Heir Conditioning:Should Your Children Get The Family Business, or What It’s Worth?

Heir Conditioning:Should Your Children Get
The Family Business, or What It’s Worth?

by Michael P. Kirby

For an owner of a closely held business, few questions cause as much soul-searching as the issue of whether to leave your children the company…or the company’s value.

This may sound like a rational business decision, but it’s not.It’s a choice that can pit your head against your heart, your love for your business against your love for your kids, and your hopes and dreams against cold hard reality.

Not long ago, a business owner in another state asked Banc One Capital to advise him on the ramifications of valuing his company for estate planning purposes.Mr. Lincoln (not his real name) was proud that his two children were both actively involved in the manufacturing business he had founded.However, when his son, the president, had a falling-out with his daughter, the executive VP, it was all he could do to keep their dispute from affecting company operations.

My Banc One colleague (whom I’ll call Bob) asked Mr. Lincoln if he wanted his children to inherit the value of the company, or its management.Instead of replying, Mr. Lincoln changed the subject.Knowing the answer was vital in order to define the valuation objectives, Bob repeated the question a few minutes later.Again the owner skirted the issue.It wasn’t until Bob asked the same question a third time that Mr. Lincoln sighed.

“You’ll make me verbalize something I haven’t wanted to admit to myself,” he said at last.”The kids can’t run the business without me.”

Coming to Grips With the Future

Every owner needs an exit strategy, for the sake of his or her family and the business itself.If your strategy is to keep working until you fall over, that’s fine–as long as you’ve made plans for what will happen to the business once they carry you out the door.Otherwise, whoever inherits your equity could pay dearly in confusion, anxiety, and poor business decisions, not to mention unnecessary taxes.

Understandably, entrepreneurs are often reluctant to strategize a future for their company that doesn’t include them.When you’ve invested years of sweat equity, time, and passion in creating a living entity, it’s human nature to resist the thought of ever being separated from it.Like the Energizer bunny, you hope you’ll just keep going…and going…and going.

When your children are added to the picture, the emotional drag on decision-making becomes even stronger.Unless you know for sure that your kids aren’t interested in taking over the business, your strong and potentially conflicting feelings for them and for your company may lead you to keep putting off the moment of truth–the moment when, like Mr. Lincoln, you decide whether or not they’re capable of running it as well as you do.

Assuming you’re in good health and the business is in good shape, the best time to answer tough questions like these is now:

  • How much longer do I really want to run my business full-time? 
  • What would I do if I no longer had this responsibility? 
  • Are my children interested in, and capable of, taking over the company? 
  • If so, what would be a reasonable time line for this transition? 
  • If not, when should I plan to sell the business? 
  • How would I want the proceeds to be invested and managed?

You may be lucky enough to have a confidant you can discuss these questions with–perhaps your spouse, and experienced friend or mentor, or your business’ attorney, accountant, or investment banker.But because the issues are so emotionally loaded and their consequences so complex, there’s a good case to be made for consulting an objective third party with the specialized experience and broad-spectrum capabilities to help you understand and evaluate the financial alternatives associated with your options, and assist in implementing your strategy once you’ve reached a decision.

If You Want Your Children to Get the Company

If you decide to pass your business to the next generation, you’ll want to explore more questions before devising a plan with your transition advisor.For example:

  • How long do I want to continue controlling the business? 
  • Will my children be ready to take over at that point? 
  • If so, should I plan tostay involved while transitioning management gradually? 
  • If not, will I need the interim support of an experienced manager until they can step up to the plate? 
  • What should the company’s new management structure look like? 
  • If I’m passing the business to more than one child, what happens if they disagree? 
  • What if I disagree with the way they’re running the company? 
  • How much income or liquidity will I need, and for how long?

The answers should produce a financial strategy that’s customizedfor your circumstances.Everybody’s situation is a little different.Divorce, second marriages, problem kids, tax issues, unusual income requirements…there’s no single technically correct approach to generational transfers.

Among the many possible solutions you may discuss are a family limited partnership (which allows you to give your children shares of ownership whose value may be discounted for tax purposes), a grantor retained annuity trust (into which you transfer non-voting stock with the children as beneficiaries, receiving in return S Corporation distributions over a term tailored to your needs, after which the stock passes to the children), or sale of stock to a trust (you take back a note which is repaid with S Corporation distributions over a specified period of time, following which the stock is distributed to the children).

No matter what alternative you settle on, you should expect your transition advisor to work closely with your financial advisor to make sure your financial planning, tax planning, and estate planning all dovetail together.For example, your compensation should be structured in a way that provides financial security and tax advantages for you, while permitting business income to continue flowing to your spouse or other beneficiaries if something happens to you.

If You Want Your Children to Get the Company’s Value

If you decide your children are better off benefiting from the wealth tied up in your business than trying to run it, consider how to maximize the company’s intrinsic value before you sell.Making the business more attractive to buyers is the cornerstone of a good exit strategy–and if you’ll be paid out of the future income stream, you want to position the company to continue generating healthy income after you’ve left.

Your financial advisor should help you answer questions like these:

  • Would I prefer to sell to an employee, or to a qualified third party? 
  • When would be the most opportune time to sell? 
  • What cost-effective investments might significantly increase my company’s value to buyers (for example, a key employee incentive plan or targeted capital improvements)? 
  • Am I willing to ease the transition by serving as a consultant to the buyers? 
  • How can I minimize my tax liability as the seller? 
  • What do I want to accomplish with the proceeds of the sale? (In addition to providing for your own needs or your children’s future, this might include such goals as leaving a gift to a church or college.) 
  • Will I need assistance in investing and managing this new wealth for current income, asset growth, or tax-favored estate planning (or some combination of these)?

To make all these elements mesh seamlessly, your financial advisor may end up orchestrating the talents of investment bankers, venture capitalists, trust specialists, and asset managers, while coordinating closely with your estate planning attorney and business valuation expert.

Whether you choose to transfer your company to your children, or to sell and pass its value to them instead, it’s never easy stepping away from a business you’ve brought into the world.But once you’ve taken the time and made the effort to grapple with this issue, once your transition team has done its work and the deal has been sealed with a final handshake, I suspect it will be easy to spot you among the group that gets up and walks out the door.

You’ll be the one with the biggest smile.