Perhaps you intend that all your shares of the business should go to one child. If you have more than one child and want to achieve equal economic disposition among all children, you may have other sufficient non-business assets to leave to those children who are not receiving the business. But if the value of the business eclipses all other assets, investing in an insurances policy can help bridge the gap to leave a sufficient legacy for those children not receiving shares in the family business.
When you intend to pass your shares of the business to more than one child, the question arises: Will this situation create active and passive shareholders? If yes, it might be a good idea to split the business ownership into voting shares for active shareholders and non-voting shares for passive shareholders. Thinking ahead, it will be beneficial to consider and address potential areas of conflict or tension among future multiple shareholders. Major conflicts typically happen on the issues of dividends and excessive spending by particular shareholders, and employment and compensation of family members within the business. To help address these conflicts, consider implementing:
- Guidelines for dividends, with flexibility to balance the capital needs of the business against the income to the family
- Guidelines for determining fair compensation of shareholders employed by the business
- Employment policies for family members specifying the level of education and experience required, ways they can enter the business, and how the business would determine their advancement, separation and compensation
- Communication protocols about sharing of information between business leadership and shareholders.
As the number of shareholders grows, some businesses institute external oversight mechanisms to help address these potential areas of conflict. One way to do this is to have an independent advisory board provide advice and recommendations to the business leadership. Another way is to retain independent directors for the board.
Out of an abundance of caution, you may want to contemplate worst-case scenarios in the lives of family shareholders, especially scenarios such as divorce that can potentially disrupt and threaten the survival of the business. Lawsuits and settlements can rapidly dissipate the value of the business. Some families have policies in place to require premarital agreements or other planning to protect the business in the event of a shareholder’s divorce. Also, families often implement buy-sell agreements to address how business interests can transition on the death of a shareholder with defined methodologies for valuation and repurchase of interests.
Also, a potential disruptive factor to consider is whether the value of the business is going to be subject to inheritance or estate taxes. If so, the family will need a plan to meet this tax liability without disrupting the business. There may be wealth planning strategies that you can adopt to make transition of the business more tax-efficient, so adequate planning is critical.
Working with External Advisors
It’s also a good idea to invest time in introducing the next generation to internal and external advisors, trustees and financial providers. There is value for the family in having a reliable team of advisors who know the family members and can provide continuity for future generations. The next generation can start to build relationships with the family’s advisors to ensure good working relationships into the future.
The process of transitioning ownership and leadership of your family business to the next generation involves many facets and requires careful forethought. Ultimately, the rewards of a successful transition, of course, make the effort worthwhile.