business from one generation to the next is common. One of my earliest consulting projects was to assist a family going through the transition.
“Dad won’t leave! He was supposed to retire, and the place was supposed to be mine to run! But he still comes in every day and shoots down every new idea I have for improving the business!” lamented the daughter, the new owner.
“Kids just don’t understand! I mean, I built this business and I know how it works. My daughter thinks we need new computers and fancy tools. She just doesn’t understand. Man, I’m supposed to retire on the income from this place, but the way she’s going, there won’t be anything left!” explained the “retired” former owner and father.
Transitioning the business from one generation to the next doesn’t have to be filled with conflict. In fact, transitioning from one generation to the next is no different than transitioning to any other buyer such as an multiple-system operator or competitor. Well, there is one difference with a family business: you’ll still be family when the transition is over.
Plan Now
The key to a successful transition is to plan well ahead for the transfer of the business from current ownership to the next generation. The time to begin planning is now!
Another early client of mine was a young woman who found herself the owner of the family mechanical repair shop. Her husband, who built and ran the business, passed away suddenly as the result of an accident. His wife, the mother of three young children, was suddenly the owner of a business she knew nothing about. Mrs. Smith’s car still had to go on Friday! Stuff happens. We need to plan for it.
The father quoted above, when asked if he had any written procedures for the business, simply pointed to his head and proudly said, “I’ve got it all right here!”
I suggested that the first step in transitioning the business was to find a way to get those procedures detailing how the business works out of his head and onto paper.
“It doesn’t need to be fancy,” I said. “You just need to outline who does what and how things work. Think of it this way: How do your kids run the business tomorrow if you die tonight?”
“I’m not dying!” Pop said.
"Well, you never know. Look at yourself! You drink too much, smoke too much and you’re overweight. It could happen tonight! All that stuff in your head will be inaccessible to your kids. It would actually be worse if you had a stroke or heart attack and survived. All of the information in your head will still be inaccessible, but the ongoing bills will be enormous!”
He fired me on the spot. A week later, he called me back and we began the process of creating a transition plan. Every business owner needs a transition plan to make an orderly transition to family so that the owner may retire or to handle the unexpected event of catastrophic illness or death.
Create a Team
To create a solid transition plan, most will need to create a team. The team should be composed of your accountant, a transaction attorney, perhaps a consultant, and a good life and disability insurance agent. Begin with the accountant, then build the rest of your team. But don’t wait – begin now.
Why now? One answer is that you just never know when you’ll need to use your transition plan. Certainly, the young business owner and father had no idea he would pass away that day. The other answer is that it’s cheaper earlier. Life and disability insurance will likely be funding tools in your transition plan. When you’re healthy in your 30s, those tools are inexpensive. But wait until you’re 60 and those tools will be expensive or not available at all.
Valuation
Once you have your team, the first step is to place a value on the business. There are many ways to value a business. Work with your accountant to determine what the business is worth. You may decide to hire a business appraiser to come up with a fair number. If the plan is to pass the business on to a child or other family member, you won’t need to spend a lot of money on this valuation. You just need a number that everyone will agree on.
Remember, the manner in which the sale is written will have significant tax impacts. Keep your accountant in the loop to limit tax liability as you work through creating a transition plan.
Get Your Books Straight
I have yet to review a shop’s financial statements without having some interesting questions such as, “Is that RV really a shop tool?”
Go through your books, making sure that the P&L is accurate and the proper assets and liabilities are in the proper place on the balance sheet. Don’t forget Work In Process and Inventory, items which frequently aren’t accurately represented in shop financials.
The P&L will form the basis for creating financial projections and “pro-forma” statements that will show how the kids will pay for the business later. You really need clean financials on which you’ll base accurate projections.
Separate Real Estate from Business
Many shops carry the value of the real estate on the balance sheet as an asset. Separate the real estate from the business. Consider the real estate as a separate asset. Work with a commercial realtor to determine a fair market lease rate for the land and building. The business should be considered a tenant of the building and should pay the competitive lease rate to the ownership.
In many cases, the value of real estate is understated and the business isn’t paying a fair market rate for the space. I’ve seen businesses that have paid off the property and show no rent factor. That causes problems with the financials as the real estate value is understated on the balance sheet and the rent factor is understated on the profit and loss.
In structuring a “happy family transition,” you can make good things happen by structuring agreements around real estate property lease payments. The tax hit may be significantly reduced by lowering the purchase price of the business and increasing the monthly lease payment on the real estate. Once again, work with your transition team to structure the best possible deal.
This approach helps solve one of the biggest concerns that parents have in passing the business along to the kids: their retirement income will be coming from real estate lease payments, not the operation of the business. If the kids drive the business into the ground or sell it, the lease payments will continue as the space can be rented to someone else.
Determine Roles
Deciding who does what is easier said than done. Who will continue to run the business and who will need to come into the business to perform duties being performed by the person who’s leaving? While it may not be obvious to the kids, Dad performs many duties. He comes in at 6 a.m. and does “owner stuff” that may not be seen or appreciated. If he retires and leaves, who will do those things? If the answer is “I will!” then who will do the things you currently do? The business may need to hire someone to complete the duties currently being performed by the son/daughter who’s assuming the role of boss.
This does not have to be complex. In the example earlier of the owner who carried everything in his head, the answer was to brainstorm among the family members to create an organizational chart of who does what on several flip chart pages. Those pages were consolidated into a few pages on a word processor. Soon, everyone knew who did what. Then, if someone isn’t available for any reason, that person’s duties can be reassigned to others.
