Five Business Ownership Transition Mistakes to Avoid

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Ownership transition can be difficult.  It is not something that most business owners like to think about.  We will all, inevitably, transfer our ownership to others, if only at death.  We talked about the Ownership Transfer Matrix in previous posts and pointed out the inevitability of eventual transfers of ownership.  Take a look and see if you can figure out how to avoid transferring your shares in your business.

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1. No Buy-Sell Agreement.  Owners of businesses who do not have a well-crafted buy-sell agreement are playing with fire.  In the event of the death of an owner, his estate may have no leverage in selling the stock back to the company.  This can create problems for the estate, which may have to pay estate taxes (assuming a taxable estate) with no corresponding proceeds from the sale of the stock.  On the other hand, if the estate is substantial, the company may have no leverage in repurchasing the shares.  This could be unfavorable, especially when the ultimate disposition of the shares is to an undesirable (from an ownership perspective) spouse or child of the former shareholder.  There are limited options for a favorable outcome in this situation because with the death of a shareholder, the interests of the company and his estate will immediately diverge.  It is far better to plan for ownership transfers via a well-crafted buy-sell agreement.

If you don’t have a buy-sell agreement and have multiple owners, get with your attorney and other advisers and other owners and discuss workable terms.  Then have the attorney draft an agreement.  Have a qualified business appraiser provide an appraisal to set the initial value

2. Delay or Avoidance in Making Desired Gifts/Transfers.  More often than you might think, business owners have an intent to make gifts of shares, or engage in other significant transfer transactions, to their children.  However, they just don’t get around to it.  Procrastination can be an incredibly powerful force.  The objective of the transfers is to take advantage of allowable valuation discounts and to transfer stock at discounted (nonmarketable minority) prices.  The result is to transfer more shares than would be possible at full enterprise value and to shift appreciation to the next generation.  That objective is not met when the transactions do not occur and value increases over time.  There aren’t many good results from delay if there is an intent to transfer shares.  If an opportunity appears to sell the company on favorable terms, the proceeds will flow to the older generation, and the big opportunity to pass significant wealth will be lost.  On the other hand, if the shareholder dies before making the intended gifts or transfers, control will reside in the estate and the shares will be valued on a control basis for estate tax purposes.  In any event, if the intent is there and an owner procrastinates, the results will not be favorable for either generation.

If you have the intent to transfer stock to a second generation, work with your advisers to begin a process of implementing that plan as early as possible.  Even if you start small, you will have started.  Having started, you will likely have the confidence and momentum to continue the program to achieve your transfer objectives.

3. Patriarch Won’t Let Go of Control.  Some fathers, and it seems to be fathers more than mothers, just can’t let go of parental control of their children in a business context.  Even if estate planning has occurred and stock has been transferred to the children who may work in a business, Dad may not give up parental control, and the children most likely won’t exercise voting control.  The result is that the management growth of the next generation is stunted.  Dad still wants to call the shots, and the “kids” let him.  There is simply nothing good about situations like this.  Let me tell a composite story based on several experiences to illustrate the point.  Years ago, I valued a company where the patriarch was in his late eighties.  His son was supposedly president of the substantial business, but Dad made every important decision and was in his corner office every day, if only for a few hours.  I recall thinking how frustrating it must be to the son, who was in his sixties at the time.  The son ultimately committed suicide, whether for those reasons or others.  Dad was unable to keep things together following his son’s death and the company’s fortunes deteriorated.  The company was ultimately sold for a fraction of its former worth after Dad’s death.

Aging business owners should transfer control by age 65 absent compelling reasons to maintain it.  I used to say control should change by 55, but then I got to that age myself!  And aging business owners should transfer management control to younger folks as early as possible to provide opportunities for growth and for the company to be able to perpetuate itself. 

4. No Strategic Thinking in Transfer of Ownership.  Two short stories illustrate the importance of strategic thinking regarding ownership transfer.  Two young men approached me after a speech a number of years ago.  I had been talking about gift and estate tax valuation issues to a group of business owners.  Their father had recently died unexpectedly at age 55 owning 51% of the business.  He had planned early on to transfer control to his sons, sons each owned 24.5% of the company’s stock when he died.  Dad had resisted transferring voting control for a number of years.  The estate (Dad was divorced) was taxable and the company was valued on a controlling interest basis.  Several millions of estate taxes could have been avoided had Dad thought strategically about giving up control.  Another owner maintained control of his business until he died in his early eighties.  His will gave shares to children not working in the business, rather than passing control to the sons working in the business.  Litigation and a lengthy dispute over rights under a buy-sell agreement ensued.  The similarity between these two stories and those potential stories of others is that nothing good results when ownership is not strategically transferred.  

If you are 55-65 years of age and still have control of your business, take some time with one or more trusted advisers to brainstorm what could happen if you don’t think strategically about ownership transfer.  Then take the actions that your brainstorming session reveals.

5. Failure to Transition Ownership to Next Management Generation.  Many years ago, I worked with a company that had two 50% owners.  One owner was aging and active in the business and the other was a trust for the benefit of the now grown children of his former partner.  It came time to sell the business and we worked to identify and to qualify buyers.  The company was substantial and profitable.  The business was managed, and mainly developed, by three key managers who, at the time were in their late forties.  They had been promised equity interests in the business for many years, but the two owners would never agree to give up their 50-50 stalemate ownership positions.  I explained to the owner that this situation could impact the result of negotiations with potential buyers.  In the final analysis, the two owners did share the value of the business with their three key employees.  The buyer insisted that, as a condition of the deal, that the three key employees have a benefit on a going forward basis with them that was equivalent to about 25% of the agreed-upon purchase price.  The two owners were lucky.  We were able to work out a satisfactory arrangement for the buyer and the key employees.  The selling shareholders had little option but to accept the result.

It is important to think strategically about management and ownership transitions.  As with gifting to children in the example above, it is best to begin ownership transition to younger management on a planned and strategic basis.  Have another brainstorming session with your advisers to talk about your situation and set a strategic plan in place for management and ownership transition.

Wrap-Up

Ownership transition is difficult for many reasons ranging from financial, to emotional, to procrastination and more.  It is best to think about ownership transition, and any related management transition issues, from a strategic viewpoint.  Time flies, and if you are not working on the appropriate ownership transition steps for your business, the time is working against you.

As always, please do feel free to call me to discuss any business or valuation-related issue in confidence.  My cell phone is 901-570-9700.

Until next time,

Chris

This is a test to see if we can replicate the problem.

Please note: I reserve the right to delete comments that are offensive or off-topic.

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