There are many ways to put your family business in the hands of successors: sales of equity or assets, gifts of equity or assets, or some combination of these. There are pros and cons to every method and gaining clarity about which is best for your situation begins with answering five of The Big 6™ questions that come before the question of How will your transition your family business to successors? They are:
All six questions are interrelated. For example, the timing you choose for your business transition may change depending on the time it takes for a successor to prepare for leadership or to attract a buyer.
Three Types of Successors Influence How You Will Transition Your Business.
The three categories of transaction options relate to the type of successor you choose—an insider, third party, or no one:
- Transfers to Insiders (children, key employees, co-owners)
- Sales to Third Parties
- Liquidation
Within each are multiple options. For example, a transfer to insiders can be a one-time sale of stock (assets or membership interests) during your lifetime or at death; a sale over time or gifting (partial or total) during lifetime or at death, outright or in trust. Liquidation could occur through a public sale, private sale, or auction.
That’s a lot of moving parts, so it’s not surprising that it can be difficult to evaluate them all, much less choose your best option. To make your choice, we suggest that answer the six questions in order and evaluate all your options in light of your transition objectives (your Why) and dealbreakers.
Transfers to Insiders
When transferring a business to insiders, there are three basic options that can occur at two possible times:
- A one-time sale of your stock, assets, or membership interests—during your lifetime or at death.
- A sale over time of stock, assets, or membership interests—during your lifetime and/or at death.
- Gifting (total or partial)—during your lifetime and/or at death—to individuals or in trust.
Sales To Third Parties
In third-party sales, parties outside your business and family purchase assets or stock (or membership interests of limited liability companies or partnerships) in arm’s- length transactions. Third-party buyers typically prefer to purchase assets (rather than stock or membership interests) because assets do not typically come with prior liabilities.
Liquidation
A liquidation can be conducted via a public sale, private sale, or auction.
There’s More to Picking an Option than Taxes.
Owners identify all sorts of objectives, from the obvious—minimizing taxes—to some they don’t initially think about such as minimizing risk, lowering their stress levels, and enabling their successors to “live like owners.”
Risk Tolerance
A customer falls in the parking lot, a former employee discloses proprietary formulas to competitors: owners can pay high price in terms of time, attorneys’ fees and judgements, as well as lost sales if these events occur. When owners have a lot to lose, many aren’t willing to put everything they’ve worked for at risk. For them, making a transfer during one’s lifetime outweighs the tax advantages associated with a transition at death.
Stress
Owners frequently deal with stress from multiple sources: Shifts in regulations, competitive environment and economy, supply-chain interruptions, and a tight labor market to name just a few. For many owners, getting out from under stress is a priority that impacts their choice of transition option.
Successor Lifestyle
This factor often surprises owners, but the lifestyle of a successor can be a critical element in calculating which transition option works for you. Let’s say that your successor is one of your children whom you currently pay a salary commensurate with his or her current responsibilities. Is that salary commensurate to yours at the same point in your career? Does it enable them to buy their own homes or pay tuition? Are they able to live in the same neighborhoods with other owners?
Four Payment Elements
Another issue to consider in the selection of a transition option relates to payment.
- Time frame: Over what period do you want to receive payment for the value of your company?
- How Price is Calculated: If your successor is currently working in the company, will you (or how will you) recognize their efforts in the purchase price?
- Form of Payment: In what form do you want payment?
- Security: What level of assurance do you need that you will receive payment?
Time frame
In addition to a transition occurring during lifetime or at death, lifetime transitions can happen in increments. You may want to leave as soon as your successor owns at least 50% of your equity, or you may want to step away only when you are satisfied that the business is operating well under your successor’s leadership.
Price Calculation
Successors who have worked in a business for years before a transition begins can have strong feelings about how the purchase price should reflect their efforts. If your successor has contributed to the growth of the company, they may assume that you may sell it to them at a discount or for no cash up front. Understandably, you may want to be compensated for your investment in building the company, and the risk you’ve assumed over the years.
Form of Payment
Most successors are not able to pay for 100% of your equity and most third-party successors are not willing to pay for 100% of your equity at closing.
Financing
Before deciding whether to finance a successor’s purchase with a promissory note, we recommend that, with your advisors, you evaluate to pros and cons of doing so. You’ll want to consider the risk that your successor will default, whether you’ll be willing to take collateral if they do default, and whether a lender / borrower relationship will detrimentally affect your relationship.
Owners who give themselves a long runway by creating their transition roadmaps well in advance of their transitions give their successors the opportunity to assume a minority interest and prove to lenders that they can perform.
Gifting
Giving a child equity works for some parents who can meet their objectives related to when they want to leave and the amount of cash they need to finance their Next Adventures.
Security
The issue here is straightforward: How likely is it that a chosen successor will be able to pay the full purchase price? If the odds are even or low, are you going to be willing to step back in and take the reins?
The Options Matrix™
To organize all transition options we developed a tool called The Options Matrix. At one end is keeping the status quo, and at the other is a sale to a third party. We list your objectives and compare each to several options that you are considering. For example, if you want to transfer your business to your children, we’ll assess how each of your objectives lines up with several transition strategies.
You can learn more about the Options Matrix in our book, It’s A Journey – The MUST-HAVE Roadmap to Successful Succession Planning.
We encourage you review the Options Matrix and begin to think about your options. We are happy to chat with you about how you can use it to:
- Gain a clear picture of which option is best for you.
- Assign proper importance to your life’s work.
- Honor your financial future, your company’s and your successor’s.
- Uncover objectives and dealbreakers you may not have considered.
