How do you handle exit planning when you know for sure you are going to pass your family business down to another family member?
I was recently contacted by a young man who has a big vision for his family’s business but feels his ability to advance his vision is stalled by his father who isn’t as motivated to grow the business. The biggest problem was his father never truly left the company. While the young man was mostly in charge, the father was still a VP and around roughly 20% of the time.
There are some exit planning Dos and Don’ts when you want to keep the company in the family and avoid this type of friction that keeps the company stagnant.
Exit planning is the complete strategy for exiting a privately held company and involves addressing the repercussions for exiting a company including the financial, legal and tax options. Exit planning is done to ensure business value is maximized on exit and that personal and business goals are met while tax burdens are minimized.
Succession planning is a subset of exit planning, is your strategy for passing on the role of leadership to an employee or group of employees, generally in preparation for exiting.
Some of the special advantages of family-owned businesses are that family businesses have a strong focus on culture and values. They align around motives beyond profit and foster a sense of history and connection. Family-owned businesses are also usually much more involved in their community as they feel a sense of responsibility to their neighbors.
Some of the special challenges, on the other hand, of family-owned businesses are the intermingling of business and family issues, blurred lines within roles and relationships, and the emphasis on inclusivity over performance and/or merit.
How then, do you face and overcome these common challenges when it comes to exit and succession planning?
Let’s discuss the Do’s and Don’t of each of the 7 Common Exit Needs for Family-Owned Companies:
1) Limit ownership to a defined group
2) Create financial independence for the generation closest to exit
3) Transfer ownership down to the next generation with minimum taxes
4) Prepare the next generation to effectively run the company
5) Maintain current generation’s control of the company until the next generation is ready
6) Avoid being “unfair” to any family heirs
7) Promote family alignment and minimize discord
1. Limit ownership to a defined group
When exit planning, you want to avoid ownership falling into hands of persons outside the defined family. The most common concern is when it comes to blended families and how long the family has owned the company. In both of these instances, the number of potential owners tends to be much higher.
DO – discuss and establish a definition of “family” – make it clear from the beginning who is considered eligible to take over the business and who isn’t.
DO – create a legal agreement signed by all current and future owners preventing any sale or transfer of ownership without family approval (commonly called shareholder agreement or buy-sell agreement).
DON’T – Trap family members in the company; create a fair and affordable process to buy out family members who wish to sell.
2. Create financial independence for the generation closest to exit
A family member cannot exit the business if they do not have enough money to become financially independent upon leaving the company. In other words, the generation closest to exit (retirement) cannot fully step out if they remain financially dependent on the company.
The easiest way to become financially secure is to create a liquidity event in which that generation can convert company value into personal cash/wealth. After all, the next generation cannot step in if the current generation cannot step out.
DO – analyze how much the current generation needs to afford to retire at the desired time.
DON’T – just plan on keeping the existing generation indefinitely on the company payroll—it usually makes people unhappy in the long run.
DO – Consider tax-efficient and business-friendly tactics to create personal cash or income streams for the current generation up to and after retirement:
• Company funded retirement plans which maximize benefits for the current generation
• Lease-backs: commercial real-estate, equipment, IP
• Partial sale of the company (49% or less interest)
3. Transfer ownership down to the next generation with minimum taxes
Family business owners typically do not seek to sell the company at full price from one generation to the next, however, transfers at less than fair value are subject to transfer taxes (gift and estate taxes). The amount a married couple can shelter from transfer taxes will be cut by more than $10 million after Dec 31, 2025 so planning ahead to figure out the best way to pass company ownership without getting hit by excessive gift and estate taxes is essential.
DO – analyze the total family estate and gift situation, including understanding the potential current and future value of the company and other illiquid assets such as real estate.
DON’T – wait…you likely need to use-it-or-lose it before end of 2025 (or sooner).
DO – Consider tactics to transfer at least some business ownership or assets (especially non-controlling portions) to the next generation prior to actual sale.
4. Prepare the next generation to effectively run the company
At least some of the next generation owner(s) must be able to effectively lead the company into the future. A leadership scheme based solely on nepotism is bound to run into issues. Some level of meritocracy must also be present. Balance the company’s needs with family politics, individual expectations, and apparent precedent.
DON’T – overlook that the company is probably bigger and more complex now compared to when the current generation founded it (or took over).
DO – use outside resources such as coaches, consultants, peer groups; these resources offer experience, credibility, and objectivity.
DO – create written succession plans including training and development steps, and clearly defined progress points with timelines.
DON’T – rule out hiring professional management if the next generation family members are inexperienced or lack professional expertise.
5. Maintain current generation’s control of the company until the next generation is ready
Existing generation owner(s) can be understandably concerned about turning over control to the next generation too soon. Next generation owner(s), because they are family members, often lack the credentials and experience that would be expected of non-family member hires. However, holding on for too long causes just as many problems as letting go too soon.
DO – create effective succession plans to reduce the risk of turning control over too soon.
DO – create written job descriptions for all senior company positions, and define the experience and training requirements to hold that position.
DON’T – transfer voting stock or units until you are ready; consider transferring non-voting interests.
6. Avoid being “unfair” to any family heirs
In families where some heirs are actively involved in the company but others are not, it can feel “unfair” to pass the company to those heirs but exclude the rest. This can be especially true if the company is the current generation’s most valuable financial asset.
DON’T – Split up the company equally among heirs who are not equally engaged; it rarely works in the long run
DO – Define the value of “sweat equity”
How much of the company does an heir earn by working at the company for the long-term?
DO – balance inheritance for heirs who are not actively involved in the company by providing them with income from the company not tied to full ownership. For example:
Income from business assets leased back to the company (real estate, equipment, IP, etc.)
Preferred stock or profits-only interests
DO – Create a mechanism for generational peers (siblings, cousins, etc.) to buy one another out if necessary.
7. Promote family alignment and minimize discord
Many of the challenges that all businesses face can be more complicated once family dynamics are layered on top. Family, personal emotions and relations are often difficult to keep separate from business issues, but you have to try.
DO – use Family Business Councils to help segregate business issues from family issues
DO – follow sound employment practices with family members working in the company
Market-rate compensation, expense reimbursement policies, job descriptions, performance reviews, etc.
DO – create annual budgets to identify how much profits / cash will be reinvested for growth and how much will be distributed out to owners
I hope these Do’s and Don’t of Exit Planning help give you an idea of where to start and where to go. If you need guidance along the path, give me a call! I’d love to help coach you through a plan that works for you. Book a call.