Passing The Torch — Transferring A Family Business To The Next Generation

Introduction — When Planning and Expectation Face Reality

Consider the following situation: A young man,1 by himself or with one or more siblings, starts or takes over or buys a small business and grows it into a strong successful enterprise. He and perhaps his siblings have children who work in the business in the summer and after school, and he has given them a stake in the company with nonvoting stock or other equity. One day many years later, with the business thriving, the founder and owner decides that the time has come for him to cash in on the product of his hard work and take the value of his equity in the business and retire. The children decide that the time has come for them to stop being simply employees and to take over their perceived rightful place as owners and management. In other words, the time has come to pass the business to the next generation. Now what?

Everyone in the family has probably assumed for a long time that the founders would one day retire, and that the children would take over. Those involved may have done some preparation for the transition by estate planning, transfers of nonvoting or at least noncontrolling equity and placing children in some board or management positions. Most likely, however, the founders and the children have not fully considered some of the more difficult issues and problems in moving a business to the next generation, including:

How do children, whose only income and source of funds is the business, find enough money to pay the likely very substantial amount needed to buy ownership and to cash out the founders without crippling the business? Can the person or people who created and built and grew the business and who consider it their personal domain or "baby" turn over real control to children without hovering over and second guessing, making a smooth transition and proper management and authority impossible? What happens if the children to whom the business is to be transferred cannot agree among themselves on significant management or operating issues? What if they simply do not like one another and do not get along? What about serious disputes during transition, between the founders and the children or the children among themselves? If principal parties cannot resolve their disputes, can the transition proceed and the business continue? To repeat, now what?

1. Money — Buying in Without Breaking the Bank

   With few exceptions, children who have grown up in a family supported by a family business have few if any resources of any substance outside of the business. If they are in line to take over as the next generation, they most likely have worked at the business and earned from it a salary and benefits, but they probably have needed most or all of those earnings for daily living expenses and support. As the heirs apparent, they may have been given or earned stock or other equity in the business entity, but the equity interests are most likely nonvoting or at least far below control, and shareholders or partnership or operating agreements almost certainly prohibit them from selling the equity or using it as collateral for a loan.

   The founder or founders and first generation of a family business ready to retire and pass the business on to the next generation usually have reached a stage at which they want, and consider themselves entitled to, the equity they have built over the years and therefore expect a good deal more from the transition to their children than a continuation of salary or even distributions and a share of profits. If the founder has worked for years to create a business that he could sell to a third party for a very large amount, he most likely does not want to give up a material portion of that value by selling to his children.

   Thus arises the common problem and conflicting interests of financing the transition of a family business to the next generation when, as often happens, the children are not independently wealthy and there is no reasonably available outside source for meaningful financing. How do children purchase their parents' business, when the business itself is the only source of funding, without draining the resources of the business? The simple answer is that they cannot, and that they and the founders must devise a mechanism to arrange for such funding that accommodates the needs and interests of all the parties.

   One relatively simple mechanism to provide for funding involves agreements that assure that the business will consider potential fundamental transactions, such as mergers, sales of substantial assets or equity placements, with a view to the obligations to the founders and will use as much of the proceeds of such transactions as is reasonably practicable to pay those obligations.

   As discussed below, until the founders have been paid in full or for some other agreed reasonable time, the selling founding generation should have a level of control and even a veto over proposed or potential fundamental transactions. This initially serves the possibly important objective of preventing younger and less experienced owners from making...