How to plan who pays for succession

Justine Ferguson is a consultant with Family Business Solutions Limited and an associate with Wright, Johnston & Mackenzie Solicitors based in Glasgow, Scotland.

It is never too late to start planning for succession. The financial/business options for providing what meets each family member's needs are not as limited as they may at first appear

"It all seemed so straightforward when we started up the company" sighed Tony Blair, family business entrepreneur. "Back then we were all pulling in the same direction. When times were hard, the business came first – simple! Cherie and I didn't think twice about freezing our pension contributions or putting our salary increases on hold. We got used to making personal sacrifices for the sake of the business. Now we are in our 60s and thinking about retirement, I am beginning to wonder whether we have done the right thing. We made those sacrifices because we always thought our pension was in the business and that we were contributing to the value of our shares. Now that we need to realise the investment we have made over the years, the timing could not be worse. The business desperately needs to re-invest in plant and equipment if it is going to remain competitive. It can't do that and pay us out. Our two children both work in the business and want to take it over from us, but I can't see how they can afford to pay us what our shares are worth, so what do we do?"

Fictional family business founders Tony and Cherie Blair's experience is typical of many family business owners who will eventually have to face up to a complex, yet predictable dilemma – how to plan who pays for succession.

A difficult balancing act
As Tony describes, in the early stages of family business life, every effort is geared towards the survival of the enterprise. Most, if not all, of the family's wealth can be tied up in the business and family members often willingly sacrifice personal return for the sake of the business. When times are hard, the family will tighten it's belt. When times are good, the family will re-invest in the business.

Sooner or later, however, the needs of family shareholders and the needs of the business begin to diverge, as Tony is discovering. Family members' lives are constantly changing and predictable events like births, deaths and retirement can each trigger predictable cash needs for shareholders who will then look to the business to meet those needs. When shareholders' liquidity needs and the financial needs of the business collide, planning who pays for succession becomes a difficult balancing act.

To family business owners who are facing the financial reality of a succession in ownership, the options may at first appear limited to a choice between "do nothing" or "sell". However, a wider range of options are available.

So where do we start?
The real question to be addressed is whether the family has enough of a shared vision to wish to continue in business together. It may take years of family discussion and reflection before an answer is reached to this question, or the family may share an instinctive view of how the future will look. Either way, the family's answer to this fundamental question will determine which financial ­solution will best meet their needs.

If we sell, are we selling out?
If continuity of family ownership is not the goal, then sale provides an effective one-off liquidity solution for family business owners seeking an exit route. Sale is a theme on which there are several variations for family business owners to consider.

Sale could involve a trade sale to a third party or a public offering of the company's shares. If these ideas are not appealing, the company could be sold to the management team or a combination of management and employees. Management buy-outs (MBOs) and management employee buy-outs (MEBOs) sometimes appeal to family business owners because they provide an opportunity (although there is no guarantee) for the culture and values created by the family to be perpetuated by the "extended family" of management and employees, even after the original family connection ceases.

Whatever sale route is chosen, planning is the key. Decisions on issues such as future capital investment, risk-taking, cost-cutting and strategic direction will be very different in a company that is being fittened up for sale in a matter of years, when compared to a company where long-term family ownership is the goal and timing is critical if a distress sale is to be avoided.

The options explored so far envisage total transfer of the family's ownership interest. If the family is prepared to consider relinquishing some, but not all, of its ownership, then an external investor is another route to consider. Such investors may wish a seat on the board, which could have dual benefits if a transition at board level is occurring simultaneously with ownership succession and additional management skills and capabilities beyond the family's resources are needed. Where a business need for reinvestment coincides with shareholders' liquidity needs, as in the Blairs' case, and the decision is made to sell, then this may affect the price attainable if a purchaser has to factor into his offer the costs of that reinvestment.

Continuity of family ownership
If the agreed aim is for the business to continue within the ownership of the family, a family business will then be faced with the dilemma identified at the beginning of this article – how to balance the financial needs of the senior generation, the business, and the desire of the next generation to continue in business together.

How much will it cost?
Unless a sale to a third party is contemplated, there is little point spending time and money on obtaining a "market valuation" of the company's shares at this point. Tax issues aside, the only value that matters is the one which the senior generation are prepared to accept and the next generation and/or the company are willing and able to afford. Glenn Ayres, the President of FFI, describes this process as balancing family needs with the company's ability to pay. If ownership is to remain within the family, then it is far more relevant to focus on the needs of both generations and the business and find the best possible outcome, rather than focusing on what a fictional third party might be willing to pay on the open market.

Who pays?
So let us assume that Tony and Cherie have, after much soul searching and number-crunching, figured out the fund they feel they need for their retirement. The next question to be addressed is "who pays" and, specifically, whether the proposed ownership succession may be funded using a combination of family and business resources only, or whether external resources are required.

Making best use of internal resources
Depending upon the amount of time available, it is worth considering how compensation packages (salaries, bonuses, pension contributions, consultancy agreements after retirement and other benefits) can be structured to provide a fund outwith the business which can help meet the needs of the senior generation in retirement. Dividends may also be used to contribute towards such a fund which will then need careful management to ensure it meets the senior generations' goals.

If time and business resources allow, the senior generation may be in a position to gift their shares to the next generation outright. However, if, like Tony and Cherie, they find themselves in their 60s and family company shares remain their principal asset, they will have to come up with a way to extract value from their shares, too.

Family buy-outs
If the next generation of the family are willing and able to take on the business, then a family buy out will probably emerge as the preferred alternative.

It is worth emphasising that this is a viable option whether or not a family succession in management and leadership is in prospect. Families may be tempted to assume that because there are no family successors waiting in the wings to take over the running of the business, then the only option is to sell. In fact, there is no reason why family ownership should not continue, provided a suitable management team can be retained or recruited. With no family involved in the day to day running of the enterprise, however, appropriate governance structures and processes that encourage regular communication and information-sharing must be introduced if effective relationships between the board/management and family owners are to be maintained.

Unless the next generation have accumulated sufficient resources to buy out the seniors, then it will be necessary to look beyond internal resources to fund a family buy-out. Similar to a management buy-out, a family buy-out could be structured so that the next generation of the family would borrow from an external lender to buy out the interests of the senior generation.

If, like the Blairs, an urgent need for reinvestment in the business occurs simultaneously with a succession in ownership, then the period over which the senior generation is paid outmay have to be extended to accommodate the needs of the business as well as the family.

Whatever Tony and Cherie decide, they certainly have far more to consider than they first thought. There are many more options than the traditional "do nothing or sell" choice and only they know what will suit them best, depending upon their family's vision for the future of the business. They may have done nothing for far too long, but it is never too late to start planning who pays for succession.