Lessening Conflicts
Have you already transitioned the business or are in the process of transitioning and want ideas to help lessen the conflict right now? This is the first step. Conduct some brainstorming sessions and define who does what, exactly. Then, when conflict arises, refer back to your agreements. Include a “mediation clause” in your “who does what” agreement as a process to follow if there are business-related family disputes.
Find an independent party to referee disputes. That person could be your accountant, a trusted friend with a good business head or a consultant. Just find someone who can listen to all sides of an issue, review and understand the financial impact of decisions, and offer a solution.
Forecast Accurately
Perform solid financial planning by creating pro-forma P&L’s and cash flow statements. The biggest problem in most business sales is the failure to accurately forecast the financial impact of the transition.
For example, Dad agrees to sell the business to his two children for $500,000 and they’ll lease the building and property for $6,000 per month. Currently, the business pays $4,000 per month in rent. Since the buyers are the kids, Dad is not taking a down payment on the $500,000. Instead, he will accept a note for the $500,000 with a 25-year amortization, seven-year call at 6 percent. (That’s a $500,000 loan, amortized over 25 at 6 percent interest, balance due in seven years).
Many will jump in, saying, “Sounds good! Let’s do it!” But someone needs to create pro forma P&Ls and cash flow statements with the new loan payment of $3,221.57 built in as an expense. Those same forecast statements need to show the rent at $6,000 per month plus annual adjustments. Lease payments typically are adjusted annually based on the Consumer Price Index (CPI). Figure a 3 percent annual increase in rent, so next year the rent will be $6,180. Leases typically include property taxes, which should be included in the financial planning as well as insurance expenses.
Just considering the rent and loan payment, overhead is increased by $5,221.57 per month. At a 40 percent gross profit percentage, the business must generate an additional $13,539 in sales each month just to cover the overhead increase. Next year, the numbers will be bigger. How will those additional sales be generated?
Emotional Issues
There is no denying the fact that a business sale is very emotional for the seller. Mom and Dad may have spent 40 years of their lives building the business, and so selling that business to anyone is very emotional. Selling it to the kids is even more so!
The solution is mutual respect and continued communication throughout the transition process.
Kids: Understand that Mom and Dad have been coming to work at 6 a.m. for the past 40 years. They built the company! The business is their baby and it’s impossible for them to just get up and go. It will take time! They’ll still be around. Seek their guidance and keep them involved as appropriate. They probably faced the same problem you’re facing today, so keep communications flowing.
Mom, Dad: Respect the fact that the business has been passed along. Be ready with advice, when asked. Enjoy not having to go in every morning! Really enjoy the rent check. Go in if you really have to, but offer gentle guidance and understand that some of your greatest lessons were learned by making mistakes. The new owners deserve to learn the same way. Avoid saying, “I told you so” whenever possible.
Many emotional issues can be avoided by one of my personal rules: “Never borrow from family.”
In the example above, the kids should borrow the $500,000 from a bank or through an SBA loan. Yes, they’ll have to come up with the down payment, but the parents get their money and the debt is outside the family. If the business fails, the parents still have their money and the property to lease.
Yes, tax issues must be considered, but avoid borrowing money from family!
On a related issue, if any equipment is on a lease, rewrite the lease to the new owners. Don’t assume the existing lease. Do this to protect the seller. If Dad’s name is on the lease and the kids don’t make the lease payment or are habitually late, Dad’s credit is damaged, not the kids’ credit. So re-write the leases.
Of course, work with your transition team to analyze the best structure for your transition.
The key to dealing with most problems that arise with the business transition within a family is to maintain open and honest communication throughout the transition.
Other Issues
Most of this article is written from the view of transitioning the business from the parents to the kids, but the same planning involved in the family transition is useful in overall succession planning. Your team should have discussions regarding other possible events, such as your untimely death. Or more likely, you’ll suffer some form of disability, which may require your exit from the business for an extended period of time.
In the case of the business owner who passed suddenly and left his wife as owner of a business she didn’t understand, a succession plan would have included sufficient life insurance to allow her to hire a qualified manager. He should have left a “who does what” list so that the business could continue as she dealt with the devastation of losing her husband and returning to the work force on the same day.
Don’t ignore the possibility of significant disability. Odds are we’ll be disabled before we die, so plan for that. This is an issue personally as well as for the business. How will the business continue for an indefinite period of time without you? You can’t expect the business to continue paying you a check while you’re out, so how will you pay your personal bills if disabled?
Disability and “Key Man” insurance is readily available and affordable, if you buy it early. If you wait until you need it, it’s simply not available! Everyone should carry a private two-year disability income policy. Yes, Social Security has a disability benefit, but approval will probably take two years.
Look at life insurance, disability insurance and “key man” insurance as tools in your succession planning tool box.
Summary
Transitioning a business from parents to kids is an emotional yet common occurrence. The process should be planned early and involve the work of a transition team composed of your attorney (transaction specialist is best), your accountant, a good insurance agent specializing in life and disability insurance, and key family members.
During the transition, it’s critical to maintain open and honest communication and a focus on the numbers that drive the business. Determine a path to resolve conflicts before they arise, and find someone who can help mediate.
With proper planning, the transition can work well for all involved.
Hank Nunn is a 37-year collision industry veteran. He may be reached at [email protected].
