Succession planning for business owners
Family businesses have for decades formed the backbone of the private sector in Ireland with approximately 75% of Irish owned businesses being family owned. Yet the unwillingness of family business owners to effectively plan succession is one of the main reasons that many family businesses fail to survive to the second generation with even fewer business surviving to the third generation and beyond. Research would indicate that approximately 30% of family business transfer successfully from one generation to the next.
Business owners considering succession to their business may be daunted by the number of issues involved. However approaching succession from one angle only such as tax planning or ownership transition, may mean that other areas of the business may suffer and can lead to significant problems in the future.
In starting the succession planning process, business owners should consider the following:
- What are your goals as a business owner?
- The ability of the next generation to take the business forward. If there are gaps in the required skill-sets, how will those gaps identified will be filled?
- Take time to consider family issues and the goals of key stakeholders, particularly family members.
- It is critical at the outset to outline the current and future governance framework to provide clarity for family members and help to minimise conflict in dealing with all aspects of the business.
- The succession plan for the management of the business and the role of the shareholders/board of directors
Management & Ownership transition
Historically in a family business, transfer of ownership and management often coincided. Today a more professional approach is often adopted and ownership and management may transition at different stages. In some instances while ownership may transition to family, at a management level, the transition should be to those individuals most capable of running the business and that may often be a mix of family and non-family employees.
Any transition, at an ownership or management level is a cause for concern for all stakeholders who will be conscious as to how it impacts their position. For that reason, it needs to be carefully managed to ensure all key individuals are kept on board. Where succession is planned coherently as part of the overall strategic plan for the business, this minimises the potential for disruption at what can be a difficult time for the family.
For most business owners, the business is in value terms, their largest single asset and can represent a lifetime of personal endeavour. Most business owners will view their business as their legacy for future generations and it would be most parents wish that the business will pass to their children. Two critical questions need to be asked; are my children interested in taking over the business and are my children capable of running the business. There can often be two very different answers to these questions.
It can be difficult for a parent to be objective in assessing a child’s interest in the business and their ability to run the business. Assistance may be required from non-family employees or external consultants in assessing children and their development needs. Where succession is planned over a number of years, this gives the business owner time to assess its future management candidates. If there is one obvious suitably qualified family member, then the decision is easily made. If, however there is more than one child involved in the business, or if there are children who have a desire to take over the business but are not suitably qualified, this can lead to some difficult decisions having to be made by parents. An outside perspective can assist the business owners in choosing the right successor.
Where a company has a clear strategic direction, the selection of a new CEO should be based on determining who is best suited to implementing that strategy. While most parents may wish for a child to take on this role, sometimes a non-family member of management is more suitably qualified. The bigger a family business becomes, the more often there is either a mixed family/non-family team.
It is important that the future management needs of the business are fully understood, as management skills and styles that were successful in the past may prove ineffective today. As part of the management transition, business owners should:
- Decide when they will retire – fix the date and communicate it to all key stakeholders
- Determine future business management needs and capabilities required to take the business forward
- Define key leadership positions and identify potential leadership successors for those positions
- Once potential successors are identified, match their existing skill sets with the required job core competencies and identify areas of development.
In selecting the right successor, what is best for the business often needs to be put ahead of what is best for individual family members. Transparent selection criteria should be the determining factor in identifying a successor. It is unlikely that any one candidate possesses all of the ideal behaviours and characteristics and it is existing management’s responsibility to prioritise what they wish to see in the next leader of the business. Considering succession candidates within the family can raise difficult issues and therefore it is best approached on an objective professional business basis, where competence is the overriding criteria. Significant consideration should be given to non-family members being the next CEO of the business, where the competence of the family candidates is not comparable. On occasion, promoting a senior employee to the CEO role for a number of years, while allowing for family members to shadow them and develop over time can be beneficial in facilitating family assuming the main leadership role in the future. In such a situation, the non-family managing director would act as a mentor to the next generation running the business until a transition within the family is possible in the future.
As part of any development plan for successors, it is important that they receive appropriate mentoring from existing senior management, clear objectives are set and feedback is given on a timely basis and that there is adequate development of the required skillsets. This is certainly an example of where “no one size fits all” and in some cases, this may require the successor to work outside the family business for a while or to take appropriate management courses. It is vital that knowledge transfers to the next generation are facilitated by way of hands on experience, developing capabilities and strengths and encouraging and promoting team development. Once a plan is designed and implemented, it is critical to monitor the development of the candidate and to benchmark their progress against the development plan to ensure any areas of difficulty are identified and examined. Finally there should be a clear retirement date for the existing CEO and if required, an appropriate policy for any role they are to play in the business going forward.
