Business Survival and Succession

11/14/2011

If you are a family business owner, many would say you are the backbone of the American economy. Approximately 90 percent of all businesses in this country are either family-owned or family-controlled.  They come in all shapes and sizes, representing all sectors of our economy, from agriculture, to services, to technology, to manufacturing.  Family businesses generate an estimated one-half of the U.S. Gross National Product and pay half of all wages earned in this country.  

Most family business owners think of their business as a child.  Simply put, they love their business.  They make sacrifices for their business.  Like their children, they want their business to grow and be or continue to be successful.

However, statistically, family businesses do not tend to out live their founders. At any given moment, 40 percent of family businesses are in the process of transferring their ownership. Unfortunately, about two-thirds of these will fail, meaning the business will die.  Of the one-third that survives an initial transfer,only one-half will survive a second transfer.

Why such a dismal success rate? The reasons are as varied and unique as the businesses and business owners themselves.  Nevertheless, many of the failed transfers can be traced to three causes -  people, taxes and cash

The family element in every family business can mean the difference between its success or failure during the transfer process. Common triggering events include the retirement, disability or death of the business owner.  Tough questions must be asked and answered.  Otherwise, a business that took you decades to build can be destroyed overnight.  For example, who will run the business after you?  Will it be your spouse, one of your children or a non-family member key employee?  If  not your spouse, will your spouse be financially dependent on the business or financially independent of the business?  What arrangements have you made for an alternative inheritance for your business-inactive children? Have you in-law proofed your estate?  Thinking ahead to the second-generation transfer of your business, what provisions have you made to encourage thrift and industry among yourgrandchildren?

Aside from the people planning issues, what effect will estate taxes have on the survival of your business?   It is true that there is much uncertainty in our federal estate tax system.  However, the one real certainty about the federal estate tax is its long-term uncertainty with each change in Congress and theWhite House.  It has been around for a long time, and my guess is the tax will continue for well into the future.  Accordingly, careful monitoring of the economic, political and legal climate is required. Why?  Because estate taxes could eat up your net worth at death, leave less to your family, and possibly even force a sale of your business just to meet an estate tax cash call (just nine months after the date of death).

Unless you carefully coordinate your financial plan with your estate plan and your business succession plan, there may not be enough cash to fund your ultimate objectives. An appropriately funded estate plan can help meet all of your people planning objectives and provide liquidity for estate taxes (and business debts).

A fundemental key to the suvival of a business is a properly structured buy-sell agreement.  A buy-sell agreement is a lifetime contract providing for the transfer of a business interest upon the occurrence of one or more triggering events defined in the agreement such as death, disability or retirement.  

A buy-sell agreement is commonly structured in one ofthree general formats: an Entity Purchase Buy-Sell, a Cross-Purchase Buy-Sell or a Hybrid Buy-Sell.  Under an Entity Purchase Buy-Sell Agreement, the business entity itself agrees to purchase the interest of a business owner. Conversely, under a Cross-Purchase Byy-Sell Agreement, the other business owners agree to purchase one another’s interests. The Hybrid Buy-Sell Agreement gives the entity a first option to purchase the interest before the remaining business owner(s).  The selection of the appropriate buy-sell format is critical for a variety of tax and non-tax reasons beyond the scope of this blog.

A buy-sell agreement must be properly funded.  In other words, how will the ownership interest of a deceased, disabled or retiring owner be paid for and what will the price be?  Generally, the buy-sell agreement itself will provide a mechanism for how the price will be determined.  It could be a fixed value or determined based on a formula.  Common options for paying for the ownership interest include the use of personal funds, creating a sinking fund in the business itself, borrowing funds, installment payments and life insurance. 

The bottom line is clear.  Without a properly funded, well thought out, buy-sell agreement, your family business, or any other closely held business, will likely not survive you or your disability. If you are one of the many business owners without a business succession plan, with a properly funded buy-sell agreement, you should immediately discuss with your team of advisors the appropriate terms for such a plan for your own business.