Transferring Businesses to the Next Generation

One issue which every small and medium sized business faces at some point is succession. It is extremely difficult to ensure that a business continues after the founder leaves. For the founder, this means problems in recovering the value wrapped up in the business.

Many business owners think that succession planning is simply a matter of letting the kids take over. Sometimes this works. More often, it does not. Less than one third of family businesses survive into the second generation. Only 12% make it into the third. Even family businesses that become giant corporations are not immune to this problem. Ask the Eaton family, or the Bronfmans.

Succession planning is like compound interest – it works best when time is plentiful. While it is difficult to forecast far into the future, there are steps owners can, and should, take now to increase the chances of a continued success after the owner is gone.

There are two broad questions that accompany succession planning. First, who can the business be sold/transferred to? Secondly, what steps should be taken to provide the most flexibility, and to ensure that the present owner gets the best results?

For a family business, the preference is usually to keep it within the family. This is particularly so in businesses such as farming, where there may be a strong emotional attachment to the land that supports the farm. In almost all cases, keeping it in the family means that the spouse or one or more children will take over. The spouse is often only a short term alternative; if one passes away, the other may be too old, or not have the desire, to continue the business for a long period.

Passing a business to a child or children involves as much psychology and mediation as legal skills. If there is only one child who desires to continue the business, fine. Other than equalizing the value with other children on the owner’s death, which admittedly is not always easy, the child can be trained and groomed to assume operations.

In some cases the child will only take control upon the death of the parent, but in other cases, the parent will want to gradually wind down his or her time commitment and retire. Depending on the level of control that the parent wishes to maintain, there are different ways of structuring the takeover, from an outright gift, to more stringent controls over voting power.

If there are multiple children who want to take over the business, different considerations apply. One cannot guarantee that they will continue to get along, but if there is already friction among family members when the owner still controls the rudder, don’t expect the divisions to just disappear. Steps may have to be taken now to heal rifts.

After family, the most common alternative is to sell the business to existing employees. There are a number of advantages to this. For one, the employees will be the best acquainted with customers, business methods and other aspects that will make the transition smoother. The employees are often highly motivated as well, since they may be out of jobs if they cannot swing a deal.

Not all employees are able to afford the substantial capital investment to take out an owner, however, and this may mean the owner has to be paid over time. The risk to the vendor thus increases. Also, if there are significant divisions among employees, finding a suitable bloc willing to buy, while ensuring that other employees still feel part of the business, can be a challenge. Absent family or employees, an owner has to go to third parties. Some of these may be known to the owner, such as friends (although be aware of the risks, legally and personally, of entering into business deals with friends) or they may be complete strangers.

The biggest hurdle is often finding these buyers. Personal and business contacts are the usual method, but there are a growing number of businesses that specialize in matching buyers and sellers of businesses. Professional advisors, such as the business’s accountant or lawyer can also be a good source of contacts.

If a transfer is not on the immediate horizon, there is a tendency to do nothing, thinking that the plans might change. There are actually several things that can be done at any point which will help decrease the hassle of business succession.

It is obviously impossible to accurately predict what will be needed if one is only planning on getting out in 10 or 15 years. This doesn’t mean that nothing can be done, though. By ensuring that things are under control now, opportunities can be taken advantage of more quickly, and with less cost.

Sometimes the simplest procedures are the most important. For example, keep business records up to date and comprehensive. This includes financial statements, minute books, and other business documents. This is also valuable for day to day operations, but if opportunity knocks, having the information quickly can be the difference between completing a sale or not.

The details that seem minor now may also become more prominent later. For instance, the business might be habitually late with certain payments or filing fees. This may not cause a serious problem operationally, but an outside purchaser might consider these to be more important, and will look at the deal more skeptically.

One of the things that is commonly neglected in a corporation, often with perilous results, is a unanimous shareholders agreement. One feature of a USA is that it can control and bind the directors of a corporation, notwithstanding how the votes on shares are allocated. For succession planning, however, the key feature of a USA is the “buy/sell’ provisions.

Buy/sell rules can be triggered in many different cases, but they often apply on the death of a shareholder, when one shareholder wishes to sell their shares, or if there is disability or marital breakdown. In such a case, the USA acts as a road map for disposition of the shares -how it is done, how much is paid, when it is paid, and so on.

In my experience, the benefit of a USA is not so much how disputes get resolved (although this is important) but that it prevents most disputes in the first place. The very act of negotiating a USA forces parties to turn their minds to things that they wouldn’t, or would rather not, think about when the business is fresh and exciting. Each party gets a better picture of what is important to everyone, and can adjust their expectations accordingly.

Tax liability is always a concern when selling a business. In most cases, there will be some tax, but it can be minimized. What are some ways of doing this?

For the moment, there is still a capital gains exemption when selling shares of a qualifying small business corporation. Not all shares are “qualifying”. For example, there is a requirement that the company have minimum levels of active business income. Steps can be taken to “purify” corporations, but it cannot usually be done immediately. Therefore, business owners should look to the future and determine what can be done now to ensure the maximum deductions are available later.

In conjunction with the capital gains exemption, or perhaps in substitution, an “estate freeze” can minimize tax. A freeze does just what it implies. It usually involves exchanging the shareholder’s current common shares, which increase in value as the company grows, with preferred shares. The new preferred shares are non-participating – no matter how much the value of the company changes, the preferred shares retain the same value. As part of a freeze, new common shares will be issued to someone else, usually a child, so that future corporate growth (and capital gains tax) accrues to them.

An estate freeze works well when the original owner believes that he or she has enough assets, and doesn’t want the tax hassles of further growth. It can also be set up so that voting control continues to rest with the original owner.

These are only a few of the techniques used in contemplation of succession planning. In a well thought out plan, not only will flexibility be increased for the future, there may even be some immediate benefits. And remember – succession planning is a process, not an end result. It is important to regularly monitor the business situation, in conjunction with advisors, and determine if any new directions are necessary.