How many ways can a family business get into trouble? Maybe an infinite number, if the stories told by family business consultants are any guide.
“In a non-family business you have rational problems and rational solutions,” says Don Schwerzler, an Atlanta-based family business counselor. “But in a family business you have rational problems and emotional solutions. Decisions are made not necessarily on what’s best for the business but what’s best for the family. That makes things difficult.”
The resulting disruptions can be costly. Schwerzler offered three illustrative scenarios that recently crossed his desk:
◊ When one family member got a divorce, half of his stock went to an ex-spouse with no business experience. To avoid a destructive addition to the management team, the business had to buy out the ex-spouse—at a significantly higher price than the stock’s value.
◊ Shareholder siblings had such major disagreements that the business could not move forward. As a result the business needed to be liquidated.
◊ Three of four shareholder siblings wanted to borrow $500,000 to make business improvements. One shareholder balked at signing for the loan. So his stock had to be purchased by the other three—resulting in an expensive restructure of the strategic plan.
Save or spend?
Conflicts often arise over financial strategies that impact individual pocketbooks.
“Very often there is a tension between ‘savers’ and ‘spenders’ in a family,” says Schwerzler. “That tension often forms the basis for disagreements on how the business should be run.”
All such conflicts get bigger and scarier as the family gets larger.
“Once you have a sibling partnership, things start getting complex,” says Schwerzler. “And a consortium of cousins gets very complex.”
Domestic battles often escalate and end up destroying the enterprise. Little wonder the family business survival rate could bear some improvement.
“Statistics show that about 30% of family businesses make it to the second generation,” says Schwerzler. “Twelve percent make it to the third generation, and only 3 to 4% to the fourth.”
How can your own family business stay out of trouble—or at least minimize the damage when a disruptive event occurs? Consultants recommend drawing up what is called a “buy-sell agreement.” Also referred to as a “buyout agreement,” this document governs any situation that results from the death or departure of one of the organization’s stockholders.
Among the questions answered by the buy-sell agreement are these: What events will trigger a stock buyout? Who has the right to purchase the stock of a departing owner? How will the stock be valued? What mechanism will be used to resolve disputes between family members?
Trying to answer such questions when a disruptive event hits is a recipe for disaster. The fraught emotions characteristic of such times can play a destructive role.
“If you are trying to hammer out a buy-sell agreement while there is turmoil in relationships, you are working in a context which is not ideal,” says Kimberly M. Hanlon, a Minneapolis-based attorney active in business and estate planning matters.
The challenge is especially acute for a business undergoing diminished profitability—the very condition that can often catalyze family members to cash out.
“When a business starts to go downhill, family relationships often go downhill too,” says Hanlon. “People start blaming each other and it all goes south.”
The moral is clear: Smart family businesses plan ahead.
“Think about the terms of a buy-sell agreement while relationships are still good among family members,” says Hanlon. “People who are level-headed and thinking clearly tend to come up with fair and reasonable terms.”
Terms of endearment
Maybe you already have a buy-sell agreement in place that you want to improve, or maybe you are ready to create one for the first time. In either case here’s some help in the form of the most common questions such a document should answer:
1. Who has the right of first refusal on a departing owner’s stock?
In other words, what entity has the right to purchase the shares of a family member who dies, or who just wants to cash out? The answer, depending on the advice of your accountant and attorney, might be the other family business owners or the business itself. The idea here is to keep those shares from falling into the hands of outsiders who might lack operating expertise or who might not have the best interests of your business at heart.
Your document should also address the disposition of a family member’s stock when that individual gets divorced. Commonly the business will have a “call right” on those shares. A “call right” is a provision that empowers remaining family members to buy out the shares. Again, the idea is to keep the stock out of the hands of an individual who might not help the business grow.
2. How will the value of stock be determined?
When it comes time to buy out shares of a departing owner,
some mutually agreeable method must be used to set a price on the shares.
“Will the valuation be done by a single CPA experienced in valuations?” poses Hanlon. “Or will each person hire a different CPA for independent valuations, with the final value somewhere between the high and low extremes?”
Another approach is to specify a set share valuation formula—such as a given multiple of earnings—ahead of time. This can be less than ideal, though, since business and market conditions at the time of an owner’s departure may be different from those at the time a buy-sell agreement is written.
