The 7 Deadly Transition Sins
Business ownership transitions are difficult. Many business owners will procrastinate and not take timely action. Here are some of the avoidable consequences.
Failure to have a solid buy-sell agreement for multi-owner businesses. Businesses without such an agreement are playing Russian roulette. If an owner dies, her estate might not have any leverage in obtaining a satisfactory price for the business interest. We frequently encounter obsolete Buy-Sell agreements which were executed when the business was first formed many years ago. The agreement might set the buy-out at book value (or an unrealistic formula value) and the business is now worth many times book or formula value. One of the owners dies and there is a battle royale between the surviving owner(s) and the estate of the deceased owner. A necessary corollary to a Buy-Sell Agreement (or Continuity Agreement—see below) is to understand the true value of the business. The best way to do this is by getting a qualified appraiser to value the company and update that value periodically.
Failure to have a business Continuity Agreement for sole-owner businesses. If the sole owner dies or becomes disabled, the business is at risk of dissipation. Key employees might become nervous about the future of the business and look for new jobs. Sometimes I hear the refrain, “But I have plenty of disability and life insurance.” That’s great, and it is important to have insurance to protect your family. But why let a business worth, say $1 MM or more, go down the drain? A well-crafted Continuity Agreement might empower your key employees to run the business and give them compensation incentives to do it successfully. This might allow the business to continue profitably until the owner is able to return or until the business can be sold. In addition to employees, I have helped craft Continuity Agreements with major suppliers, and in one case, with a competitor who was a likely buyer of the company.
Failure to choose among children to manage the company. If there are 2 or more children active in the business, they will often work effectively together as long as Mom and Dad are alive and active in the company. However, if the senior generation is no longer on the scene, the children will sometimes fight for control of the company to the great detriment of the business. The senior generation must establish a mechanism for either one of the children or perhaps an outsider to have a deciding vote to break deadlocks and avoid prolonged family quarrels. Sometimes children can work cooperatively as business owners, but parents are generally poor judges of this and it is advisable to bring in an outside expert to assess the situation.
Reluctance to relinquish control. We recently worked with a business owner who was over 75 years old, wanted to sell the company to key employees, had a valuation done to determine the worth of the business, but couldn’t “pull the trigger” to sell some of his stock to key employees. This problem is sometimes most acute in family businesses when mom & dad are reluctant to hand over control to the children. The longer this reluctance persists (men are much worse offenders than women here), the more difficult the transition will be. As a general rule, ownership transfers should begin no later than age 65.
Failure to think clearly about the tax consequences of ownership and management. We recently worked with a single dad (divorced) who owned 55% of his company and his 3 sons who owned 15% each. Dad died unexpectedly and the fact that he owned a controlling interest in the company meant that his estate was subject to federal estate tax. If each son had owned 17% (and Dad owned 49%), Dad’s estate would have saved more than $800,000 in estate tax. As a practical matter, Dad would have retained control with the vote of 1 of the 3 sons and otherwise exercised considerable financial leverage over the sons. There was no real disadvantage to Dad in reducing his share to a non-controlling 49% and it would have saved lots of tax.
Failure to sell at the right time. Owning a business is an inherently risky enterprise. If you are at an age when you can’t afford to wait out a prolonged slump, you should sell while the market is good. For example, we worked with the owner of a civil engineering firm in 2007 who was then 65 and wanted to sell to a third-party and work for 2–3 years for the new owner. He procrastinated, the recession of 2008–09 hit, the market didn’t recover until 2014 and he finally sold the business in 2015. He had to work harder than he ever did in order to keep the firm above water during the very bleak years of 2009–2012 and ended up selling for less than the company was worth in 2007. The strong M&A market we have enjoyed for the last several years won’t last forever.
Failure to transfer ownership to the next management generation. We recently worked with 2 companies that both had promised younger managers ownership in the company but had delayed actually transferring shares. In one case the younger managers were now in their early fifties and questioned whether they had sufficient working career remaining to make it financially worthwhile to buy out the older owners. This forced the owners to consider a sale to a third-party, something they did not want to do. In another case, the younger manager ended up leaving the company. This left the owner in a situation without an internal buyer and a substantial management hole in the company. Furthermore, it made it much more difficult to sell the business to a third-party because of the weakness in the management team.
Transitioning out of ownership is one of the most difficult challenges that a business owner will face during his career. The road is filled with emotional and financial dangers. Perhaps the most common error that business owners make is to wait too long before beginning to plan their exit. Procrastination can have fateful consequences.
Published in Business2Business magazine, March 2016