There comes a time in the life of every family owned or closely held business when the owners must think about what will happen to the business once they are no longer at the helm. In some cases, the answer may seem obvious: “Of course, my (son/daughter/ niece/nephew) will take over.”

However, statistics show that successfully passing a business to the next generation is more difficult than many might imagine. According to the Family Firm Institute, only 30 percent of family owned businesses survive into the second generation and even fewer – 12 percent – make it to the third.

Why the high failure rates? Sometimes the business is tied too closely to the founder to succeed after he or she is out of the picture. Or the next generation lacks the talent or interest required to make the business succeed.

In many cases, though, the failure rate is simply the result of inadequate planning prior to the actual hand-off. The transition of a business from one generation to the next is a complex matter, mired in both financial and emotional implications. Frequently, assumptions are made, communication is lacking and – in general – basic, good business practices go out the window. However, simple preplanning can help avoid potentially painful missteps.

Assume Nothing
Business owners should never assume a child or other family member will take over the business. The question must be asked aloud in a formal business context. Often, business owners have not had clear communication on this topic with the otherwise-close family members who might succeed them.

If the interest is there, the next question is whether he or she actually will be able to succeed happily in this role. Here, the advice of existing non-family management and outside consultants can be valuable. Consider using the same evaluation process on the future generation as you would on an independent candidate being considered for the position.

Ultimately during this process, some owners will discover that they can actually do more for the next generation by selling the business to an outside party and providing offspring with capital to invest in something better suited to his or her personal skills, style and interests.

It Is a Sale
Keep in mind that all transitions are sales transactions. Whether selling to a family member, a trusted partner or a third party, you are always selling the business and must consider every aspect of the sale. A couple of questions must be answered.

First, what do you consider the fair market value of your business? A common setback for a family business is disagreement over the value of the business. Although the incumbent generation feels it is selling the business for less than it is worth but giving successors a fantastic opportunity, the new generation feels it has overpaid for a business it must repair or re-fit for a new era.

Consider outside valuations and third-party facilitators to help negotiate the price. Another option is to set a price range to anticipate increased or decreased profitability during a defined period of time. This allows the transition to both reward the departing generation and protect the future one.

Second, are you in a financial position to sell to a family member? Frequently, selling the business to a family member means accepting a lower price, reduced guarantees, extended payment terms or delay in payment in exchange for the gratification of seeing your businesses continue into the next generation.

If your needs are for current cash and guaranteed payout, transition to a family member may not be the best option. Often, an outside buyer is more likely to bring a larger down payment to the table, provide more substantial guarantees and pose less of a moral dilemma if legal actions to collect future payments are necessary.

Preparing a Successor
If all the financial and personal aspects are in order, the next step is to prepare for the actual transition. Remember that running the business and working as part of the business are two very different things. Even if a family member has been an integral part of the company his or her entire career, steps will need to be taken to prepare for the leadership change. A formal, written transition plan with mutually agreed-upon roles, guidelines, objectives and a timetable – reviewed and updated on a recurring basis – may help not only with the transition, but with expectations of both parties. It will also provide a sense of achievement as the transition progresses.

In anticipation of this transition, it is important to recognize the potential cost to the business or compromise in lifestyle that will result from time spent to train the next generation to run the organization. In most cases, you will be paying your successor while he or she learns, and shifting your own focus off some business matters while spending extra time on others to fulfill the necessary educational process. You also likely will be spending extra time on the business at a point in your life when you could be enjoying more leisure time.

Planning is Key
Ideally, plans for the future of the business should be made five to seven years in advance of the anticipated transition. Although little can give a family business owner a greater sense of satisfaction than seeing the company continue successfully into the next generation, it is important to recognize that it is not always possible. Early discussions about expectations on both sides can help you to either plan for the transition, or recognize that it may not have a beneficial outcome.

Transitioning a business to the next generation is a goal for many businesses. Realistic expectations and sound business principles can only enhance the process. As in any family dynamic, communication and planning are essential for a positive outcome. The following case studies – one a cautionary tale, the other a success story – illustrate the value of effective prior planning.

The Hazards of Assumptions
When his partner decided to sell his half of their mid-sized service company, a father invited his daughter to buy the partner’s half. After reaching a verbal agreement, the business thrived as the father and daughter worked together through the daughter’s seven-year buyout of the business partner.

As the transition period came to a close, the father wanted to take some additional compensation from the business, just as the daughter had plans to invest in expansion and growth. Because there was no written agreement about the father’s exit strategy, the two had been operating under very different assumptions. The daughter believed that the father would retire and accept the same purchase price for his half of the business as she had paid for his partner’s share. The father felt the increase in value of the company should be reflected in the purchase price of his share. And, he was reconsidering his retirement. The two reached an impasse. At this point, professional advisors were brought in to help resolve the transition, which was taking years longer than expected.

The advisors worked with this client to:
• Establish a formal buyout process
• Act as a neutral third party
• Develop legal documents
• Reconcile the transaction with estate planning

Had a third party been involved sooner, they could have avoided the years it took to reach the final transaction.

Smoothly and Profitably
After building a small distribution firm that comfortably supported his lifestyle, another father decided it was time to start thinking about transitioning his business to the next generation. He approached his son, who worked on Wall Street, to discuss the possibility of the son joining the company. At the time, the business was generating less than $1 million annually.

The son was agreeable but had a significantly different vision of the company’s goals and potential. The two worked with their professional advisors to develop a transition plan. They discussed:
• Where they wanted the company to go
• Who would be in charge
• Who would handle different areas of growth and operations
• Their corporate goals
• Estate planning and the future handoff

To avoid future conflicts, the parties agreed in advance on major issues. This allowed the son, who had taken a cut in pay to join the company, to take control of the company’s growth and attract larger clients and products, while his father continued in his operational role.

In five years, the company was generating annual sales of $10 million, and five years later it was at $50 million. With the previously established estate plan, company ownership shifted from father to the son when the father died.  

Alan Bordogna is a partner at J.H. Cohn LLP. He has more than 30 years' experience with privately owned businesses and has helped numerous family owned businesses address transition issues. He can be reached at abordogna@jhcohn.com.

# # #

Article appeared in US Business Review, November 2006

home | samples | background | info

copyright 2008, Carole Dicton [bdo blog]