Paul Hennessy is lead partner for Family Business Services at PricewaterhouseCoopers.
Dermot Reilly is a partner at PricewaterhouseCoopers. For a full copy of the report visit www.pwc.com/ie/bws
When PricewaterhouseCoopers launched its survey of Irish family businesses earlier this year it found the key threat to all family businesses was succession, and yet only 51% of Irish family businesses have a formal succession plan in place. PwC's Paul Hennessy and Dermot Reilly explain why
Succession is the single largest threat to all family businesses. It is said, "The final test of greatness for a business manager is to know how and when to let go". But the process of letting go along with the process of preparing the successor often proves too difficult for many family businesses.
Family business owners should recognise the duality of succession, which is the succession in ownership of the firm and succession in the management of the firm. Though linked it is important to plan for each separately.
Planning for ownership succession
Many family business owners find it difficult to address issues relating to illness, retirement or death and as a result make succession planning a low priority or put it off to an undefined future time. However, the importance of early planning cannot be overstated since it greatly increases the likelihood that family business owners will meet all of their objectives. In the survey, 46% of participants anticipate a change of ownership within the next five years and, of these, almost half expect that ownership will pass to the next generation of the family.
From a financial and taxation perspective, the best strategy is to transfer an operation on the brink of value explosion, and some owners attempt to time their transition or succession accordingly. A properly developed ownership succession plan should be customised to the individual business with its basic structure determined by the nature of the ownership change expected – transfer to the next generation or sale to employees or another third party.
A well-devised ownership succession plan, implemented on a timely basis, can result in considerable tax savings. Structuring an effective ownership succession plan can involve complex financial and tax issues and serious consideration should be given to involving a professional advisor. In the survey 65% of family businesses believed they would require assistance in planning for these aspects of a succession plan.
Financing ownership succession
One aspect that is often overlooked in devising a succession plan is finance. How will the transfer of ownership be financed? This is particularly important when ownership of the business is to remain within the family. How will the current owner, in many cases the founding entrepreneur, realise the capital value of the business they have created and built? In other words, how will the next generation finance their entry into the business?
Obtaining finance to fund the transfer of ownership is an area that requires careful planning and consideration. The ability to arrange financing requires an understanding of the appropriate options. In most instances, multiple sources of funding are used including:
Existing cash/assets of the business
As a rule, private businesses should build their cash reserves to levels where current assets are 110% of current liabilities. In certain situations a stronger cash position than this will be required. For the purchase of a minority family member's shareholding, existing cash may be sufficient. If redeeming the interest of a more significant, or majority family shareholder, existing cash can be used for a portion of the purchase price, which can make it easier to arrange financing from a third party or from the seller.
Banks or other financial institutions
Obtaining financing through a bank or other financial institution can be a challenge because a significant portion of a family enterprise's value is often tied up in intangible assets. Many lenders may not accept intangible assets as collateral supporting a loan. As a result, financial institutions will be likely sources of funding when the borrowed funds do not represent the majority of the value of the assets being acquired, or when the borrower has independent financial resources that can be used as collateral.
Third-party funding sources can include investment bankers, venture capitalists or other parties looking for an investment opportunity. Some of these parties will will look for an equity position which can be costly and will probably require the family to give up some level of equity shareholding.
Life insurance can serve as a funding mechanism for transfers of ownership in two ways. First, when the owner dies, the policy can provide the funding required for purchase of shares by the company or family members. Second, if the policy has a cash-accumulation provision, the cash value of the policy can provide funding.
A cross- purchase agreement is where one or more shareholders own the insurance policy and use the proceeds to redeem the interest of a deceased shareholder or to fund the purchase of the deceased shareholders shares by the next generation. Life insurance can also be owned by the company and used to fund its redemption of the deceased shareholder's interest.
Shares from an acquiring entity
If the business is being sold to another company it may be possible to exchange shares of the acquiring company for shares in the family business. In considering an exchange with another privately held company, the resulting shareholders' agreement and the marketability of the shares received must be carefully evaluated. In transactions with publicly traded companies, consideration should be given to restrictions on the sale of the shares, as well as the shares' marketability and anticipated future performance. A retiring family business owner should be comfortable that any shares received as part-consideration for your shareholding will increase or at least hold their value during any 'lock-in' period. Immediate tax exposures can be avoided through this type of 'share-for-share' arrangement. Apart from postponing the date when tax is payable, such an approach may provide the current owner with a further opportunity to manage the tax exposures. An individual intending to emigrate may ultimately avoid any tax exposure by selling the replacement shares after relocating abroad.
Ownership transfers to family members are usually more complex than transfers to an unrelated third party, but less risky financially. However, the emotional issues surrounding family transfers, the valuation assigned to the family business, the financing structure used and the high level of scrutiny from tax authorities create other types of risk which require careful planning and communication. As with all matters financial, it is best to plan and plan early.
Managing the tax issues involved
It is essential that all the taxation issues, both pitfalls and opportunities, be taken into account as part of the ownership succession plan. It might be assumed that the availability of historically low capital tax rates of 20% should eliminate the need for any significant level of tax planning. In reality, major efficiencies can be achieved at every stage in the succession process.
