PROTECTING SENIORS’ INTERESTS IN A BUSINESS TRANSITION
Peter Berenson, CPA, PFS
Forman, Itzkowitz, Berenson & LaGreca
For seniors, transitioning their business to the next generation can be, in some ways, like teaching their child to fly from the proverbial family nest to independent adulthood. During the growth and developmental years of both the business and the child, seniors typically nurture both with love and money and build emotional bonds. Then, when they contemplate separation from each, the senior/father begins to assess the related risks.
Understanding business transition risks and how to protect against them requires a brief overview of the two basic transition types: management control and stock ownership. These can occur simultaneously or independently, and gradually or instantly. In other words, seniors can transfer daily and strategic management to the next generation while retaining ownership. Or, they can transition some or all of the ownership to the next generation while retaining daily and strategic management. Or, both types of transitions can occur simultaneously. The major difference between the two types is that as long as seniors own more than fifty percent of their business they have the legal authority to grant and/or reclaim management control. Once the fifty percent threshold is crossed, this legal authority is substantially diminished. Nonetheless, while the degree of risk may differ with either type of transition, the nature of the risks is the same.
WHAT’S AT STAKE?
Not every business transition will be subject to all of the risks discussed below, but any one of them could have profound and unintended effects.
The loss of seniors’ financial security is a risk that must be carefully considered, especially if their retirement depends on the future success of their businesses. Perhaps they are looking forward to payments under consulting or non-competition agreements, or from the sale of their stock. In addition, seniors may have personally guaranteed company bank loans, leases or other obligations. If the business proves unable to meet any of these obligations and the seniors are called on to honor their guarantees, they may have to drastically alter their retirement plans.
It’s common for seniors to be concerned about their children’s and grandchildren’s financial security, even after a business transition has been completed. Seniors may need to consider reducing their life styles if they choose to step in and compensate for the financial effects of business difficulties.
With the high rate of failed marriages in our society, seniors think a lot about their children joining those ranks. If precautions are not taken, a divorce settlement could adversely affect the proud tradition and financial stability of a family business.
The livelihood of employees, vendors and even the community, while not necessarily direct or legal obligations of seniors, may weigh heavily upon them when they consider a business transition. This is particularly true for businesses that are dominant employers in small communities. The results of an unsuccessful business transition can be particularly severe for these non-family stakeholders.
But, damage to family harmony and relationships is perhaps the greatest risk of
all in a business transition. It’s not unusual for family members to go to their graves without speaking to each other after an unsuccessful transition.
Just as it’s unrealistic to completely protect a child leaving the family “nest,” seniors can only use reasonable methods to protect themselves in a business transition. Implementation of these methods should commence long before becoming a senior and span three phases of life: parent, business-manager, and creditor.
Protection methods during the parent phase should begin in the child’s cradle and end in the parent’s grave. They begin by clearly communicating expectations and business and personal values. This can often be accomplished by serving as an effective role model and should continue through all three phases of life. Helping a child obtain the best possible education provides the foundation and tools to blend his or her new independence with the values and traditions of the family business. The child should then be expected to build on this foundation by gaining practical experience either within or outside the family business.
Prenuptial agreements can be a difficult discussion topic for parents and their children who are planning a wedding, but they are receiving increasing attention as a tool to protect family businesses against the adverse effects of a divorce settlement. They are legally binding, are entered into usually before marriage, and establish the financial settlement at the time the agreement is executed should there be a breakdown of the marriage. As with any legal matter, it’s important to seek qualified legal advice before entering into a prenuptial agreement.
Business manager phase
Seniors should consider additional protection methods in the business manager phase as they look toward a business transition. Advisory boards can be invaluable not only with a company’s development and strategic planning, but also with objectively addressing issues that family owners have difficulty discussing and resolving among themselves. This type of open communication can help family owners form a cohesive team, and to prepare the field for a successful business transition. Advisory boards function similar to boards of directors but their decisions are not legally binding. Few family owned businesses have advisory boards because their owners have difficulty agreeing on the need for one and who should serve on it. Research has shown that the most effective advisory boards are ones that are composed of people in the same or similar industries who have proven track records. A team of professional advisors: attorneys, accountants, bankers and consultants – can be another effective method of protection. Through its collective experience and objectivity, this team can help structure a transition plan that addresses the concerns and needs of all family members within the existing legal and tax environments
When seniors transition their businesses and depend upon payments from them to support their lifestyle, they become creditors. After all, they become the financial institution that funds the transition and, like any financial
institution, they should protect themselves against the associated risks. They can accomplish this by agreeing with the next generation of family owners/managers on financial goals, benchmarks, and covenants for the business, and consequences for failure to meet them during the transition period. These steps can also help the succeeding generation by establishing a framework of accountability for them.
The following are examples of the kinds of financial goals, benchmarks, and covenants that are similar to those imposed by institutional lenders:
* Inventory turns will be no less than 2.75 annually.
* Compensation for the next generation of family
owners/managers will not exceed their current levels plus 50% of the
increase in net income.
* The company will make no loans to the next generation of family
* The next generation of family owners/managers will deliver
quarterly financial statements and aged accounts payable and receivable
schedules to the seniors within 25 days after the end of each quarter.
* Total company debt will not exceed 1.75 times stockholders’ equity.
* The next generation of family owners will schedule and
arrange quarterly family meetings, led by a facilitator, to review the
company’s success in meeting the goals, benchmarks, and covenants.
Failure to meet the goals, benchmarks and covenants could result in the
seniors, at their option, terminating or postponing the transition, or in
reclaiming management control.
While these formal creditor protection methods are important, it’s also
important to remember an estate planner’s response to a survey published in Silver Spoon Kids by Eileen and Jon Gallo. He said “[I say] to my clients whose children are disappointments, lazy, and fail to live up to their
potential: no device that I can draft will make up for lessons that weren’t
learned as a child.”