Family Business Transition

Wayne Rivers
president of The Family Business Institute

Family business is big business. There are about 24 million family businesses in the United States, accounting for about 89 percent of business tax returns. In all, about 82 million people, or 62 percent of the American workforce, are employed by family enterprises. According to the Small Business Administration, small companies (those with 500 or fewer employees) create approximately three-quarters of net new jobs and generate 64 percent of the annual gross domestic product in the United States.

When the media portrays business, it almost always emphasizes big business and focuses especially on scandal-plagued companies like Enron. Family businesses represent the silent, virtually invisible majority of the North American free enterprise system.

This article presents key statistics, along with commentary, real-life family business examples, and a call to action for those who manage and own family businesses to rouse themselves to undertake the difficult task of self-perpetuation.

The bulk of statistics come from insurance giant MassMutual and the Raymond Institute, which funded a study published in January 2003, along with the Canadian Federation of Independent Business (CFIB) which produced a study in June 2005. Although the data overlap in a few areas, each study presents an interesting, if not downright startling picture, of the state of family business planning in North America.

Business Scenario
John and Mary Jones, co-owners of JZ Jones Construction Co., were enjoying a pre-dinner drink on a Saturday night. After a terribly busy week, they were reflecting on the states of their company and their lives, now that they were approaching 60.

“I’m worn out!” exclaimed John. “Our growth in the last four years has been a great thing for the company and our finances, but I’m working harder than ever before. I really thought by the time I was 60 years old that, as a man who ran his own business, I’d be able to slow down a little bit. The way things are going right now, I can’t see a time when that’s going to happen. I’m not sure how much longer I want to work this hard.”

“Well dear, I’ve told you how important it is for you to take more time off,” said Mary. “We’ve been married 35 years, and I can’t remember the last time we took a vacation that didn’t have to do with a construction industry meeting. Before we get too old to do it, I’d like to travel and see a little more of the world. We’ve worked so hard all our lives to build up a little money, and I’m afraid that, because you’re still having to work we’ll never get a chance to enjoy it.”

“I worry about Steve, Jody and Robert, too,” she continued. “You’ve created opportunities for Steve and Jody in the company, but poor Robert is barely making ends meet in his rock band. He’s got child support to pay for little Amy, too. As a mother, I just don’t know what to do about Robert.

“In fact, Steve told me the other day that the way our current estate plan is written, if something happens to us, the business would go to all three of the children equally, and he thinks that’s a rotten deal for him. He just doesn’t see how he’d be able to get along in business with his brother!

“The other thing that I don’t really understand is all these trusts. The long and short of it is that the business would go to me if something happens to you, and that’s about the last thing that I want. I’d rather find a different way to have financial security and keep me out of the middle of the children and business affairs.”

Revolutionary Change
John and Mary aren’t alone in their cocktail-hour discussion of the future of their family company, and the two surveys mentioned earlier have documented that many family business owners share their frustrations and concerns.

There is a sea change in the family business marketplace. About 40 percent of family businesses expect the leadership of their companies to change hands within the next five years, according to the surveys. Well over half (56 percent in the MassMutual study, 71 percent in the CFIB) expect a leadership change within 10 years. More than four out five businesses are still controlled by their founders, according to the MassMutual report.

As in the case of John and Mary Jones, whose three children will inherit the business, the succeeding generation of owners and managers won’t have an easy time coordinating the respective roles of owner and manager. The need for communication between sibling partners is infinitely greater than the need for communication in the case of a sole owner.

About one-third of the companies surveyed have a chief executive who is older than 60, and the average age is 54. About 11 percent are younger than 41, and just 11 percent are older than 71, according to MassMutual. In all, about 88 percent of survey respondents believe the same family or families will control their businesses in five years, but succession statistics undermine this belief.

Consider that while 30 percent of family-owned businesses survive into the second generation, 12 percent are still viable into the third generation, and only about 3 percent of all family businesses operate into the fourth generation or beyond. The statistics say there is a disconnect between the optimistic belief of today’s family business owners and the reality of the massive failure of family companies to survive through the generations.