A key factor underlying any management transition plan is ensuring that all relevant individuals (family and non-family) are kept up to date with the proposals and decisions and are fully on board with the plan.
Often in family business ownership and management transition are viewed as one in the same thing. However it has become more common for professional managers to be brought in to run a business whilst ownership remains within the family. Alternatively some family members could be involved in management with a wider range of family members succeeding in an ownership context.
Where business owners decide to transfer ownership to the next generation rather than to sell and realise the value of their business, two primary issues arise:
- Ownership configuration; and
- Preparing the next generation for ownership – particularly if they are not involved in the business
Families are generally very sensitive to issues of fairness, particularly in the context of division of assets amongst children. The question often arises as to whether ownership of the business should solely transition to only those family members actively involved in the business or whether all family members should be treated equally. Very often, a substantial part of the family business owners’ net worth is tied up in the family business and thus it may not be possible to equalise family members working outside the business using solely non-business assets.
Where business owners have a desire to ensure control rests with family members working in the business whilst at the same time ensuring that they are making appropriate provision for all of their children, separate voting shares could be considered with the majority of the voting rights passing to either family members working in the business or to those family members viewed as most competent to take the business forward. Alternatively control mechanisms can be included in a shareholders agreement.
It is important to manage the expectations of both family members working in the business and passive owners as quite often their expectation as owners will be very different. While passive owners may be supportive of management, they will usually desire financial benefits such as dividends or other cash distribution from their ownership whereas family members working in the business, who are remunerated for their executive role and may have a preference for surplus profits to be reinvested into growing the business. The remuneration policies for family members working in the business needs to be transparent and reflective of their role as a key executive in driving the business. The remuneration rates should be reflective of market norms for such a role. It should be clear that this remuneration is separate from any dividends or other value that they may receive in their capacity as shareholders also.
With passive shareholders, it is important that there is an appropriate communication process to ensure they are kept informed on the company’s direction and priorities. Different ownership perspectives are a source of potential conflict and appropriate governance structures should be put in place to manage what are often predictable scenarios and differences of opinion.
Preparation for ownership
When considering ownership transfers to the next generation it is important that the next generation display a level of maturity and understanding of the responsibilities of ownership; at a very minimum an owner must be a responsible owner.
Training and developing future owners, whether or not they work inside the business is as important as training the next generation of management and leaders. Responsible owners will have sufficient knowledge and acumen to participate meaningfully at shareholder meetings and contribute to decision making; they will provide management with the support they need to take the business forward, to balance the needs of the business and the family and find constructive ways to resolve conflict and differences of opinion. They should be aware of the family’s legacy and their role as owners to ensure that the business exemplifies the family’s values.
In preparing the next generation for ownership, business owners should consider the following:
- Talk about the business with your children from an early age. Most of the lessons about responsible ownership will come to them informally.
- Instil stewardship – convey to future shareholders that ownership means taking care
of a business and its shareholders. It is not about power or control.
- Owners should have a broad understanding of the family’s business, its industry and the marketplace it operates in.
- A future owner should understand the family values and how they are reflected in the business. Owners should have a good understanding of the strategic direction of the family business.
- They should be aware of the principles of family business governance, including the interactions of any family council, board of directors and management team.
- Owners should be aware of the trade-off between business growth versus liquidity and
- Owners should know their legal rights and responsibilities as an owner and simultaneously
should be aware of the challenges of management and difficulties of being a director in order to understand the concerns of other stakeholders in making informed decisions
The greater the level of preparation by both the existing owners and management team in devoting time to the development of the future ownership and management team, the greater likelihood of successful transition at both an ownership and management level. Ultimately this should be part of a comprehensive governance framework for the business.
In transferring ownership of their business to the next generation, current business owners need to fully understand the value of their business and any associated costs and taxes that will need to be funded. Depending on the potential costs of a lifetime transfer, business owners may consider postponing ownership transition until they pass away at which time shares in the family business will pass under their will.
As part of an overall succession plan, it is important to ensure your will is up to date. Equally as shares transition to the next generation it is as important that the next generation ensure they have a will in place.
It is often the desire that shareholdings of family business remain within the ownership of bloodline family members and thus pass down to children rather than to a surviving spouse on the death of a shareholder. However the legal entitlement of a spouse needs to be considered in this context. Where there is a valid will in place, spouses have a legal entitlement to one third of their deceased spouse’s estate where that spouse has children or grandchildren (and half of the estate where there are no children or grandchildren). In the event that a person dies with no will, their spouse is entitled to two-thirds of their estate if there are children or grandchildren (and the entire estate if no children or grandchildren). Under the Civil Partnership and Certain Rights and Obligations of Cohabitants Act 2010, cohabitating couples may also have a right to benefit from their partners estate in certain circumstances.
