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Transferring the Family Business in Three Steps
Many business owners would like to transfer the ownership and management of the business they have created to their children. Understandably, they would like to preserve their legacy with as little disruption to the business as possible. Passing the business to the children might also result in less expense and disruption to the business than transferring it to a third party.
Before deciding to transfer a business to children, there are four key questions to ask:
- Is the child ready to take over the business?
- Is the owner ready to release control?
- Is the business in good order?
- Can the business afford a substantial debt to the owner?
For most business owners, their entity is the biggest asset on their net worth statement.
With an intergenerational transfer, the child or children typically do not have the funds to purchase the business from their parents. Therefore, it is vitally important for the owners to consider their financial goals and ensure that cash flow from the business is sufficient to meet the needs of the owners as well as the child or children.
To help in the decision-making process, the owner can follow these three steps:
- Evaluate his/her current financial situation and long‐term financial goals
- Assess the readiness of the business to be transferred
- Consider the readiness of the child to lead the company
Intergenerational transfers of a business can be one of the most complex transactions to complete. Not only may the owner have to negotiate family dynamics, but they also may have to deal with a child who does not have the means to buy the business outright and who may also not qualify for a business loan. These steps may help the process go smoother.
Step 1: Analyze the current situation
The first step is for the owners to analyze their current financial situation and goals. Projecting their existing assets without the value of the business against their long‐term financial goals will reveal either a wealth gap or a wealth surplus. The child will have to pay for the company if there is a gap. These payments will come from the business.
A parent would not want to give a child a used car with bald tires and bad brakes. Similarly, a business owner doesn’t want to gift or sell a company with issues to a child. A business owner should ensure the business has a strong business plan, a strong management team, a diverse customer base, and a good balance sheet.
Often an owner wants to retire before the child or children are ready to take over. It may take time for the child to be ready to take on the responsibilities of ownership. It is essential to wait until the kids are ready or hire someone else in the interim. Engaging someone else can be expensive and affect the owner’s financial goals
Step 2: Preparation for the transition
There are three parts to the preparation phase:
- Preparing the owner
- Preparing the business
- Preparing the child or children for the transition
After the analysis phase, the owner should understand their personal financial situation and the company's strengths and weaknesses. During the preparation phase, the owner should try to close any wealth gap or strengthen their financial situation. If there are gaps in the management team, the balance sheet, or the customer base, it would be prudent to correct these issues before the transition. The owner should help the children with the knowledge they need to run the company, including introductions to critical vendors and financial institutions.
Step 3: Decide on the strategy
Once all the analysis and preparations are done, the next step is deciding on a strategy to transfer ownership to the children. This will depend on the following: 1) the value of the business; 2) the financial position of the owner; and 3) the owner's goals.
The strategy will all depend on the financial readiness of the owner. If the owner does not need the value of the business to meet their financial goals, the question is how to gift the company. If the owner needs the business's value or income stream, the question becomes how to structure the sale.
If the value of the business is above the estate tax exemption and the owner's goal is to gift the company to the children, there could be gift or estate taxes issues. In this situation, giving minority shares over time may be sensible for the valuation discounts. It is also possible to create two share classes so the owner can keep control until a triggering event occurs. In this situation, if the business owner needs the value of the business to fund their financial goals, a sale to the children for fair market value may be the best solution.
This gift or sale could be made to an irrevocable trust for the benefit of the children. This could remove the assets from the owner’s estate and could protect the shares from future creditors, such as the ex‐wife of one of the children. The trustee could control the distribution of funds to the children and, if the situation permits, may allow the owner to pay the taxes. This strategy could also help if the owner wanted to treat the children separately. If some children work in the business and some don’t, the owner may wish to distribute shares equal to the children’s participation. Additionally, having lending powers in the trust may help the children secure financing when the parents step away. It is important for the owners to include their own legal and tax advisors in these discussions.
Conclusion
Transitioning a business to children can be delicate. Family dynamics generally complicate the process, especially when there is no equal company distribution. When faced with planning for the transition of a family business, planners like to start on step three, deciding the strategy. These complexities require analysis to ensure all parties in the transfer can meet their goals and objectives.