October 1, 2015
By Danielle Walsh
As a business owner, you spend years building your company, but what happens when it’s time to retire or just slow down? The nature of being in business requires juggling a number of priorities, while attempting to maintain a life at home. This balancing act often means planning for your eventual exit from the business is never really top of mind.Â
Why is that? Well, as someone who assists businesses with succession planning, it’s been my experience people either think they will be around forever or retirement is so far into the future that succession is not a priority. Unanswered questions and uncertainties surrounding the whole issue of exiting or retiring are also factors that cause business owners to continuously put aside dealing with this important issue.Â
Although succession planning isn’t always about family, statistics show between 80 to 98 per cent of all businesses in the world are family-owned and operated, and in Canada, they contribute more than 50 per cent of the country’s gross domestic product (GDP).Â Research also demonstrates most owners would prefer to transition their business to the next generation and keep it in the family. However, this isn’t always possible. So what are the options when it comes to exiting a business?Â
This option entails a detailed examination of the inner workings of your business by the purchaser (i.e. due diligence), which can be extremely difficult for you. In many cases, the price/value you are expecting to receive is much higher than what the purchaser is willing to pay. This can lead to a long and painful negotiation process. As part of the buy-sell agreement, you may have to agree to stay on as a manager for a certain period of time (e.g. between two to three years) while the business transitions to the new owners. This can be demoralizing, as you would no longer have decision-making authority and you may not agree with the changes being made to the business you spent your life building. Experience would indicate this process is always more difficult than anticipated on the exiting owners. However, with this option, your financial retirement is more secure and, in some cases, you are able to make a clean exit.Â
Long-standing managers may be interested in purchasing the business and continuing your legacy. This is often a more desirable option for business owners, as their hard work and dedication remains intact and carried on by managers they know and care for. You may need to decide who is the most competent manager to run the business among those who work for you, while considering whether they can afford to buy it. Further, if more than one manager is interested, there is no assurance they would be compatible as co-owners or even want to be partners in the business. Typically, you will need to fund all or part of the transaction (e.g. vendor take back), since the managers will be counting on using the business’s profits to pay you over time. This means there is a higher degree of risk for you with respect to your retirement. However, when the conditions are right, this option tends to bring more satisfaction and comfort to the exiting owners than an outright sale to a third party.
This involves passing the business from one generation to the next, with the hope of continuing the family legacy for years to come. This option also presents its share of challenges, even when it’s the owner’s preference.Â Research demonstrates that although most owners prefer transitioning their business to their children or nieces and nephews, 67 per cent of companies don’t make it to the second generation, while 88 per cent don’t make it to the third generation. Given the number of family-owned and operated businesses in the jewellery industry, the desire of these owners to transition to their children, and the dismal succession statistics in trying to do so, this article focuses on the information family business owners need to know to successfully transition their companies.
Family business succession planning can be depicted as the ability to paint a clear picture for the next generation for the long term (e.g. for the next 10, 20, or even 50 years) with respect to employment opportunities, management succession, and ownership succession.
While this may sound like a daunting task, it does not need to be. However, it does require the willingness and determination to answer a number of critical questions, such as:Â
When these succession questions remain unanswered, family members tend to have different expectations as to how each will be dealt with. At this point, the picture for the next generation is unclear or uncertain, and when this happens, it can lead to conflict amongst family members.Â
Imagine, however, answering those questions in a ‘family business constitution’ (i.e. your family business rules), which would be developed primarily by yourself (the owners) and family members who are active in the business. Once completed and approved by the active family members, these rules would be communicated to the entire family, including spouses and children, at least once a year. This would help paint a clear picture for all family members and facilitate the transfer of the business to the next generation. Everyone involved would know what kind of experience or education they are expected to have to enter the business, as well as who can own shares and how they will be obtained. In other words, they can make informed decisions about their individual and collective futures in the family business.Â
You may think these succession strategies only apply to big family businesses, however, this is not the case. The size, industry, and geographic location of the family business do not alter the need or the ability to paint this clear picture.
