A California-based family business was facing the worst crisis in its history. Not only was its founding patriarch and CEO starting to exhibit signs of mental deterioration, but his erratic behavior was threatening the bottom line. Business decisions were being neglected. Customers were being mistreated. Top employees were headed out the door.
With the future of their company at stake, the other family members at the third-generation enterprise realized they needed to find answers to three questions: How could they convince the CEO to relinquish control before he irretrievably damaged the organization? Who would shoulder his responsibilities? And where would they find the money to purchase his share of the business?
Our opening story is not unusual. Family businesses everywhere can find their future imperiled when a critical person can no longer exercise managerial duties. Sometimes the cause is physical or mental disability. Other times it is an unexpected death, resignation, termination, retirement or divorce.
Luckily, the California business mentioned above was able to resolve its crisis by resorting to a tool available to family businesses everywhere: A document called a “buy-sell agreement,” drawn up in advance of the crisis, mandated the terms by which the family business stock was bought and sold and the procedures for responding to unexpected events threatening the organization’s survival. In this case, the document required performance-based assessments of the CEO’s mental competence.
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“A good buy-sell agreement can shelter a family business from costly disruptions caused by material events involving its owners,” says Sam Brownell, founder of Stratus Wealth Advisors in Kensington, Md. “The right provisions can even keep company shares from falling into third party hands — an event that can damage the organization’s profitability or even threaten its survival.”
OUT OF THE BLUE
Divorce – A family member’s divorce settlement grants the ex-spouse a batch of company shares — and a measure of unwelcome control over business decisions. The business faces a costly forced valuation and a search for cash to recapture stock.
“When a member of a family business sues for divorce, very often the spouse’s attorney will try to attach company stock,” says John R. McAlister II, vice president of The Beringer Group, Radnor, Pa., a family business consultancy. “It might also come to light that the spouse had been gifted some stock during the marriage.”
Personal Bankruptcy – A family member with a large portion of the company stock runs up excessive credit card debt. When the creditors start to eye his shares as part of a bankruptcy settlement, the business risks losing substantial operational control to outside parties.
Minority Shareholders – Over the years, the business has granted so many corporate shares to children and grandchildren that passive shareholders now burden operations. “Problems can arise when people inactive in the business must be consulted to one degree or another about key management decisions,” says Richard R. Spore, an attorney with Memphis-based Bass, Berry & Sims. “Passive owners often resist shouldering the risks of change and can have conflicts of interest with those running the enterprise.”
Under-performing Personnel – A second-generation family member who recently joined the company has under-performed to the extent that she must be terminated. The organization risks losing control of her stock.
VALUING THE STOCK
Any of the above events, and others like them, can create hard feelings among family members. They can also disrupt business operations and even result in the loss of managerial control to third parties unless a carefully worded buy-sell agreement has set forth appropriate procedures.
Because most solutions to ownership crises require the recapture or transfer of company stock, any successful buy-sell agreement must first specify how corporate shares will be valued. Setting a reasonable price can be difficult, though, when people on either side of the negotiating table push for assessment formulas that favor their interests. Those relinquishing stock will naturally seek the highest value possible.
The challenge can be especially great when individuals expect the value of their holdings to be equivalent to publicly traded corporations. “Any business’ selling price will typically be less if the transition is with family members rather than third-party buyers,” says Brownell. “One reason is that external buyers who already have human resources, accounting, legal and other support departments will not need the redundant ones in a purchased enterprise. That makes the remaining parts of the business more valuable. In contrast, a next generation buyer will need to retain those support departments. The fact that there is more expense involved in keeping them reduces the value of the purchased organization.”
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The more expansive blend of interests characteristic of a family operation can also create confusion about value, says Brownell.
Negotiations will need to aim for a price that represents a win for outgoing and incoming family members, while also leaving sufficient reserves to sustain the business as an ongoing enterprise for the employees and the customers. “The need to ensure that the business thrives and serves a mix of constituents means that the price will likely be a little bit lower than if the sale were to a third-party buyer,” says Brownell.
Some family businesses try to resolve such conflicts by inviting both sides to weigh in. “Many buy-sell agreements have provisions that call for both seller and buyer to get appraisals,” says Travis W. Harms, the leader of Mercer Capital’s Family Business Advisory Services Group (mercercapital.com). “The idea is that if the two results differ within a specified percentage, then everyone agrees to accept an average of the two.”
Unfortunately, what seems on the surface like a good solution too often turns out to be yet another source of conflict. An appraiser will usually shade the business value assessment to reflect the interests of whoever is footing the bill. “Once the parties are locked into a conflict, it is rare that the conclusions of the respective appraisers will be very close,” says Harms. “The upshot is that the business ends up hiring a third appraiser. Not only does this take time and money, but there is still plenty of room for argument. Inevitably, one or both parties will be unsatisfied and that can lead to hard feelings and litigation.”
