This post is by Giles Ellis, an experienced business coach and Director at GECA Chartered Accountants.
Succession is a problem facing many New Zealand business owners and a common solution is to pass ownership to a son or daughter who is working in the business. However, while this solution may appeal for its simplicity and retention of business ownership within the family, it can come with a number of issues that need to be considered as part of the succession process. These issues include:
- Value of business versus value of other family assets such as property.
- Structure of a business sale to a family member and how to fund it.
- Timing and parity of distributions of assets from one generation to another.
If not dealt with appropriately, consequences can be serious including wealth erosion and damaged family relationships.
Consider the following situation which represents a typical New Zealand family owned business.
The father founded the business 15 years ago and is the sole Shareholder and Director. His son joined the business 8 years ago and has worked his way up to General Manager over that time. The business currently has 20 staff, a $5m turnover and budgeted EBITof $1m.
The son would like to succeed his father owning the business and has asked his father what his plans are for exit and succession.
To answer this, the father worked with his business adviser to create a Succession Plan with the following objectives:
- Sale of the business within five years, achieving an exit value of $6m, being a $2.5m increase above its current $3.5m value.
- Confidence his son would be able to meet the requirements and responsibilities of being both owner and CEO.
- Maintaining amicable family relations and parity of distributions between the parents and siblings in the event the ownership did transfer to one child.
- Positioning the business for sale to a third party in the event the succession to the son did not work out.
These objectives ensures the parents will have funds available to meet their future lifestyle requirements, provide their son with a business succession opportunity and provide for an alternate exit pathway if required.
Ownership Transfer Transaction Structure
Once a decision has been made to pass on some or all of the ownership in the business to a family member, it is necessary to consider how to structure the transaction to meet the needs of the both the Owner and the Successor. Consideration needs to be given to the following:
- The percentage of ownership that will be transferred, the timing of this and if it will be way of instalments.
- The valuation of the business at the time of share transfers.
- Whether the shares will be paid for or gifted.
One of the biggest issues present in a succession to a family member is how to fund the transaction.
Often the shares are gifted to the child, however, this creates issues of fairness with other family members who may question why someone is receiving a valuable asset when they are not. To maintain equity and fairness, this approach is often recognised by way of inheritance offset so the value of shares gifted to the child working in the business is offset against the amount other family members receive from the inheritance pool at the time of the parents passing. Again, this approach does present issues, primarily around asset valuation. A business asset may increase or decrease at markedly different rates than a property asset investment and the final amounts received by beneficiaries may differ as a result.
A better approach to the issue of share transfers to a new generation is sell the shares to the family member at an agreed value.
To do this the business is valued by an independent valuer and this is used as the basis of structuring an ownership transfer.
In this situation above, it was decided to sell the son a 50% shareholding over 4 years subject to meeting various performance hurdles including year on year profit increases to achieve the exit value required by the owner. The transaction was structured as a loan that allowed the son to buy the shares in tranches with loan repayments funded by offset against his dividend entitlements.
So far so good. However, the sale of the remaining 50% ownership stake became contentious when a value was placed on it. The son proposed he should buy the remaining 50% at the original value placed on the business at the time of original valuation. However this meant the capital gain of approximately $2.5m in the business value would go to the son at the expense of the other siblings as part of an inheritance pool.
The alternative approach of valuing the remaining 50% stake at the time of sale in five years’ time led to adverse outcomes in that it the de-motivated the son to increase the value of the business as he would then have to pay for half of it, even if he would ultimately recovered a third of this value back through his inheritance entitlement.
A third approach was considered which was for the father to hold on to the 50% stake and have this as part of the inheritance assets. However, this would have led to the same situation as above where the son would have to pay market value to buy shares of his siblings if he wanted to maintain full ownership. Keeping the siblings on as minority owners typically creates issues managing the business and should be avoided where possible.
So as you can see, succession to a family member may appear to be the easiest option to exit your business but has a number of issues that need to be addressed to ensure a successful ownership transition and maintaining amicable family relations.
The most successful ownership transitions benefit from the experience and skills of a trusted business adviser who understands your circumstances and the nuances of various family relationships. If you need advice to plan your succession and exit, call Giles now on 0800 758 766.