Interestingly, Canadian family business owners assume that a family member will be the successor in only about 64 percent of cases.

Estate Planning
Nevertheless, the state of estate planning among family business owners is probably better than ever. Based on the MassMutual survey, 67.5 percent report a good understanding of the amount of estate tax due upon death. Having said that, other than preparing a will, almost 20 percent of family business owners have no estate planning. Additionally, while two-thirds of significant shareholders in family companies know of the senior generation’s share transfer intentions, awareness surprisingly dropped from 76 percent six years earlier.

Even worse, more than one in three respondents have no knowledge of the senior generation’s transfer plans. Senior generation family business members struggle mightily with how to fairly divide up their life’s work product. In John and Mary’s case, their issue is how to treat Steve, Jody and Robert equitably when they have such different strengths and ambitions.

A 2006 PriceWaterhouseCoopers survey found that 53 percent of the chief executives of the fastest growing U.S. private companies don’t address the disposition of their business in their estate plans at all. In addition, just 22 percent of the owners surveyed have revised the plan in the past five years.

Business Scenario
Steve joined JZ Jones Construction after completing a couple of years of college. He was a marginal student and couldn’t wait to sink his teeth into the operations of the family company. He has proven to be an energetic and capable manager and has handled most assignments in the family business successfully.

Middle child Jody was a straight-A student and went to work for General Electric for six years after her college internship. She was a successful manager, received several promotions and uniformly outstanding employee reviews. She was on a fast track before she decided to return to her family’s hometown with her husband Eric. At 31, she’s been employed in the family company for three years but has spent a great deal of that time away from the business due to two troubled pregnancies.The younger son, Robert, is a musician who travels the country and has a hard time making ends meet. He was married but divorced after less than three years of marriage. He has one daughter, Amy, who lives with her mother. Because the divorce was so bitter, it’s still a topic of conversation at family gatherings.

A challenge for John and Mary is to decide who should one day run the business. Steve is a capable leader and has done well in the company, but with all her talent and big company training, Jody is probably a better candidate for future CEO. To his credit, Steve is a good manager and has more tenure at the company than Jody. She’s a great mother and can’t reasonably be expected to put in the 70-hour work weeks that Steve considers the norm.

John and Mary love Robert a great deal but worry about what owning a third of a successful company might do to him. He’s never handled money well, and Steve, in particular, has indicated that he has no interest in sharing future ownership with his “black sheep” brother.

The estate planning that John and Mary have done is sophisticated and extremely tax-wise. However, like most tax-wise documentation, it places control of the family business empire solely in the hands of Mary if something happens to John. Mary has indicated she doesn’t like this arrangement and is quite uncomfortable with the prospect of having business debt and potentially refereeing between her children.

Furthermore, if Mary lives for 20 years beyond John’s demise, and Steve and Jody run the company effectively during that period, a modest 7 percent growth rate would quadruple the size (and presumably the value) of the company. That would earn them the perverse privilege of paying vastly more estate transfer tax than they would have otherwise.

While John and Mary have spent thousands of dollars in the estate plan’s execution, they are still uncomfortable with all of the unknowns and how to treat their three very different children equitably and reasonably.

Exit Strategies
The surveys tell us that, for company owners who are considering their exits, the most common method is to attempt to sell to non-family members (CFIB). Some 26 percent intend to transfer their businesses to family members, and 26 percent of the others have created no plans at all. Since the surveys indicate that approximately 40 percent of family companies will transition within the next five years, to have no plan at all for how that’s going to happen is downright startling.

Having worked with and observed family companies for the last 18 years, we also have to challenge the wisdom of basing an exit plan on selling to someone outside the family. Though it may be an owner’s dream for a deep-pocket purchaser to waltz in at the precise moment when the founder is ready to exit, in reality it almost never happens.

