Building a successful business takes hard work, careful planning and significant foresight. When a business has been able to maintain its success for a significant period of time, owners and/or executives must begin the task of succession planning. Family owned and operated businesses face particular challenges in this area.
While succession planning is complex and more of an art than a science, by focusing on three critical areas, you can help your clients improve the transition period of their businesses.
One of the easiest traps that your client may fall into when setting up a succession plan is poorly structured compensation of the next generation of leaders or owners. When a family business has attained a certain level of success, there’s often a desire to pass wealth on to the next generation. Very often, the desire is to not only pass on the business itself, but also to pass on assets owned outside of the business. A family that’s owned a successful business for a number of years has likely also accumulated wealth outside of the business. This can be in the form of stocks and bonds, real estate, investments in other companies, collectibles or cash. When bringing someone from the next generation into the business, it’s tempting to combine that individual’s compensation for working in the business with his overall anticipated “inheritance.” This can be a dangerous precedent to set, not only for other employees, but also for the family member entering the business, because he could be earning more compensation on a current basis than appropriate, as a means of wealth transfer.
If the next generation joins the business in a marketing role immediately after completing school, for example, they should be paid fair market compensation for an entry level marketing professional. By increasing their compensation to include some component of their “inheritance,” an inexperienced marketing professional will quickly rise to the compensation level of a seasoned executive. This will give the family member an inflated sense of his worth to the business and can dampen his drive to succeed and grow with the company. Perhaps equally as important is the fact that it doesn’t teach the next generation about the value of hard work and earning their success. The assets that your client wants to pass on to the next generation, irrespective of the business itself, can be done in various other ways. The family can transfer non-business assets via traditional methods using trusts and outright gifts that aren’t tied to performance in the business. By keeping the two sources of income separate, the groundwork is laid for teaching valuable financial lessons.
Once the next generation joins the family business, they need to begin planning for their own financial future. They’ll need to think about their own retirement, buying/renting a home, planning for potential children and building cash reserves. As many recent graduates learn, the task of attaining financial security is something that takes time and great effort. It requires sound strategy and planning combined with willpower and execution. Joining a family business won’t instantly grant financial security and a guaranteed lifelong paycheck. However, it will provide benefits in the planning stages that many young adults aren’t afforded. Mainly, access to company leadership and the ability to have a frank conversation about what their future and earnings potential may be.
When joining a family business, the goal is often for the next generation to eventually be in the driver’s seat. That insight can be invaluable when trying to make a “rent or buy” housing decision or determining how much money should be socked away for retirement or children’s education. Financial planning should take into consideration their current and potential earnings, as well as the money that will come from their “inheritance.”
Flexibility and Communication
Like other pieces of the succession process, the task of planning for the next generation’s financial security can’t be done without serious, unfettered communication. Everyone who’s involved in the succession plan, whether he’s the predecessor or the successor, needs to be fully aware of what the future holds and how to get there. There is no “one-size-fits-all” succession plan with a defined timeline and step-by-step instructions. Succession plans are best when they’re fluid and can be adapted to different variables (for example, the health of the parties involved, market conditions and expansion plans). However, no matter how the succession plan is structured or implemented, communication about the future is integral in obtaining the full buy-in of the successors and forging trust between them and their predecessors. Communication can’t simply be around what the future holds, it must deal with what goes on today as well.
As mentioned earlier, the next generation needs to earn their way through the business on their own merits. Part of doing that is providing feedback on positive performance and assisting with correcting areas for improvement. In the same vein, the predecessor is grooming a future leader, so the communication must be a two-way street. While the predecessor may know the business inside and out, from inception to present, that doesn’t mean that a newcomer doesn’t have valuable insight on today’s world and ideas on how to modernize or streamline an already successful business. Make sure that communication is something your client not only accepts, but strongly encourages.
Succession planning isn’t an easy task - it’s not for the faint of heart. It doesn’t come without challenges, and it doesn’t happen overnight. Then again, neither did building the business that got to the point of needing a succession plan in the first place. A succession plan is something that’s very specific to each business. There are various elements that may work for one family business and not another. When constructing and implementing a succession plan for your client, be mindful of keeping compensation separate from “inheritance,” assist the next generation with their financial planning and communicate every aspect of the plan. The hallmark of a solid succession plan is the ability to implement it successfully for multiple future generations.
For information on the transition from the perspective of millennials, see “Bridging the Gap.”
Nicholas Fedele is a CPA and Senior Tax Accountant at WeiserMazars LLP