Often a significant part of a business owner’s estate will be derived from his/her shareholding in the family business and so it can be difficult to satisfy both a surviving spouses’ legal entitlement under the Succession Act and the family’s overall objective that shares are protected for bloodline family members only. In some cases, the company would acquire the shares from the surviving spouse so that he/she will receive the value of the shares; however this means that the children and future lineal descendants of that deceased shareholder cannot participate in the ownership of the business into the future.
Even where a spouse is happy for shares to pass directly to the next generation and so does not wish exercise his/her entitlement to their legal right share, consideration needs to be given to how the surviving spouse will be adequately provided for during the remainder of their lifetime. It is often the case that income from the family business comprises a significant part of the family’s overall annual income. If the shares pass directly to the next generation, the surviving spouse may not have adequate resources to fund his/her living costs. Consideration could be given to granting a life interest in the shares to the surviving spouse with the remainder interest passing to the next generation on that spouses’ death. This ensures that the surviving spouse can continue to enjoy any income from the shares whilst also achieving the objective that the assets are protected for the next generation.
Enduring Power of Attorney
Business owners should also consider putting an Enduring Power of Attorney (EPA) in place. An EPA enables you to choose persons called “attorneys” to manage your affairs on your behalf in the event that you become mentally incapable of doing so. In our view this is something that everyone should have; however it is of significant importance for business owners. If you were to have an accident or become ill such that you no longer had mental capacity to deal with your affairs this could adversely affect your business while your family go through the lengthy and costly ward of court process to give them the legal authority to make decisions in relation to the business. In the meantime any shareholder decisions are stalled which could have significant implications for the business. This only adds a further layer of stress to the business owner’s family at an already very distressful time for them.
Rather than a direct transfer of ownership to the next generation, the use of discretionary trusts are becoming more popular as an alternative option for holding shares in family business; particularly where CAT business relief may not be available. Take an example of a business owner and his/her spouse who wish to pass the shares in their family business to their three children equally resulting in three shareholders owning one third of the business each. Over time it is likely that shareholdings may become diluted as different branches of the family pass their shares on to the further generations. As the number of shareholders increase, the ownership structure can become more complex and fragmented with family members having unequal shares.
Therefore often business owners will consider transferring their shares to a family trust for the benefit of their children and future generations. While family members need a mechanism to access value from the company they do not necessarily need to hold the shares in their own names and often having significant personal wealth can be a burden. Holding the shares through a trust protects the capital value of the shares for current and future generations and as the potential number of beneficiaries increase it can provide a level of protection against future marital breakdown. As mentioned above, it is often the case that shares in a family owned business pass down the generations to bloodline family members only. A trust can protect the capital value of a business for these family members but also provides a mechanism to look after the income requirements of a surviving spouse
Holding shares in a discretionary trust can also help to alleviate the potential tax burden, as it should be possible to transfer the shares to the trust with no Capital Acquisitions Tax (CAT) arising. If shares were to pass down through the generations, there would be a CAT charge at 33% (3.3% if business relief applies) each time the shares transfer to the next generation and over time as family shareholdings become more diluted it is less likely that business relief will apply. This can mean that the overall capital value can be significantly impacted due to the tax costs of transfer. Holding the shares in a family trust will eliminate CAT on the capital value of the shares when the shares are transferred to the trust and successive generations can be beneficiaries of the trust.
Where assets are held in a discretionary trust, discretionary trust tax will apply following the death of the settlor, provided all of his/her children are over the age of 21. This results in a once-off charge of 6% based on the value of the assets held in the trust and an annual charge of 1%. Whilst this can prove costly particularly if the business is of significant value, it is often the view of business owners that this is a justifiable cost in terms of their overall estate plan to avoid the dilution of shareholdings and to protect the capital value of their business for future generations.
Often business owners will deal with certain legal documents together when considering their overall estate and succession plan. For example, when a business owner is putting a will in place, he may consider the merits of transferring his business assets to a discretionary trust rather than directly to the next generation. In addition, we would strongly recommend putting an EPA in place at this time too. Before transferring shares to the next generation, business owners may also consider putting in place a shareholders agreement. This allows them to set the terms upon which certain key matters relating to the business are dealt with; such as appointment of directors, share transfers and valuation of shares. New shareholders are required to sign a deed of adherence to the shareholders agreement ensuring they also become bound by the terms of the agreement. It is also becoming increasingly popular for individuals who have or may receive shares in a family company to put in place pre-nuptial agreements to protect the legacy assets of the family.
