The options for transitioning control of family business equity generally involve a transaction of the business for full or partial value or a gift of the business to future generations. This can be either in the current owner’s lifetime or via the terms of a will and estate plan.
Where the current owners have not accumulated sufficient wealth outside the business – and are reliant on a realisation of value from the business in order to fund retirement – consideration must be given to how to fund the succession event in a way that will navigate the needs of both parties. Specifically, how can a scenario be arrived at that doesn’t overly burden the next generation with excessive personal or corporate debt, while providing appropriate capital for retiring equity holders.
In the scenario where succession involves a sale of the business, we’ve detailed below three of the most common strategies for funding transition of control between generations. Keep in mind, however, the scenarios below will attract a variety of different taxation outcomes which are a fundamental element to an effective succession strategy. We haven’t discussed these for this article’s purpose.
Common strategies for transitioning control between generations
Buy / Sell
In scenarios where there is an unplanned for event, such as death or a key family member becomes unwell, insurance policies can assist to fund the transfer of an exiting owner’s interest to the continuing owners.
They can be used effectively as part of a will or broader estate plan.
Vendor finance
Where the purchaser of the business is unable or unwilling to obtain external finance, it may be necessary to consider vendor financing.
Vendor finance is where the vendor finances the purchaser by deferring payment of the purchase price for the business. The purchaser will generally be required to make payment in instalments over time with payment not passing until the final instalment is made.
This scenario may be attractive where by future business profits and cash flow can provide a mechanism for purchasers to fund the buyout price.
It’s important that the implications of vendor finance are well understood by all parties to the arrangement. The scenario of the departing generation being dependent on their retirement funding from the current generation, and ultimately the business performance and cashflow, has the potential to lead to challenges in the family dynamic.
In arm’s length dealings, vendor finance will typically attract a risk premium reflective of risk of default of payment. Family business transactions may choose to accept this risk as a practical means of financing the next generation into the business.
Traditional Debt
Traditional banks will typically approach the debt funding of family succession in a similar manner to all funding requests, with a view to understanding the underlying risk and performance metrics of the business, and generally with a request for a secured position over any funding.
This can make securing funding by incoming generations challenging where real estate security may not be an option given the age profile of those seeking to take on the business.
For instance, in the Primary Production sector, the Regional Investment Corporations provides loans to assist eligible farmers and farm businesses who are planning for, and implementing, succession arrangements.
The AgriStarter Loans have certain features which are more concessional than typical commercial debt and can be utilised, amongst other things, to buy out relatives during farm succession, pay for costs associated with succession planning and invest in new infrastructure, machinery or productivity enhancements.
Other considerations when undertaking – or planning – a transition of ownership
Many family business succession arrangements will be structured utilising a mix of the above elements.
We have seen examples were incumbent generations sell down a portion of their interest in the business, as opposed to a total exit if there are insufficient funds to effect a full buy out. Adding vendor finance, and where possible external debt, into the mix may be appropriate depending on the specific dynamics of a succession scenario.
A well planned succession strategy will take into account not just available funding options, but what scenarios are likely to achieve the best outcome from a family cohesion and dynamic perspective
Working with clients
Family businesses that proactively plan for the succession process and can put in place a pre-agreed set of rules around (such matters as transaction value and who of the ‘next gen’ are eligible to buy into the business) will typically see the best chance of success in long term business continuity.
We work with family businesses of all shapes and sizes – with multiple generations, from all sectors. While every scenario is unique, we find those with a Family Charter in place can help make discussions around these areas more seamless. A Family Charter provides a mechanism that documents these ‘rules of engagement’ to ensure all parties have a clear understanding of the critical elements around funding, price and eligibility that are critical for ensuring an effective succession process.
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