If you’re a Walton, inheriting part of the family business will probably work out well for you — four of the 10 richest Americans on Forbes magazine’s annual list are Waltons — but the odds are against most of us. A study of 3,000 wealthy families found that 70 percent of the wealth did not pass to the third generation. Eric Papenhagen, vice president of asset management and trust for MB Financial Bank in Rosemont, said the majority of family businesses experience some problems as they transfer ownership and operations from one family member to another.
The upcoming retirement boom will trigger the transfer of thousands of family businesses in the next few years. Smart Business spoke with Papenhagen to get continuity and transition tips for family businesses.
Do most transfers of family businesses go well?
Statistically, most family-owned businesses struggle and do not survive the transition to the next generation. Two common reasons for failure are liquidity issues and family issues.
Liquidity is an issue because most family firms have most of their wealth tied up in the business. When a business is inherited or sold from one family member to another, significant taxes and buyout obligations may be due, not to mention the capital required to continue operating the business.
Family issues that need to be resolved center around conflicts among family and non-family employees in the business. Many owners and partners are very focused on running their business today, and they neglect or wait too long to think about succession issues that could be addressed with family discussions and planning.
What are the keys to making a smooth transition and keeping a business in the family?
First is to ensure adequate funding. When a family business transitions to the next generation, additional liquidity may be needed to fund a retirement package and pay taxes. These businesses need to review their transition options, create a plan, anticipate their capital needs and fund the plan appropriately.
Family issues can be more difficult. Sometimes the second generation does not have the same passion, knowledge or experience as the founder. It is really important to have discussions with the family and develop long-range plans to bring out these potential issues. Many owners do not look five, 10 or 15 years down the road and do not have the same enthusiasm for long-range planning as they do for running the business.
In addition to key employees and family members, most successful businesses also have key advisers, such as accountants, attorneys and bankers. During most transitions, it would be wise to maintain the same advisers. These key advisers are familiar with the business and its success, which will likely increase the chances of a successful transition.
What are some of the errors and oversights you commonly see during business transitions?
Planning is the leading shortcoming.
Planning tends to get put off, and when plans are done, they are not thorough or updated. One reason is because businesses may use their regular accountants or attorneys for the planning, instead of someone with specific expertise in estate and succession planning. We often see plans that are outdated or not very applicable to the specific business.
How can insurance help business transition?
Insurance is a commonly used vehicle to fund transition costs. Three main insurance strategies include: ‘key man’ insurance, buy-sell agreements and irrevocable life insurance trusts.
Businesses can take out a key man insurance policy on the owner or perhaps a salesperson that generates a majority of the revenue. The business owns the policy and pays the premium. If the insured unexpectedly dies, the business is the beneficiary and will receive the policy payout. The proceeds can be used to operate the business until a qualified replacement is found.
Buy-sell agreements are used when a business is owned by partners. The agreement details what happens upon the death of one of the owners, and it is funded with a first-to-die policy ensuring funds are available for a buyout. A properly funded buy-sell agreement can provide assurance to the surviving owner that the business can continue and it can also provide the deceased owner’s heirs with funds to meet their ongoing needs.
Lastly, family business owners that wish to pass their business to the next generation upon their death should consider an irrevocable life insurance trust. If they have a taxable estate, the proceeds from an irrevocable life insurance trust can be used to cover significant estate taxes and expenses. This vehicle can prevent an unwanted sale of a family business by providing liquidity at a time when the business is not liquid and cannot obtain sufficient financing.
ERIC PAPENHAGEN is a relationship manager and vice president of asset management and trust at MB Financial Bank. Reach him at email@example.com or (847) 653-2138.