3. How will the stock purchase be funded?
You must also plan for the funding of a buyout—perhaps a line of credit that can be tapped for the money. Absent such a plan, the payments required to purchase the stock of a departing owner can be crippling. Your business may need to sell off some of its assets to raise cash, or borrow money, which can have a negative impact on your line of credit.
This is a good spot to mention the value of life insurance as a source of funds to purchase the stock of a family member who dies. Valuable as it is, though, life insurance is not the final answer. The fact is that an owner can be incapacitated while still living.
“With today’s modern medicine, a person can have a stroke or a heart attack and continue to live,” notes Schwerzler.
An owner who is incapacitated in that way can no longer function in the business, yet there is no life insurance money to buy out the individual’s stock at a time when large medical bills must be paid.
“How will the business deal with that?” poses Schwerzler. “How will that exit from the business be exercised?”
The wise family business will plan for alternative funding sources.
Try as you might to avoid them, domestic squabbles are bound to occur. As an adjunct to your buy-sell agreement, write up a procedure that will be used to resolve disputes between family business owners. For some situations, arbitration or mediation may be the best course of action. Alternatively, you may designate a board of nonfamily trustees who are empowered to cast the deciding votes on issues over which family members disagree.
Disputes often arise from the conflicting interests of siblings or other family members inside and outside the business.
“I tell my clients not to have siblings or family members outside the business co-own the business with family members who run it,” says John J. Scroggin, partner in Atlanta-based Scroggin & Company, a law firm active in business and estate planning. “It never works. You have tied them together financially, but they and their families have different goals, which inevitably breeds conflicts.”
In a typical situation, says Scroggin, a family member inside the business is working 24/7 and resents the fact that a substantial part of the equity value he or she is building is going to other family members. Meanwhile, the outside siblings are upset because the family member operating the business is getting a “significant” salary and
doesn’t value the opinions of the non-working family owners.
“I suggest giving the non-business family members other assets,” says Scroggin. “Or set up a mechanism that gives them an income stream that is not connected to the family business.”
As the above comments suggest, varied skills are required to iron out family business wrinkles. Don’t try to write a buy-sell agreement without the assistance of experts, including your attorney and accountant. You may also want to utilize the services of a consultant who specializes in family business. (See story on Page 41.)
Revisit the document
With the passage of years, personal and business goals change. Your buy-sell agreement needs to change with the times.
“Don’t just create your buy-sell agreement and stick it in a drawer,” says Schwerzler. “Have a CPA or tax attorney review the document every two or three years.”
Modifications will need to reflect changes in family relationships and in tax laws.
Above all, avoid a temptation to procrastinate.
“At small- and medium-sized businesses, creating a structure for transition is often shunted aside for lack of time,” says Schwerzler.
That can be fatal for the future of the enterprise.
“Any family business should have a transition plan in place—and a buy-sell agreement is an important part of that plan.”
Get professional help
“The very best way to find a consultant is through referrals,” says Kimberly M. Hanlon, a Minneapolis-based attorney active in business and estate planning matters. “Ask other business owners whom they use, and if their consultants have been doing a good job.”
Select a consultant who has a lot of real-world experience creating buy-sell agreements for family businesses.
“You want someone who has experiential learning,” says Hanlon. “Reading about the topic is not the same as experiencing the outcomes of different scenarios.”
Bear in mind, too, that you will be sharing a lot of personal, intimate family information with your adviser.
“When creating a buy-sell agreement, the journey is often more important than the destination,” says Don Schwerzler, an Atlanta-based family business counselor. That “journey” involves heart-to-heart chats with family members. “When you start talking with family members you start uncovering potential problems. It’s important that all of the family relationships are understood before you write the buy-sell agreement, so you don’t kill the goose that lays the golden egg.”
Successful counselors, then, are multi-talented, understanding of human as well as financial dynamics. The alternative is disjointed advice.
“A family business may have a CPA who is good at tax work but not so understanding of family relationships,” says Schwerzler. “So the owners end up going to a family therapist who may be good at the warm fuzzy stuff of human enterprise but may not understand the profit motive of a business. As a result the family gets conflicting advice.”