In the past year, we have completed or are still in the middle of at least six business valuation and perpetuation cases involving family members or key employees (one party as buyer and one as seller). These cases and the dozens we have worked on over the years typically have the following issues that need to be addressed:
- Lack of planning and preparation by the founder;
- Financial expectations for the buyer or seller, or both;
- Estate and tax issues’
- Transfer of control over the business;
- Fairness to the children involved with the business; and
- Fairness to the children not involved with the business.
The first step to transferring the family agency to the next generation is to clarify what everyone’s intent is and develop a specific timetable for key milestones.
In theory, this should be easy. However, some agency owners require a lot of soul-searching to actually commit to a plan.
A lack of clarity for the direction of the family business can lead to personal strife and family rifts. Many of the people we have worked with have said they had been talking about it for years before we were brought in. Some perpetuation candidates have offered to pay for it themselves. Some have had to threaten to quit. It doesn’t have to be this way.
Resentment can also set in with perpetuation candidates when there are no specific plans for ownership transfer. This is especially true for the children or key employees that do an excellent job managing and growing the business. They might get to a point where they don’t want to build it further, without credit for their own personal production and business success. In other situations, the children or key employees might languish under the control of a strong parent or owner and not find their own path for business success and leadership.
Express Intent in the Will
If the candidate(s) are family, the owners need to indicate in their will that this particular family member or members are “intended” to be the perpetuation plan for the seller/owner. The estate executor needs to be clear if there are other siblings that are not candidates and will not be part of the ownership of the business. Then, the non-candidate family members cannot insist the firm be sold if the owner dies, for example.
At first glance, some parents do not want to do this approach, as they are afraid their other children will not feel this is fair, especially if the agency’s value is a major part of the owner’s estate. This can be dangerous and totally unfair, and we often see this situation turn into a real mess when it did not have to be. Sometimes, even the other siblings’ spouses might still force a sale to occur, even if the siblings understand that their brother or sister deserved to own and run the business.
However, with proper planning and open communication there are many solutions.
One such approach is for the perpetuation candidates to pay the estate a fair value for the agency to make the estate whole again. If the estate is large enough, the children that were not perpetuation candidates can be left an equivalent value in other assets.
Part of the planning needs to be a valuation of all the assets in the estate, including a business valuation of the agency.
For those children that work in the agency, it helps to encourage their success by letting them build up “sweat equity.”
One approach is for the perpetuation candidates to own the books of business that they have produced, or to create a vesting/deferred compensation plan. The overall agency value is then adjusted down to account for the book ownership or deferred compensation liability.
This technique will let them build their own personal equity while not making them pay for their own effort.
It is important to have a producer agreement or some agreement in writing that details the plan. Keep in mind that accounts that have been passed down are usually excluded from these plans.
Pay attention to the tax implications of creating a vesting/deferred compensation plan for the producer.
Transfer Ownership Now
For those owners that have reached the point where they are ready to pass the reigns to the next generation now, there are a variety of options to consider. Usually, the first question is, “How much money do the owners need to take out of the agency?” This helps in narrowing down the various options.
Most of the time, the sellers are taking out a large salary, a bonus, car expenses, entertainment, personal supplies, personal accounting costs, cell phones, health insurance, and sometimes health supplements, life insurance, travel expenses, tickets to sporting events, and the like.
Often, some people have not saved enough for their retirement. They might already be more than 65 years old, sometimes even in their 70s. These people need to maintain a certain level of income from the business for years to come in addition to the sales value.
For others, they are financially secure because they saved money and invested in other assets outside of the business. They might not need much or any income from the business.
Regardless of the circumstances, it is important to create a financial pro forma to understand the business’ cash flow, as well as the value of the business.
Pro Forma Work is the Key
The cash used for an internal buyout of an owner for a small business is more often than not generated from the income they normally pull out of the business. Any salary or perquisites paid by the firm decreases the profits or EBITDA (defined as earnings before interest, taxes, depreciation and amortization), which lowers the agency’s value and lowers the cash flow the buyers are able to use to buy them out.
If they do want to keep taking some of these expenses for a number of years, then those expenses are left in and negotiated, then the value of the agency and the owner’s stock value becomes less.
A good mergers and acquisitions (M&A) consultant can show the owner and the buyer, how the seller can’t have their cake and eat it, too. It is a give and take. There is only so much cash flow in the business.
Terms for Success
For internal buyouts, the sellers need to be flexible with the terms and realize they will not get top dollar for the business. Because of the limited cash flow from the business, it will typically take the buyer five to 10 years to pay off the seller.
Taxes become a major part of the equation. For each $1 the seller is paid for the business, the buyer needs to generate $1.67 before tax dollars, assuming a 40 percent tax rate.
Again, a good M&A consultant can work with the buyer and seller to structure the deal with certain techniques to help lower the tax burden and create a win-win for the buyer and seller.
How to Make it Fair
If there are multiple children and some not in the business, the sibling buying the business should make payments to the seller/owner based on a fair market valuation. This would have the same effect as if the seller/owner is selling to an outside party. Otherwise, any discounts or gifting should be accounted for in the will or by some other means, to equally distribute the inheritance.
Internal perpetuation can be very rewarding from a family standpoint, if properly planned and communicated.
Even though external sales can often give the owner a higher value, the intention of the owner and those that have paid their dues (time and sweat equity) to keep the business in the family can override the difference in equity.
If the owner(s) continue to vacillate and not come to terms on timing, value and terms, then some discontent could arise among the family members or key employees that have been waiting a long, long time.
The key is to start it now, especially if the owner is older than 62 years old. Bring in some trusted advisers, determine the overall estate value and the agency value. Estimate the future income needed from the business. Review the available options.
Then, sit down with the family/owners to create a roadmap to perpetuate the business.
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