As part of the succession planning process, business owners should consider the potential tax costs of ownership transition and how these costs will be funded. Often in family businesses, most of the wealth is tied up within the company whereas any tax costs of transfer are personal costs to be funded by the business owner and his/her children.
Generally on the disposal of chargeable assets, capital gains tax of up to 33% can arise. However retirement relief may apply to reduce the overall tax cost for the business owner on a transfer of shares to his/her children. Where the ownership transition happens before the business owner turns 66, full relief from CGT should apply on the transfer of shares to children (the relief may be restricted where part of the value of the company is not derived from the trading business assets). After 66 this relief is restricted to €3m.
For children receiving shares in a family controlled company, CAT business relief may apply to reduce the CAT rate from 33% to 3.3% (again the relief may be restricted where part of the value of the company is not derived from the trading business assets). Where ownership is transitioning from first to second generation, it is likely that the company will fall within the definition of a family controlled company; however over time as shareholdings become diluted and the ownership comprises first cousins and beyond, it is less likely that CAT business relief will apply.
In both cases there is a claw back of the reliefs if the assets are sold within 6 years.
The complicated dynamics in a family business needs to be properly managed to ensure a successful transition of the business. Family governance is a system of processes and structures put in place at the highest level of the business family and ownership to make the best possible decisions regarding the direction of the business and assurance of accountability and control. This involves understanding how the business and its governance structure i.e. the board of directors interacts with the family. The main requirement is to have good governance and internal controls, so that the decisions made by owners, directors and executives serve the goals, mission and values of the business and are respected throughout the organisation.
There is no one size fits all in deciding what is the appropriate governance structure for your family. There should at a minimum be formal family meetings to discuss business issues. This is important where other family members are working in key management roles while some family shareholders are not employed in the business. As the family ownership evolves over time, a family council may be established that will make certain family based decisions and provide feedback to the board of directors on certain family matters. Families will often prepare a family policy document to allow clarity and minimise conflict in dealing with all aspects of the business.
Prudent business owning families recognise that predictable issues are going to come up that will create some conflict or friction. They ask, how are we going to deal with this issue or that issue when it arises? By establishing policies before policies are actually needed ensures issues are attended to before they become personal and emotional and therefore are addressed more rationally and expectations are managed for family involved inside and those outside the business.
When preparing your family policy document, it is important to focus not just on the policies you need now but also to look ahead and anticipate what policies need to be in place for the future, particular as the business transitions to the next generation. It is important that all key stakeholders are involved in the process of formulating and agreeing the family business policies. It is often easier to start with the policies where there is less likely to be differing views such as family values, code of conduct and philanthropy. Once these policies have been agreed, then you can move on to those that may require greater discussion to reach consensus – such as dividend policy, remuneration policy for family members, participation on the board and shareholder decision making policy.
Policies should emerge from values, beliefs and principles that the family believe should apply in operating their business. There are a range of questions family members need to consider in formulating their family business policies some of which include:
- How are family decisions made? By vote? By consensus?
- Where voting, who is eligible to vote?
- How is deadlock resolved?
- What rights do family members have to be on the board of directors
- What are the criteria, if any, for family members to be appointed to the board?
- Do spouses have any entitlement to work in the business or sit on the board?
- How is a family employee’s compensation package agreed? Market rates or some alternative?
- How is performance of family members assessed and who will determine those standards of performance?
- When will family members be permitted to work in the business? Is outside experience required first?
- How will we handle conflict? Will we solve our problems behind closed doors and not in front of employees?
When family policies are agreed, many of these issues will need to be documented. Some may form the basis for an overall guiding statement of how the business should operate or a detailed document of protocol may be followed. On a more comprehensive basis, they may be documented as part of a family constitution and at a shareholder level by way of a shareholders agreement. Many of the issues mentioned above will be included in a family policy document or family constitution. Often a family constitution can be a pre-cursor to a formal shareholders agreement which is legally binding on all family members who are shareholders in the business and will provide further legal certainty on certain matters. Typically a shareholders agreement will deal with appointment of directors, voting rights, transfer of shares including how and to whom shares can be transferred and at what price and distribution policy.
Failure to appropriately plan for the succession of your family business can significantly impact on its future success. The current business owner’s attitude is key to the successfully transition of a family business. In our experience where business owners embrace the succession process and the preparation required to ensure a successful transition, this results in a smoother transition and a greater prospect of long-term success. Business owners can take pleasure in knowing that the business they have built will last successfully into the next generation.
The above article was first published in the Sunday Independent on 16 September 2018.