January 21, 2019

Preparing to Transition the Family Business to the Next Generation

When you run a family business, you should start thinking very early in the company's life cycle about how you're going to pass it on when you retire.

“The day you start your business is the day you should develop your exit plan," said Natasha Davis, a senior wealth planner with City National Bank in Irvine, Ca. “Realistically, we know that doesn't happen, but ideally you start planning at least five to 10 years before you pass on your business internally to family members."

Davis said she often gets initial calls for advice from business owners who say they have a letter of intent to sell their business in hand.

“That's too late to do any longer-term planning like tax mitigation, so it's best to prepare for any business transition several years in advance," she said.

Key Components of a Successful Transition of a Family Business

Less than 30 percent of family businesses survive into the second generation and even fewer make it into the third generation of a family, said Ramez Baassiri, author of “Interrupted Entrepreneurship: Embracing Change in the Family Business," and a board member of a multi-generational family business.

“Succession planning is crucial for corporate governance, but many leaders miss out on this planning because they're just running too hard to build the business," said Baassiri.

Even in families with a plan, transitions can take time. Baassiri's parents had a succession plan in place for their business, but his father died unexpectedly. He said it took six to eight years for the business to fully adjust to the ownership transition.

Communicate Early and Often

Three possible scenarios are available to family business leaders, said Baassiri, including remaining in a leadership role, stepping back into an advisory role or bowing out completely and turning the business over to other family members or outsiders.

No matter what choice is made, constant communication with family members is essential.

“The person who's considering stepping aside has to feel they've accomplished something and that they matter," he said. “The person stepping in needs to feel they're joining a sustainable platform and that their skills will be valued."

Family-owned businesses considering future transitions must establish trust and communication between family members and other participants in the business, said Amy Castoro, president and CEO of The Williams Group, a consultancy in San Clemente, Ca., and the author of, "Bridging Generations: Transitioning Family Wealth and Values for a Sustainable Legacy."

“You need to take the pulse of all the stakeholders and find out if they're on the same page," said Castoro. “Is the goal to expand the business with the next generation or to sell it to benefit the next generation?"

Take a Team Approach to Transition Planning

A third party can facilitate these discussions to reduce potential family tension.

“One of the main reasons family businesses fail is because the owners are not developing a process early enough for management and ownership transitions," said Davis. “One role of a wealth advisor is to talk about these processes and to bring in additional advisors such as attorneys, tax experts and estate planners if they're missing."

It's important to have both the family's estate plan and business plans in alignment, said Davis.

“You don't want to have a succession plan in place that contradicts your estate plan, such as a will that states your business goes to your kids when you pass away and a business operating agreement with buy-sell documents in the bylaws," she said.

For example, your business operating agreement could give the right of first refusal on your business to a partner, yet your will could provide the same business as an inheritance to your kids.

You may need to explore options for segregating parts of your business so you can sell some parts, and structure a buyout or purchase life insurance to compensate offspring who aren't part of the business and won't get proceeds of a sale, she said.

Some of these plans may require legal assistance. “A lot of people avoid calling an attorney even if they have one because of the expense," said Davis. “We work with families to streamline the questions they need to discuss with an attorney."

Obtain Third-Party Business Valuations

A business valuation is an essential part of transition planning regardless of the actual plan, said Davis.

“If you plan to sell the entire business or even just parts of your business, you need a baseline understanding of the value," said Davis. “If you plan to gift the business to your family, you need to know the value and include that in your estate planning and tax planning."

Valuations are particularly important for families in which not all members of the second or third generation are involved in the business, said Castoro, because the value will likely become part of their inheritance.

A preemptive valuation is essential for stakeholders to redefine their expectations and to make sure they know where the company stands, said Baassiri. It should encompass both the current financial state of the main business and any extra ventures being explored by family members, he said.

You may also consider an experiential valuation, which has a different purpose than the financial valuation.

“The biggest asset of any company is its people," said Baassiri. “You need to have a third party do an unbiased experiential valuation to determine who is fundamental to the company's success and who needs more training."

An outside consultant can analyze the work being accomplished by employees and family members in the business and make recommendations for restructuring and possibly additional education to maximize each person's potential. It would be up to the company leaders to decide whether to implement those recommendations.

Prepare the Next Generation for Business Leadership

A succession plan is only as good as the people involved, so an important step is to identify members of the next generation who want to run the business and determine how to prepare them for leadership roles.

“It's essential for family members who intend to run the business to get explicit education, such as a university degree, as well as implicit education both inside and outside the family business," said Baassiri. “It's best for family members to get some experience outside the business and then have a number of years within the business before assuming a leadership role."

Baassiri recommends two-way mentoring for family business leaders, with the founder passing on wisdom earned while building the business and younger members sharing their external experience and ideas.

Align Family and Business Values

A fundamental element of a successful multi-generational family business is finding a way to align non-family members in the business as well as family members inside and outside of the business around a fundamental purpose, said Castoro.

“If one person values the biggest payout from the business and the other values building a sustainable long-term business, you need to look for an overarching goal," said Castoro. “You don't need agreement, because that can be impossible. You need alignment, something people can get behind to co-design a solution to disagreements."

For example, while the exact plan may be cause for disagreement, family members may be able to agree that they want the business healthy for the long-term benefit of future generations even if some members are also looking for a short-term payout. There may be a way to accommodate both sides as long as everyone can agree that they want the business to continue.

Building communication skills is vital for a sustainable business legacy, said Castoro.

“A family-owned business is like a Swiss watch which needs all of its intricate parts functioning together for success," said Baassiri. “That takes pre-planning about who's getting educated and how they are getting educated in the business and communication to make sure every team member has the right attitude toward change.

Given the complexity and the number of options available, it's important to consult with professionals to evaluate your situation before a sale. City National Bank's wealth planners can help you weigh your options. To learn more, contact us.

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This article is for general information and education only. It is provided as a courtesy to the clients and friends of City National Bank (City National). City National does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors or persons quoted as of the date of the article with no obligation to update or notify of inaccuracy or change. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.