Business Scenario
The owner of a successful mechanical contracting company was recently chatting about his eventual exit. His thought was that if he couldn’t transfer his company to his son and daughter in the next few years to assure his financial security, he could just sell it to an outsider. When asked what exactly would attract a purchaser to his company, he said, “It’s perfect for an outsider; we have almost no structure here. Someone who’s a good corporate manager could really come in here and make this thing work and take it to a whole new level.”

This owner has an inverted view of what purchasers actually want. He considers it a strength that a buyer would be able to select a company with little or no structure, create systems for success, and imprint a new stamp on the company. What purchasers actually want is a company which is already successful. They don’t want to have to reinvent the wheel; they want to see a machine which is capable of producing a predictable stream of sales and profits in the future.

The things buyers look for — market dominance, structure, systems, independence from one or a handful of managers, stability, predictable cash flows, etc. — are exactly the things this owner identified as missing from his firm. To be blunt, many family business owners have pipe dreams about the “sellability” of their enterprises.

In addition, a significant number of business owners intend to participate in the operations of their companies after the transition, according to the CFIB survey. How they plan to do this, if almost 40 percent intend to sell to people outside their families, is not exactly clear. Consider that 38 percent of owners intend on being “special advisers,” while 7 percent expect to remain as senior executives. Nearly one-third (29 percent) don’t know what their role will be after transition. Nearly one-quarter (24 percent) of respondents said they will have no attachment at all after transition.

When asked why they plan to have a role after succession, 44 percent of owners said it was because of their “personal attachment,” according to the CFIB study. The longer an entrepreneur has been at the helm increases the likelihood that he’ll want to have a role after transition has taken place.

Even those who have planned their exits seem to have done so in a way that may jeopardize their success.

Business Scenario
A significant petroleum distributor and convenience store operator planned to sell his company to his family’s junior generation. He spent time, energy and tens of thousands of dollars on all the things leading up to the sale. However, the lion’s share of the deal was contingent (due to considerable seller financing) on the next-generation family business owners running the company profitably over the next 15 years, in order for the transition to become a true win-win.

If the junior generation runs the company into the ground, the senior generation stands to lose millions and will experience a significantly restricted retirement. Precious little time and attention was spent on preparing the successor generation to run the company successfully in the absence of the founder.

The owner in this scenario should have spent the same amount of time, energy and money in preparing the second-generation leaders in their proper roles, leadership mandates and success strategies. That would have strengthened the back part of the deal, where 80 percent of the financial transaction took place, and guaranteed it was as sound as the legal and financial parts. Without successful company management and operations, this deal could become a transaction valuable only on paper.

The data and statistics we have covered paint a none-too-flattering picture of the succession plans of family business owners. Family business is a massive economic engine in North America, and given that well over half of family companies expect a transitional event in the next 10 years, one would think that there would be a virtual state of panic among owners and stakeholders of closely held companies.

Business Scenario
John and Mary finished up their cocktails and prepared to go to their club for dinner. John said: “You know, Mary, I know how to run my business and make money, but we’ve never had to deal with these complex succession issues before. If you think about it, no family business owner really has to go through this except once per lifetime. We need to think about how to get through these next five or 10 years of transition the best way possible. I think the best place to start is to have a heart-to-heart among the whole family about how they envision the future. What we learn from our kids and their spouses might even surprise us when it’s all said and done.”

“I think that’s one of the best ideas you’ve had in a long time,” Mary replied. “It really makes sense for us as parents and stewards of this family to do a little ‘focus group study’ of the next generation to figure out what they want. Why, they might tell us to sell the business, put a few million dollars in our pockets, and move to Florida. Until we ask them, we simply won’t know.”

John, in a flash of insight, had come up with a brilliant idea. Beginning a productive dialogue among the family is a great place to start to determine future succession and transition strategies for any family company.

Wayne Rivers is the president of The Family Business Institute, Inc. FBI’s mission is to deliver interpersonal, operation and financial solutions to help family and closely-held businesses achieve breakthrough success. Wayne can be reached at 877-326-2493, info@familybusinessinstitute.com, or on the web at www.familybusinessinstitute.com.