Can you keep your family business in the family?
A few years ago, The New York Times reported on the estate of Allen Frechter. Mr.
Frechter owned Plexi-craft Quality Products, which he ran until the day before he died at age 86. Frechter had no plan for keeping the business going after his death. In fact, given what his son, the executor of his estate, discovered about the business, it was surprising that the business lasted as long as it did.
• Purchase orders were all handwritten.
• There were no computerized customer lists.
• There wasn’t even a product list.
• Data for analyzing how the business was doing were not available.
Fortunately, the son had good business sense, and experience in managing a business of
his own. He was able to turn things around. He moved the business to a less expensive location, began a system of digital data entry for the prior six years of sales, and modernized the business in ways that his father was unable to do. The firm was projected to double its revenue in about six years.
Not every family is lucky enough to have such a talented heir to take the helm. The better course is to plan for business succession in an orderly fashion.
Identify the future leaders
The first question, perhaps the hardest question, concerns the next generation of leadership. Are there family members who will participate in the business, who eventually will take command? Or will key employees be in a position to acquire the business, with the skills needed for continued prosperity? How will these individuals be groomed to meet their future responsibilities?
If family members will be active in the business, it is important to get some of the business’ equity into their hands early on. An ownership stake provides a critical incentive, and there may be long-term tax advantages as well.
The future leaders of the company are the people who are willing to put their names to a buy-sell agreement, the promise to acquire the business in the future on terms acceptable to both parties today.
Get a sound business valuation
The buy-sell agreement, in turn, must be founded upon a reasonable value for the business itself. Valuing a family business is as much an art as a science, and it is a job for a valuation expert. The vague question “How’s business?” must be quantified, reduced to numbers. Among the factors to consider to get a starting value:
• historical earnings
• dividend-paying capacity
• tangible assets
• goodwill and intangible assets
• prior sales of company stock
• values of comparable companies
• the general outlook for the industry
• the general outlook for the economy
In general, a discount is applied to the value of a family-owned business that reflects its financial fragility. These discounts may include ones for lack of liquidity, for minority interests that lack meaningful control or influence over management decisions, or for the harm that the company may suffer when it loses the services of key personnel. Family businesses do not typically have a “deep bench” of management talent.
Fundamentally, the asserted value of a business must pass a “willing buyer, willing seller” test. The more documentation goes into the valuation, the more secure all parties should feel about it.
Understand the tax hurdles
The valuation sets the bar for the seller and the buyer of the business. It also potentially sets the bar for the tax authorities. Federal estate taxes kick in at $5.34 million in 2014. The threshold is usually much lower in the minority of states that have retained their “death taxes” (estate tax, inheritance tax, or both).
For married couples, the marital deduction defers federal estate taxation until both the husband and the wife have died. What’s more, with the new “portability” election married couples may routinely double the value of the federal exemption, to over $10 million. That’s enough to remove the tax worry from a large fraction of family businesses.
Owners of larger businesses will need the services of an experienced estate planner to address the death tax conundrums. Life insurance and trust planning may enter the picture at that point.
Rely on professional counsel
Given the evolving tax environment and the inherent complexity and unfamiliarity of estate planning, consider assembling a “cabinet of advisers” to create and implement the business succession plan. Key players on the team should include:
• An accountant who is familiar with the company’s financial history;
• An estate planning attorney who understands state inheritance laws as well as death tax exposures;
• An insurance agent to look at creative ways of funding the buy-sell agreement and developing a pool of capital to meet death duties;
• A banker who can bring financial acumen as well as access to credit at a critical point in the business’ life;
• All the family members who are active in the business, as well as key employees who are positioned for future leadership slots.
Assembling the team transforms succession planning from “something we need to get to” into an active process of executing current tasks and supervising the plans that the team develops.
Put us on your team
Over the years we’ve helped many business owners with their succession planning. Our counsel includes expertise in estate settlement and trust management, as well as sensitivity to the variety of family issues that attend wealth preservation and wealth management. We would be pleased to share this expertise with your family as well.