SUCCESSION PLANNING
Like dancing with porcupines

Buying out your elder partners? Do it carefully.

A 68-year-old sister/aunt owns 35% of the company but never worked in the business. While she counts on her quarterly dividend distributions, her family’s next generation wants to reduce dividends to grow the business. A 75-year-old uncle comes in to work once a week, but still demands the full compensation and benefits he earned in his prime. His nieces and nephews acquiesce because, “We want to still be friends with Uncle Bill when this is over.”

In family businesses, we often read about succession difficulties when fathers transfer power to sons or daughters. But what about when it’s time to buy out, retire or nudge an elder sibling, cousin, uncle or aunt out to pasture?

Before the next generation can take charge, sometimes a less-than-productive family member needs to be bought out. Succession planning may come to a screeching halt if the seller has an unrealistic view about the value of his ownership or his contribution to the business. A reluctance to address this tough family issue exacerbates the problem. Either way, years may go by.

Here’s where the adage, “No good deed goes unpunished,” holds true: Excessive generosity (with compensation, bonuses and dividends) to less-than-productive family members comes back to haunt everyone. Senior generation peers may have been “generous” over the years in supporting their less productive siblings or cousins and back down when its time for tough negotiating Meanwhile the next generation is anxious to move on.

As a result, unresolved issues may fester for many years, the next generation may quit the business from frustration, and without next generation involvement or leadership, the business may eventually be sold.

Where do families get stuck? In my experience, the problems and solutions lie in several areas:

Don’t tiptoe around hard issues. Andy Grove built Intel on a philosophy of “creative confrontation.” In other words, it’s better to get in shouting matches and solve problems quickly than let issues fester for fear of offending someone. Families often don’t realize they aren’t helping other family members when the business provides them a safety net.

Negotiate a buy-sell agreement with options to buy or sell shares during the holder’s lifetime. If your current agreement doesn’t provide options to buy or sell, say at age 70, and then again at 75, then consider amending the agreement. No one wants a widow (or widower) to later negotiate with 30-something, next-generation owners who may not share the same compassion for elder relatives that their parents did. A “put” or “call” option is not an automatic trigger, but means that if either side wants to buy or sell the provisions are in place without further negotiation.

Use a realistic valuation methodology and keep it updated . Establishing a price, based on a fair market value formula or an appraisal of a 1% interest, can help curb unreasonable expectations about the value of one’s shares, especially for inactive family shareholders. Often the interests that may be bought or sold are non-marketable, minority interests.

If there is no binding buy-sell agreement, then some old-fashioned horse trading is in order. In one case, the 72-year-old uncle and his 38-year-old nephew each hired their own appraisers and (no surprise) the conclusions were miles apart. My firm was hired to help them agree on price and terms. Agreeing on one appraiser or methodology ahead of time can save time and money in reaching a consensus.

Communicate operating results and how they impact share value. Valuations are typically based on three-to-five year rolling results, weighted so that the most recent period carries greater impact. But projected future cash flows may be significantly different. So educate your shareholders as to how operating trends and business decisions may impact the future value of their shares.

Separate the family dividend from compensation. Too often, the thinking is: If you’re going to pay family, you might as well pay salaries that you can deduct(for income tax purposes. This tactic can create unrealistic future expectations while ignoring personal performance.

Tax-deductible compensation should be based on individual contribution and level of responsibility, while non-deductible S dividend distributions are paid pro-rata to all shareholders. Letting the income tax impact drive family income decisions causes later problems, since family members may come to assume that the business “owes” them a continuing income.

Implement a “tag-along” agreement. Sometimes elder members hold onto family business shares in the hope that the business may get sold to a third party for a windfall price. They may be reluctant to sign a buy-sell agreement, since it may not reflect such a possible windfall.

A tag-along agreement promises that if an internal family-sale occurs, and the business is later sold to a third party for a far greater price, then the seller will participate financially in the third party transaction. The term of the participation is usually for five to ten years, and the percentage of participation usually declines over time.

A cautious and respectful process may take a few years. But it can produce an agreement that both sides view as “fair”. The definition of “fair” isn’t the highest or lowest price, but the price and terms that lead to a graceful exit. At the end of the day, elders need their pride and the appreciation of their successors. If you keep this goal in mind, even a tough porcupine can be tamed.