It is never too early to develop a family business succession plan. If you currently own a jewellery business and know some of your children, nieces, or nephews are interested in becoming part of it and you are hoping to keep it in the family, then you are ready to start. The sooner you do, the less conflict there will be and the easier the discussions and decisions surrounding succession, family, and the business will become.Â
Here’s an anecdote. I had a client who was ready to retire. He was nearing his late 60s and had three adult sons who were more than competent to run the business, as they had been working at the company for more than 10 years. The brothers were becoming impatient to take over from their father, as they all had children of their own that may be interested in working in the business in the near future. The owner sought guidance from a number of different advisors: an accountant, lawyer, financial planner, and an insurance broker. However, he never felt ready or comfortable to formally transfer management responsibility or ownership to his sons.Â
Why is that? When I first met him, it became clear to me the owner’s issue was not related to the technical components of the succession plan (e.g. estate freeze, tax, valuations, trusts, shareholders agreement), but rather with the non-technical components, such as family dynamics, work ethic, personal and business values, generational differences, and sibling rivalries. He understood three people who don’t get along and can’t make a decision together could easily destroy the business he spent his life building.Â
By implementing a number of succession guiding principles supported by some family business rules, the owner felt much more comfortable about transferring the business to his sons. One of the most important family business rules for this family was agreeing to a dispute-resolution process that would allow them to effectively address and resolve conflict. Today, the sons run a successful family business and even have some of the next generation working alongside them. This would not have been possible without a process to deal with their differences. Every year they review their constitution with the entire family and celebrate the opportunity and legacy they have been provided.Â
The following are critical components of a successful exit strategy:
Research by Williams and Pressier shows that, in contradiction with traditional belief, a lack of communication is the cause of failure in family businesses 60 per cent of the time. This can either be between members from one generation (i.e. brothers and sisters or cousins) or between members from different generations (i.e. daughter/son and parents/uncles). Another 25 per cent of failure is due to a lack of education and preparation on the part of the next generation. It should be noted only three per cent of failures are due to issues related to financial planning, taxes, and investments. The importance of setting up governance structures, such as family meetings or family councils where open lines of communication can help deal with issues relating to the family and the business, cannot be overstated.Â
It goes without saying the long-term success of any business is contingent on having competent management. Family businesses can achieve this by developing formal grooming plans for all potential successors. These plans should expose next generation successors to all aspects of the family business with a focus on continued learning, both within the business and outside it. Preparing successors for leadership and ownership is an integral part of any succession process. Ensuring a grooming plan is in place for all potential successors will help current owners obtain an appropriate level of comfort with respect to their competencies, work ethic, and commitment to the family business.
In a family business, equal is rarely fair and this is one of the main sources of conflict. This issue applies to many facets of a family business, ranging from compensation to ownership. Usually, all next-generation family members are paid the same despite a large discrepancy in responsibility, years of experience, education, and commitment. This often results in frustration from those who work the hardest, and in extreme situations, can result in the family business losing the most valuable family members.Â
To avoid this pitfall, successful family businesses develop a compensation philosophy or approach based on paying fair market value. In other words, family members will be paid the same as non-family employees that do the same job. A similar situation can occur with shares in the family business. Since parents love their children equally, they usually want to divide the business equally amongst them, whether they are active in the business or not. This is done with the best of intentions, but can often lead to further conflict between next-generation family members. The allocation of shares—as well as the manner in which it is done—is one of the biggest contributors to the ailing statistics in family business succession.Â
Here’s another anecdote. A family business owner with three daughters transferred ownership equally among them. Sarah, the youngest of the sisters, worked in the business and had been managing the daily operations for the last five years. The business continued to be successful under Sarah’s leadership and annual dividends were paid to all three shareholders. However, as time passed, dividends became an issue. The two non-active sisters made it clear to Sarah they were counting on their annual dividends and they expected they would increase given the store’s performance. They reminded Sarah that together they held two-thirds of the voting control. Sarah had no choice but to concede and continuously alter her plans for investing into the future growth of the business. She also grew to resent her sisters as the business declined.
When I received a call, Sarah told me she heard a rumour her sisters were thinking of removing her from her leadership role in the family business, since they felt she did not share their vision for how it should be run. Yet, Sarah was the only one with knowledge of the business, as well as business experience and qualifications. The parents—the store’s former owners—had no idea choosing to split the shares equally among their three children would lead to so much family conflict. Unfortunately, the two sisters decided they wanted to sell the business to maximize their personal wealth. That was the end of the family legacy and the end of any family harmony.Â
Family business rules help establish clear expectations, as well as terms and conditions with respect to a number of succession issues, including ownership. An example of a rule is the stipulation that to own shares in the company, one must have a certain level of education and must be working full-time in the business. Another complementary rule may specify the number of years of full-time work required to make it into management (e.g. at least five years), ownership (e.g. 10 years with the understanding the last five have been in management), and may incorporate a test of ‘compatibility’ to ensure family members actually get along and have proven they can work together. Keeping ownership in the hands of active family members is a highly successful succession strategy. To ensure no child is privileged over another based on their life decisions (i.e. working in the family business or not), successors meeting the ownership criteria would purchase the company at fair market value, paying the owners over time from the profits generated from the business. Doing so makes this process fair. Those who choose to work for the company and pay for it, get to own it, while the family members who prefer to do other things get to benefit from other family assets in the form of an inheritance.
Although this may seem self-serving, I strongly encourage you to engage the services of a trained family business practitioner. These professionals understand the technical components of the succession process, but more importantly, are experienced, knowledgeable, and comfortable with helping manage the all-important family component, allowing you to paint a clear picture with respect to the future of your business for your children and grandchildren.
On a final note, business owners need to give serious thought to their exit plan to maximize their financial return and the degree of comfort they can experience. The sooner this is done, the better. Being informed on the specific strategies available can help avoid the pitfalls that come with a lack of succession planning.Â
Danielle Walsh is founder of Walsh Family Business Advisory Services, a consulting company specializing in assisting family-owned and operated businesses navigate the rough waters of management and ownership succession. She is a certified public accountant (CPA), chartered accountant (CA), and holds certificates in Family Business Advising and in Family Wealth Advising from the Family Firm Institute (FFI). Walsh developed her philosophy and desire to help family businesses from her father, Grant Walsh, who has worked as a family business practitioner for the last 25 years. She is also currently teaching the first family business course offered at the undergraduate level at Carleton University in Ottawa. Walsh can be reached via e-mail at firstname.lastname@example.org.
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