Transferring the Business to Family Is the Most Hazardous Exit Path
In Exit Planning, the most important element of successful transfers is financial security for departing owners. This element often is gravely threatened by the prospect of transferring the business to successors (in this case, children) before the owners (i.e., parents) are financially secure.
Most Exit Planning Advisors have at some point watched in dismay as owners prematurely transfer business ownership to their children, who then prove incapable or unwilling to maintain the business’ success that their parents spent decades building. Parents are then forced to watch as their business, financial security, and family legacy burn, smolder, and die.
Parental Financial Security
Exit Paths that do not assure an owner’s financial security are not Exit Paths at all: They’re traps that can destroy an owner’s future. However, financial security has different meanings for different owners. Thus, we as Exit Planning Advisors must help owners determine what financial security means to them based on their unique situations.
Some owners are able to enjoy financial security independent of the business. Typically, this kind of financial security is the result of long-term investments of excess earnings outside of the business.
Other owners achieve financial security by leasing personal assets—such as equipment and office, warehouse, or manufacturing facilities—to the business for its use. Maintaining ownership of these personal assets and leasing them achieves the following:
- Provides ongoing, consistent income for the owner.
- Lowers the value of the business and reduces transfer (i.e., gift or estate) taxes, thereby easing the transfer of the business to business-active children.
- Makes assets (or wealth) available for transfer to non-business-active children.
- Protects assets from the business’ future creditors after the parent exits.
The difference between these two kinds of owners is that the first owner (i.e., financially secure independent of the business) most likely needs the business to continue generating rental income.
However, most owners achieve financial security through ongoing income directly from their businesses. These owners must not consider any kind of operational or ownership transfer—not even a transfer to family—before first assuring that they are financially secure.
When transferring ownership to family (specifically, to children), owners must consider the following two points:
- Owners must attain financial independence before they transfer ownership and control to their business-active children.
- Owners must consider gifting rather than selling ownership to their children in order to legally avoid paying more in taxes than is absolutely necessary. However, by gifting rather than selling controlling interest, owners will be entitled to nothing (or at least no cash) in return.
Jumping the Gun
As an Exit Planning Advisor, if an owner tells you that he or she is ready to transfer ownership to his or her children before attaining financial security, you must consider it a red flag. Business-owning parents often trust their children with the business without considering events that are outside of their children’s control. Failing to consider these events can cause harmful and irreversible damage to the business’ cash flow or cause a child to lose control of the business. Some examples of such outside events include a child’s poor business or personal decisions that lead to decreased business value or cash flow, a child’s premature death or, more likely, a child’s divorce. Unless your owner-clients consider these events when considering transferring the business to attain financial security, they may find themselves without a steady source of income.
To protect owners while reassuring their children that the business will transfer to them someday, BEI Exit Planning Advisors take the following actions:
- Amending owners’ Estate Plans to provide for a transfer of ownership to their children following the owners’ deaths.
- Creating an Exit Plan that maps out the process of ownership transfer from parent to child as the parent attains financial security. This plan design is based on designated financial benchmarks that the business must reach to trigger subsequent transfer steps, which is an approach BEI often uses in insider-transfer Exit Plans.
If the business-active children expect to receive ownership immediately, we recommend that the child obtain financing to pay for the parent-owner’s ownership interest, but only if the financing would guarantee the parent-owner’s financial security. However, this structure means that the family will be taxed twice on the transfer: once on the parent’s gain from the sale and once on the child’s income used to pay for the parent’s ownership interest. Additionally, banks will often refuse to lend money to successors without a large down payment (usually 20–40% of the total purchase price) or unless the successor owns a large stake (about 30–40%) in the business already (even then, it’s rare for banks to lend to these successors). This means that successors must receive significant ownership before acquiring the balance of the business via bank financing.
Finally, if the business fails to perform as required or the child leaves the business during the buyout period, owners must have the right to reacquire the ownership already transferred. This enables owners to transfer the business and obtain financial security via a sale to management or an outside party.
Regardless of whom your client sells to, financial security must be achieved. When transferring a business to family, the most common error is transferring too soon. Premature transfers in an Exit Planning context are unnecessary and dangerous. Thus, we recommend that you use the techniques described above to assure children-successors that they will one day own the business and assure that parent-owners will achieve financial security concurrently.
Why Lasting Change Is Hard
Before we had any children, my wife and I lived in the heart of Dallas. One day, on our way back to our house, we were driving down Skillman Avenue when we were caught in a sudden torrential downpour.
The rain was coming down incredibly hard, which wouldn’t have been a problem if the storm drains were equipped to handle that much water. Instead, the road itself filled with water faster than we could have anticipated. Quickly, the water rose up the side of our car. Trying not to panic, we realized that we could not continue and would need to turn around and get to higher ground.
Water rising up the side of your car door is the kind of roadblock you might not expect to encounter, but when you do, it’s formidable. We couldn’t drive through it or even around it. We had to deal with it quickly or face serious consequences.
When we’re trying to implement change in our own lives, it’s important to identify and plan for common roadblocks to lasting change.
The first and, in my opinion, most important roadblock to lasting change is not addressing the real issue.
Let’s say you wake up in the middle of the night with a sore throat. You’re annoyed by feeling sick but your throat really hurts, so you get up and spray a little Chloraseptic in your mouth and drift off to sleep. When you wake up the next day, you still have a sore throat, so you pop in a cough drop and go about your day.
The change you’re making – using a numbing agent – might work if you’ve only got a cold, but if it’s strep throat, you’re not addressing the real problem. Only an antibiotic will cure what ails you, even if Chloraseptic will keep the pain at bay for a while.
Just like how more information is needed to diagnose your sore throat than one feeling, problems you encounter in your life or business require diagnostics, too. Figuring out the real problem – not just your most apparent needs – requires some introspection and a little bit of time.
Here are eight questions to ask when you need to discover the root cause, courtesy of MindTools.com:
- What do you see happening?
- What are the specific symptoms?
- What proof do you have that the problem exists?
- How long has the problem existed?
- What is the impact of the problem?
- What sequence of events leads to the problem?
- What conditions allow the problem to occur?
- What other problems surround the occurrence of the central problem?
Once you have your answers to these key questions, you can’t stop there. Your vantage point is skewed from your own perspective. You’re going to want to ask someone else to evaluate the problem at hand with the same questions and then compare your answers.
If you and all of the partners at your firm have similar answers, you’ll know you’re on the right track. If you wind up with wildly different ideas, I suggest seeking the advice of someone outside your organization. Fresh eyes can make all the difference in understanding a problem.
I often talk about being ‘too close’ to understand. You’ve probably heard the illustration about a group of people standing by an elephant with blindfolds on, trying to describe what they’re experiencing. Depending on what part of the elephant you’re next to, you’re going to have different observations.
But someone outside of that elephant’s cage can clearly identify the elephant.
The first key to making a lasting change is to make sure you’ve addressed the real problem and are looking for authentic change.
Next time, we’ll address the second major roadblock to creating last change.
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