The most challenging aspect of a family business is planning its succession. In addition to being a multi-disciplinary task with many stakeholders, the succession of a family-owned company faces the usual issues: generating profits, responding to market situations and competition, keeping up with digital transformation by adopting new technologies, management, and employee relations, and ensuring returns to all the stakeholders. In addition, family-owned businesses face other unique challenges, especially if one of the business owner’s children is already working within the company.
Family Business Succession Challenges
Emotional involvement. The complex challenges of transitioning a family business involve all the multi-disciplinary tasks and dynamics of ownership transition simultaneously with the additional emotions of the family. Overriding emotions may compromise decision-making under such circumstances. Business owners must answer tough questions like: Should I transfer the business internally to the next generation? To a new set of managers? Or, should I sell the business to another company?
Ownership power dynamics. The Boston Globe reports that only 30 percent of family businesses survive to the second generation, only 12 percent to the third generation, and even fewer by the fourth generation. Transitions get more complex with each subsequent generation because ownership becomes increasingly diffused. Some heirs are actively involved in the business, some participate in non-leadership roles, and others are passive owners. Such power dynamics place more pressure on growth and in determining who will take over.
Mismatched expectations of financial gains. The retiring generation may have greater financial expectations from the value of their shares in the company. They may solely rely on balance sheet numbers while overlooking more reliable valuation methods like the earnings capitalization model.
Unwillingness to take over. Before planning the succession, the owner(s) should consider the willingness of the heir(s) to take over the family business. An heir not already working for the business is unlikely to be interested in taking over its management.
Family roles and participation. Sometimes a family member is in the business, but other family members aren’t, or some are more actively involved. Such discrepancy of participation and involvement adds to the complexity in making decisions, as some family members may want–or expect–ownership positions, even if they aren’t actively involved.
Stages of a Successful Family Business Transfer
Like any life project, the transition of a family business requires great rigor to achieve the desired goals. Before we start, let’s first clarify the most important question: Is this an internal or external transfer?
Stage 1: Carefully Examine Exit Options
According to the Conway Center for Family Business, “about 35 percent of Fortune 500 companies are family-controlled.”
When the owner decides to transfer the business internally, they first communicate the intention to their children and other stakeholders. Doing so ensures that all family members (both inside and outside the business) make decisions and understand the financial and managerial repercussions.
Carefully consider all the aspects and implications. Since the internal transfer of ownership is gifted and not sold, the owner must carefully consider the financial ramifications. For years, gifting the business has been used as an effective way to avoid paying taxes. For instance, if the child were to buy the business, they first earned money and paid tax. After being paid with what’s left, they pay capital gains tax. This double tax can be avoided by gifting the business instead of selling it, but it also means that the owner receives nothing for the transfer of ownership.
According to Forbes, the Family Business Institute states two of the ownership succession issues that most often plague family businesses are technical mistakes and planning in a vacuum.
When owners decide to sell their company, they get the advantage of separating the business from family goals and treat it as a purely economic venture. The long-term mindset and family values give such companies an additional economic and competitive advantage, so it’s essential to chart a comprehensive exit plan.
Before doing this, however, ensure all family members agree, especially if there are children who work outside the business. They may have ownership ambitions even if they’re not in the business.
Stage 2: Make your Transition Plan
Get Ready to Pass the Torch
Have clear, open conversations about succession and ensure everyone involved (outgoing owners and incoming leaders) mutually agrees upon their roles, expectations, and responsibilities.
Differences in decision-making make consensus tricky. Business leaders may wish to use the profits towards growth strategies over shareholder rewards.
Everyone involved should expect times when managing personal relationships and business dynamics will be challenging. Since family and business are deeply entwined, CEOs can be torn between family issues and business concerns. Fair governance practices help avoid succession clashes and litigation.
Get a Valuation
Most owners have misconceptions about the value of their companies. Since value changes rapidly, it’s necessary for owners to obtain a correct estimate of their companies’ value, particularly in the case of ownership transfer. What the owner thinks about the value of their company doesn’t matter; what matters is whether they do the right things to build value and preserve it. Of course, Value Scout offers entrepreneurs and their advisors an estimate of their business value today for exit planning purposes. To learn more, schedule a demo.
All parties must understand what the company is worth and work through what that value means to everyone involved. Will it be enough for the outgoing generation to retire? Will it be too much for the incoming generation to succeed?
Most owners fail to prepare for the eventual sale or transfer of their businesses, which unfortunately results in most business sales or transfer happening in less than ideal circumstances. To avoid such a scenario:
- Carefully examine all past financial statements
- Chart out all future growth prospects
- Involve your accountant to understand the effect of new ownership on earnings and cash flow
- Take into account the market value of the real estate, company equipment, inventory of merchandise and other business assets, and the business’s intangible assets
- Hire a professional business appraiser who uses a combination of valuation methods and approaches to calculate the most accurate value of the business.
Stage 3: Assemble a Formal Team
Structure the Deal
Before you begin to explore how to sell the business, evaluate your goals for the financial transaction. Ask questions like: Do you want to give up 100 percent of ownership? How important is it for the brand to continue? What are your current financial needs? Can a partial sale of the business meet them?
Once you have clarity on those issues, it’s time to put the financials in order. Begin by preparing financial statements, market projections, and other industry-based metrics. Evaluate to understand the financial position of the business. Are there any liabilities? What are the growth in gross sales and net income? How many customers do you have, and how much market share do they represent? Do these align with your future projections?
Next, organize the team that will work alongside you throughout the transition process. People you need on the business front include a financial advisor, valuation expert, business accountant, tax planning advisor, and transaction attorney. On the personal front, you will need your financial advisor, estate attorney, and CPA advisor. These two core teams will be thoroughly involved during the process.
Prepare the Culture
Family business transitions incur change at three levels: personal, professional, and business. Owners and their families have to look at the facts before taking the next step and think strategically about the future. They must decide if the business should be monetized or passed on as a family legacy.
To prepare for a smooth transition, owners involve other key stakeholders, leadership, and executive teams. Promote discussions welcoming differing opinions and views and candid communication. This will facilitate the transition and prepare existing managers and employees for new ownership and leadership.
Develop a structured plan for incoming leaders to grow into the roles and outgoing leaders to step aside. Succession can be full of uncertainty. When all teams are on the same page, they are more likely to be supportive and confident of the future.
Stage 4: Actual Transition
Get Ready for Change
A successful owner understands that the future of the business depends on their readiness to serve as a mentor to prepare and support the new generation of leadership. This new mentorship role paves the way for them to step aside from active management and take on the unique responsibilities of mentorship as they guide the younger generation and offer counsel when required.
The long-term success of a family-owned business requires maintaining a fragile balance between holding on to traditions and accepting change.