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Embracing Beauty Performance Standards in Family Business Transfers

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Embracing Beauty Performance Standards in Family Business Transfers

Helping owners successfully transition business ownership to their children is not a job for the faint-hearted advisor.
 

At the same time there is no task more intrinsically rewarding than helping owners and their families through an ownership transition in a way that keeps intact both a family and its values.

Maintaining family harmony (or restoring it, if necessary) begins with helping owners set their goals and then creating and communicating a written plan based on those goals.

Once goals are set, an essential part of your job in creating that Exit Plan is managing the thorny issues of merit and fairness in the transfer of ownership to children. Unless you tackle these issues head-on, inaction is likely to sow destructive seeds of family discord that could assume mythical beanstalk proportions.

Let’s assume that Josephine distributes ownership to one child (Johnny) based on merit—the time and effort Johnny has put into successfully growing the business. Johnny’s siblings can easily view that distribution as, “See? My parents have always loved Johnny more. This is just one more example!” Josephine knows that is not true, and repeatedly reinforces to everyone (children and her spouse) that she loves all of her children equally. When you see that a parent’s reassurances are not sufficient, consider bringing in and working with a trained family business consultant early in your deliberations with family business owners.

Before addressing the issue of fairness (the topic of our next article), it is helpful to first examine the issue of merit as it relates to the child assuming ownership. Our advisors’ experience tells us that basing transfers of ownership to a child on business reasons is the best way to prevent siblings from accusing parents of one-sidedness and unfairness.

Ownership Based on Merit, not Emotion
 

Let’s consider two scenarios.

Scenario 1: Ideal and Rare.  Owners in this small group 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 in this group have one business but more than one child. This situation commonly plays out in one of three ways:

  1. All children are active in the business. In this case, the predominant issue is determining how multiple children will share the control and ownership of one company.
  2. One child (or several) is active in the business and one (or several) is not. How does an owner give the business (or at least a controlling interest) to the active child(ren) provided they merit it, while being fair to everyone else?
  3. Every child, active or not, gets an equal share of the business as well as all other assets. We explore the pitfalls of this approach in next week’s article on fairness.

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Performance Standards
 

If a business-active child does not merit business ownership, owners know it and so do their other children. When owners transfer a business to a non-deserving business-active child, the other (or non-business-active) children see it as nothing more than a gift. In their opinion, they should receive the same gift or a gift of equal value at the same time as parents “give” ownership to their sibling.

We recommend that parents extract themselves from any real or imagined game of “playing favorites” by setting objective performance standards in awarding ownership to a child.

In practice, our advisors employ performance standards in both transfers to key employees and transfers to children in much the same way: children in a business earn ownership in the same manner as do non-children key employees.

We routinely use performance standards to motivate (and reward) management and key employees to increase enterprise value and cash flow over time. If employees meet the standard, they receive (generally) a cash bonus. Similarly, if a child meets performance standards, the child’s reward is ownership in the business.

Performance standards can be designed in many ways to reward children with ownership. They can also be used toallocate ownership among active children. For example, if one child is president of the company or a division, the 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. The child who achieves the performance standard receives an award of ownership. The same is true for all other business-active children. They too receive designated awards if they reach and surpass their own performance standards.

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Hank Weatherby, a business and Exit Planning attorney in Connecticut, tells the story of an 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 compensation increased to $1 million. Second, the value of his ownership increased in value from about $600,000 to nearly $10 million. The daughter? She was working as the company’s accountant. Her salary was $125,000 per year. Her father gifted her, in trust, a small amount of ownership.

When I asked Hank about whether that salary and ownership disparity had poisoned the relationship, Hank was surprised. “Bad blood?  Not at all.” Hank recalls that, “Early on, dad had 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.”

As I’ve mentioned before, early and thorough communication of the owner’s goals and how the Exit Plan is designed to achieve them is essential. In Hank’s example, both children had the opportunity to “seize the ring.” One accepted the challenge with great results, while the other decided to remain active, but less involved, in the business.

Performance standards vary from business to business, but, at a minimum, they should:

  • Be written.
  • Be attainable.
  • Be tied closely to increasing business value.
  • Describe exactly the attributes and performance expected from any key employee seeking ownership.
  • Result, if attained, in the owner’s financial security.
  • Be clearly communicated to all parties.
  • Control the incremental awards of ownership over a multi-year (typically five- to ten-year) time span. As standards are met, the child earns, and is awarded, ownership via stock bonus, gift or purchase.

Benefits of Performance Standards
 

One of the valuable byproducts of performance standards is that the child who meets or exceeds them effectively demonstrates his or 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 can earn a cash award.

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 a child meets the standard, he or she creates additional cash. This cash can be distributed to the parent/owner and used to invest in non-business assets. Owners are able to leave their businesses sooner or leave as originally intended with more money. The additional non-business assets can eventually be gifted or devised to non-business active children to offset future gifting of business interests to the business-active children.

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.

Your role as the Exit Planning advisor is to show owners interested in transferring their companies to children how to use performance standards as a means of awarding ownership to business-active children. As part of that discussion, you must demonstrate the benefits of doing so before beginning to grapple with one of the most difficult aspects of family transfers: fairness.

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