It is estimated 70 percent of family businesses do not survive the second generation and only 15 percent survive the third generation. These percentages indicate transferring a family business from one generation to the next can be very challenging.
Conflicts arising between family members who work in the business (insiders) and those who do not (outsiders) are often a major source of the challenge. The prime conflict is between the insiders’ compensation and management decision-making versus the outsiders who may want more cash return, even though they are not contributing to the future growth of the business.
Here are several succession planning alternatives for situations in which second-generation family members have different objectives or interests:
- Distribute family interest equally. Divide the family interest equally among all children if they are working in the business. If there are more outsiders than insiders, cash distribution policies may not be in the best interest of growing the business. If there are more insiders than outsiders, excessive compensation could result in reduced cash distributions to outsiders.
- Separate distributions of business interest from other assets. As part of an estate plan by the first generation, distributions of business interest go only to insiders, and distributions of other assets go to outsiders. This is an ideal solution if there are sufficient assets available for the outsiders. A variation would be to sell the business to the insiders via preferred interest-bearing installment notes.
- Designate voting control. It is appropriate to separate ownership interests by giving voting control to insiders while creating a realistic policy to pay outsiders current cash distributions (hold back a portion of the earnings to fund future growth).
- Grant limited decision-making to outsiders. Family members could adopt an agreement that grants outsiders limited decision-making powers for items such as cash distributions and capital expenditures.
- Implement puts and calls. The use of put and call options is workable if all children are given equal interests. The outsiders receive a put option, which is a required purchase based upon a fair market price and paid over a number of years in which the business could afford the required cash payments. This gives outsiders the option to replace their business investment with other opportunities. The insiders receive a call option on the outsiders’ business interest, exercisable at a fair market price, and issue interest-bearing notes on extended payment dates.
- Consideration for outsiders who may want to become insiders. If a member of the second generation is not presently working in the business but subsequently decides to seek ownership and employment, an ownership agreement can be established by all the family members or by non-family directors. The use of non-family directors removes insiders from the decision-making process and will help avoid a family conflict. The price to be paid by the family member seeking to enter the business can be determined by a valuation and payable on reasonable installment terms.
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