Few challenges are thornier for family business owners than preparing for a transition of ownership. It’s a time for facing tough choices about the company’s future leaders and how the new owner will finance the transfer.
“About 70 percent of family-owned businesses will change hands over the next 10 years as the baby boomers retire,” says Krista Dobronos, senior vice president and Akron market leader for Westfield Bank. “Unfortunately, too many business owners have not planned sufficiently for this transition.”
At a minimum, this planning process should begin three years before the targeted ownership shift, Dobronos says, though five years in advance is ideal.
Smart Business spoke with Dobronos about transitioning family business ownership.
What elements should be included when planning an ownership transition?
About half of all family businesses don’t have any kind of succession plan on paper. The starting point should always be identifying who will take ownership of the business, whether it’s a key employee, a family member or an outsider.
A business owner should also consider to what degree they want to remain involved in the business. Do they want to remain an investor in the business or get out entirely? They also need to consider the best option for financing the ownership transition.
Exit planning isn’t only about the owner’s retirement. Ownership transitions can also be triggered by divorce, disability, an extended illness or unforeseen death.
What are some of the best financial options for family business ownership shifts?
It all depends on the company, its industry and those who will take over the company.
Some buyers may wish to pursue a traditional bank loan for the company, which is usually a seven-year term loan using a 10-year repayment schedule. The buyer of the business can also take out an individual loan that is guaranteed by the company.
When there is a gap between the purchase price of the company and the value of collateral to back a bank loan, the buyer may need to secure gap financing. Mezzanine financing, for example, is becoming increasingly popular, and usually takes the form of subordinated debt or an equity investment like preferred stock. The seller can also provide financing referred to as a ‘seller note’ for the buyer to cover that gap over a period of time.
What about transitioning ownership to a company’s employees?
An employee stock ownership plan (ESOP) can successfully finance an owner’s exit strategy, but it requires a longer planning process than other financing options.
An ESOP is a way that an owner can transition shares of the business to the company’s employees at a lower after-tax cost, providing employees an opportunity to build wealth.
How can business owners take emotion out of the equation when planning?
It’s important to make a decision that’s based not on emotions but on the sustainability of the business long term.
This is one of the reasons it’s so important to have trusted advisers you can turn to. Sit down with your attorney, banker, accountant, financial adviser and other professionals you trust to help you develop a sound perpetuation plan.
What do banks look for when they consider backing such an ownership transition?
With regard to the company, banks want to ensure there’s adequate cash flow to service debt related to the ownership change. Banks look at the industry the company operates in and how market forces might impact it in the future. In the new owner, banks want to see a track record of experience with that company or industry.
When considering supporting an ownership transition, banks spend time in the company’s facility or office to see them in action, observe the approach to staffing and understand their clients. This interview process is critically important for both sides. It’s like a courtship — the business owner should feel as comfortable with their banker as he or she is with them. ●
Krista Dobronos is senior vice president and Akron market leader at Westfield Bank. Reach her at (330) 668-6420 or email@example.com.
Insights Banking & Finance is brought to you by Westfield Bank
The laws of physics tell us that what goes up must come down. The reverse is true in today’s interest rate climate. Rates that have stayed low — among the lowest they’ve been in U.S. history — for such an extended period of time will soon begin to climb.
“This is a topic that gets commentary daily in the news,” says Jon Park, chair and bank leader of Westfield Bank. “It’s easy to think that it’s just noise and that things will stay this way forever. But it won’t, and companies should take precautions now against the inevitable increases in interest rates.”
The impact rate increases will have on borrowing money is obvious. But your company also could be impacted in other, more unexpected ways.
Smart Business spoke with Park about what you should expect from the coming rate increases, and how you should prepare.
When will rates start to rise and how large might the increases be?
Experts have predicted stable rates for now, with increases beginning in 2015. Once the Federal Reserve begins increasing short-term interest rates, they will likely climb at least 2 percent over a period of 18 to 24 months.
Interest rates work in cycles. The current 0.17 percent short-term rate (one month LIBOR) is considerably lower than its 20 year average of 3.27 percent. When rates have been artificially held low for too long, they will go up. It’s like tension in a spring that has to release.
Are there ways a rate hike can impact businesses that they might not expect?
Increases in interest rates will reduce the profitability of businesses in general. Though new borrowing will still occur, loans will be more expensive. Some companies are able to pass on these costs as price increases, like utilities and other businesses that are equipment-intensive. Many businesses will need to prepare for the increased cost, as the rising rates squeeze the profit margin for themselves, and their clients or vendors.
Another unexpected consequence is that the market value of commercial real estate could slowly begin to decline. The formulas used to determine a property’s worth are based on the positive cash flow the property generates, and interest rates are one of the biggest components of the formula.
What should businesses do to prepare?
Ask your bank to convert variable-rate term and real estate loans into fixed-rate loans. Many businesses have been borrowing at variable rates because it has been cheaper. Converting to a fixed rate will cost more in the short term, but will protect against future interest rate increases.
Approach your bank about re-pricing your fixed rate commercial real estate loan. Normally these loans are re-priced at five-year intervals. You may have several years before hitting the re-pricing threshold. Negotiating to re-price the loan now could secure that fixed interest rate for another five years.
You can also purchase an interest rate swap that will allow you to convert from a variable-rate loan to a fixed-rate loan. Ask your banker about the cost and terms involved to swap rates.
Finally, consider extending the term and/or renewal extension options of any real estate lease. Higher interest rates will eventually translate into higher rent payments, since interest expense is one of the largest cost components for real estate investors and landlords.
Are there other ways companies should prepare themselves from an operational perspective?
Finance your expansion now. If you need to buy a new drilling machine or update your computer system, take advantage of these low interest rates prior to the expected rise.
It is a prudent time to consider your process for accounts receivable. When interest rates are low, many companies aren’t as strict about payment terms. But as interest rates rise, it will be more important to collect your cash quicker and extend your payables longer. Plan ahead and implement the right strategy now.
This is a good time to make sure you have trusted financial advisers on your side to help you prepare for the coming interest rate hikes. ●
Insights Banking & Finance is brought to you by Westfield Bank