As part of our discussion of issues related to the transfer of family-run businesses, let’s turn to the issue of merit. We’ll look first at how merit plays a role in transferring ownership to a child active in the business as well as the role it plays in how “fair” the child (or children) not assuming ownership perceives that transfer to be.
Let’s consider two common family business scenarios:
Scenario 1: Ideal and Rare. These owners had the foresight to avoid the inherent difficulty in having multiple children, but only one company: they sired but one child. Further, that child is capable, ambitious and wants ownership. Transferring a business to this only child makes sense and isn’t that difficult to accomplish.
Scenario 2: Real and Common. Owners have one business but more than one child. This situation commonly plays out in one of three ways:
Performance standards vary from business to business, but, at a minimum, they should:
These standards control the incremental awards of ownership over a multi-year (typically five- to ten-year) time span. As standards are met, a child earns, and is awarded, ownership via stock bonus, gift or purchase.
Merit as Measured by Performance Standards
Whether selling a business to key employees or transferring to it children we generally recommend that successors earn ownership (or, in the case of employees, cash to fund the buyout). Performance standards not only govern a successor’s ability to earn ownership, but they also motivate (and reward) management and key employees to increase enterprise value and cash flow over time. If employees meet the owner-set performance standard(s), they receive (generally) a cash bonus. Similarly, if a child meets an owner/parent-set performance standard(s), the child is reward with ownership in the business.
Performance standards can be designed in many ways to reward children with ownership or to allocate ownership among active children. For example, if one child is president of the company or a division, a performance standard (for the award of a stock bonus, for example) might relate to the company (or division) reaching a revenue or market-share target, cash flow level, industry benchmark or other goal. Each child who achieves the performance standard set for him or her receives an award of ownership.
Performance Standards and Business Ownership
Hank Weatherby, a business and Exit Planning attorney in Connecticut, tells the story of the owner who brought his son and daughter into the business when his company was worth about $2.5 million. Due to the son’s efforts, the company increased in value to $40 million. The son benefited from his value-building efforts in two ways. First, his annual salary increased to over $1 million. Second, the value of his ownership of the company and the new subsidiary increased in value from about $600,000 to nearly $10 million with over $6 million of it available to him, but totally excluded from his estate for estate tax purposes.
The owner’s daughter worked as the company’s accountant at a salary of $125,000 per year. She was not contributing to the increase in the company’s value so rather than award her ownership outright or continue to increase her salary, her father gifted her, in trust, a small amount of ownership.
When we asked Hank about whether the glaring disparity in both salary and ownership had poisoned the sibling or parent/child relationships, Hank was surprised. "Bad blood? Not at all." Hank recalls that, "Early on dad told both kids how he planned to transfer the business and about the performance standards he set. Both knew the rules of the game going in and neither had any complaints."
We devoted an entire article to the importance of communication in family transfers , and the case above is great affirmation. Both children had the opportunity to “seize the ring.” One accepted the challenge (with great results) and the other decided to remain active but less involved in the business, but both were satisfied with the result of their choices.
Performance Standards and Cash Flow
If you choose to use performance standards based on cash flow increases or other key performance indicators (such as net revenue), another benefit is that as your child meets the standard, he or she creates additional cash. This cash can be distributed to the parents and used to invest in non-business assets. Consequently, the parents will be able to leave the business sooner, or leave as originally intended, with more money. They can also transfer excess cash to non-business owning children.
Performance Standards and Successor Ability
One of the valuable byproducts of performance standards is that a child who meets or exceeds them effectively demonstrates her ability to operate the business successfully. Another is that the business-active child can earn ownership under the same conditions as would a non-child key employee earn a cash award.
Performance Standards and All Children's Perception of "Fair"
Objective measurements of the business-active child’s contribution to the business buttress that child’s likely position that his or her parents’ estate (apportioned by gift or inheritance) should not include his or her business interest (whether owned or promised) because he or she has earned it. Performance standards also take the wind out of the sails of non-business-active children who may demand that offsetting assets be transferred to them in an amount equal to the “gift” of ownership to the business-active child. When children not involved in the company see that their sibling is only receiving ownership in return for his or her blood, sweat and tears, and understands that mom and dad will give them other (and more liquid) assets through their estates, the potential for family discord diminishes significantly.
Simply discussing the issue of meriting ownership vs. giving ownership to a child helps clarify goals and aspirations for parent/owners, their business-active children and non-business-active children. Once clarified and communicated, the parent’s goals can drive the design of ownership transition, which is, after all, the central aim of Exit Planning.