It’s tempting to try to head off the above conflicts by designing a valuation formula agreeable to everyone, and then setting it in stone for use later. This also carries risks. “While a clearly defined formula can avoid the problem of ambiguity, the problem is that industries, markets and business operations change over time,” says Harms. “A formula that makes sense today may not make sense five or 10 years down the road when the buy-sell agreement has to be used.”
The secret to success, say consultants, is to schedule periodic appraisals with parameters that are clear and acceptable to all family members. “All parties should understand the approaches to value being used and the assumptions being made,” says Harms. “That will reduce uncertainty and cut down on the potential for conflict later when a trigger event occurs.”
How often should the appraisals be done? For the best results, say consultants, the appraisal should be done annually. “It’s a lot less expensive to do that than to deal with the costly infighting that can otherwise result,” says Z. Christopher Mercer, CEO of Mercer Capital, Memphis.
Periodic appraisals offer an important fringe benefit: knowledge about a business’ confirmed value that can help manage the family wealth. “Valuations can help family members understand the rate of return they’re receiving on their investment in their private company,” says Mercer. “And just like any other investment, that rate is based upon three points: a beginning value, an ending value and the interim distributions.”
Mercer offers an example: If a company stock valued at a $100 one year increases to $112 a year later, then the shareholders have enjoyed a 12% return on their investment. If the company has also paid them a three dollar distribution, then their total return on investment has come to 15%.
FUNDING THE STOCK
Assessing the value of a family business is one thing. Scraping together sufficient cash to purchase a departing owner’s stock is another. Buy-sell agreements should address funding sources to obviate a lot of scrambling around when disaster strikes.
Insurance policies can provide funds for the purchase of shares in the event of death or disability. “Very often key person insurance can be taken out for individuals whose contribution to the business is so vital that if something were to happen to them, the operational and earnings capacity of the business would be unduly impacted,” says Brownell. “The policy can be structured to pay sufficient cash to either hire a replacement, offset lost income or purchase the insured’s stake in the business.”
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Neither life nor disability insurance will help, though, for trigger events such as retirement, resignation, termination or divorce. In such cases businesses can find themselves searching for alternative funding sources.
Perhaps the first solution that comes to mind is an outside lender. But in many cases that’s less than ideal. “A business that borrows money may end up reducing its future capital expenditures or cutting back on mergers and acquisitions,” says Harms.
“Those alternatives can have adverse consequences for the company down the road.”
Purchase of shares by a third party also has its downsides. “Many family businesses are wary of bringing in non-family shareholders,” says Harms. “Anyone who invests money will want to exert their influence to make the company run the way they would like to see it run. That can create a whole host of unintended and potentially negative outcomes.”
Yet another solution is seller financing: The company gives the outgoing owner a promissory note for a specified amount to be paid off with interest over a certain number of years. “Such an arrangement can help both parties,” notes Brownell. “The business benefits from a cash flow perspective, and the seller avoids receiving one huge check subject to taxation in the year received.” The downside here is mostly borne by the seller, whose default risk may not be adequately compensated for by the interest received.
Finally, the family businesses may decide to retain the outgoing owners as third-party consultants for a given number of years. This can free the business from the need to secure a large amount of cash while providing regular tax deductions for the scheduled payments. The departing executives can continue to assist the business with their managerial input, enjoy a steady cash inflow and avoid a big tax bill for a large sum received in a single year.
Family businesses should draw up and sign buy-sell agreements long before a trigger event occurs. “It’s much easier to hash out all of the ‘what ifs’ when everybody’s healthy, in good spirits, and the business is going well,” says Brownell. “You do not want to suddenly try to figure out who owns what part of the business, how people will be compensated, and how the business will be valued the morning after a material event occurs.”
Such timeliness is especially important when it comes to business valuation, says Harms. “It’s remarkable how reasonable people can be about valuation when they don’t know if they’ll be the buyer or the seller of stock at a certain price.”
Allocating company stock, valuing shares and wrestling with family personalities may seem like formidable tasks. But the result can be a carefully crafted buy-sell agreement that not only saves the business from the crippling costs of a financial crisis, but also keeps the family functioning as a unit when something bad happens.
And a cooperative family effort is critical to success. “Buy-sell agreements need to make sense for all the parties involved, or people will refuse to abide by them,” says Spore. “And that means the business may end up with the very problem it wanted to avoid in the first place — litigation. That’s expensive, difficult and painful for everyone.”