One of the first stages in any ownership succession plan is to have the company valued by an accountant or corporate finance advisor to assess the owner's likely exposure to capital taxes when the business is transferred to the next generation or disposed of by way of trade sale. Of family firms participating in the survey 61% have had a valuation performed to determine their exposure to capital taxes.
Many companies, particularly traditional family ones, may have diversified over the years into a range of business operations. In such circumstances, the value of the enterprise may be enhanced by separating the business into separately identifiable units so that each is held separately by the founder or owner. Such a structure would allow the owner to pass certain parts of the business to specific successors and to sell other parts to third party purchasers. Moving to such a structure can have significant tax costs, particularly capital gains tax and stamp duties, unless carefully planned and executed. A tax efficient splitting of the component elements of a business also presents the owner with an opportunity to retain an interest over some parts of the enterprise, for example, property interests, thus providing a rental income stream for the owner's retirement. Of the Irish family business owners surveyed 70% have considered separating the property assets from their business.
When preparing an ownership succession plan it is important for a family business owner to review all the options for extracting value from the business they have grown over the years. A number of routes can be considered. These include:
- The establishment or enhancement of pension scheme arrangements so that significant cash lump sums and/or pension income can be provided on a tax efficient basis.
- The capacity to pay tax free ex-gratia payments from the company.
- Entering into restrictive covenant arrangements.
- The extraction of the dividends from the business.
Developing an effective tax strategy around ownership succession is an issue that should be addressed as early as possible. Being aware of the issues and options available improves the chances of structuring the ownership succession in as tax efficient manner as possible.
Achieving sibling equalisation
There are other important issues in terms of ownership succession other than the obvious financial and taxation implications outlined above. So often family shareholdings have been passed on to the next generation usually in equal shares without consideration of the impact of this.
Behind many family business transfers there are often tensions, family feuds and falling outs caused by transfers that haven't gone according to plan. Aside from the very complex issues that arise around tax, other problems often arise when one or more sibling feels they have been short-changed. Even when an equitable strategy seems to be in place, unforeseen problems can arise further down the line, particularly when the sibling who inherits or buys the business becomes answerable financially to the rest of the family.
For the Gorman family the process of transferring the business from parents Niall and Tanya to their son Brian and his wife, Michelle, was well-planned and avoided the pitfalls many families fall into. It started ten years ago when Brian returned from overseas to the family business and realised that that was where his heart was and what he wanted to do.
Niall and Tanya were aware of the danger stories around family business transfers and were mindful of the need to create an equitable situation for their daughter Claire and an exit strategy for themselves which would help to ease them out from the business and into retirement. With this in mind, Niall and Tanya began planning for sibling equalisation at an early stage acquiring property and other assets so that when the transfer date approached there was sufficient assets to achieve an equitable balance between Brian and Claire - the active and passive family business members respectively.
It follows that attention needs to be given to the effects on the dynamics of the family and the ownership group after the desired devolution of the shareholding; and that succession plans need to address continuity in ownership issues.
When presented with the challenge of dividing business ownership in a fair manner, a founding parent may find it difficult to allocate assets on an equitable basis. Where there are a number of siblings involved, each with their own agenda, what is equitable to one party may not seem equitable to another. Equalisation is further complicated when not all siblings work in the business. The issue quite often is to allocate to the passive siblings assets that will generate income at a level similar to that generated by the business.
Often promises have been made to one child by a now-deceased parent. In one real-life scenario, a son who owned a majority of the family business was verbally promised his parent's share of an estate agency. This promise surfaced after one parent died.
The surviving parent had to 'correct' the unequal nature of the estate division. This resulted in negative feelings among family members, and unnecessary grief for the surviving 85 year-old parent.
As part of the ownership succession process a family business owner should examine the company's balance sheet to determine what assets are available for equalisation. Where other assets are insufficient, the owner can purchase life insurance or begin a savings programme outside the business and pass that savings programme to the passive family members. Property is an asset commonly allocated to passive siblings. If income producing, this asset can replace salary earned by the sibling active in the business.
It is advisable to determine what assets are available for equalisation at an early stage. In our survey of Irish family businesses, 84% believed they had sufficient assets to allocate between active and passive family members. If assets are insufficient the best solution may be to start an asset acquisition programme. If equality is achieved by passing business ownership to all family members, regardless of whether they participate in the business or not, then some mechanism must also be established so the non-participating family members can either relinquish ownership or receive an appropriate level of earnings from the business.
Achieving sibling equalisation is tough work. It requires a commitment from all parties and siblings must continually exchange information and trade off individual needs for common good. Dealing with sibling equalisation requires commitment and objectivity to be successful. Bringing these components together is the key challenge for many families.
The final word
Building and implementing ownership succession plans often involves tremendous family subjectivity and emotion. This makes it very difficult for any family to build these processes and structures effectively without the involvement of an independent advisor. We at PricewaterhouseCoopers offer such an objective voice. The role played by a professional adviser is to critically and constructively evaluate the ownership succession plans and to present the best alternatives for the business, family and owners – not just for one specific individual. This ingredient is often one of the most important factors within the ownership succession process.