Planning to Pass On Your Family Business

Larry Berman spent most of last winter in Palm Beach Gardens, Fla., perfecting his golf game and enjoying 85-degree days. Meanwhile, in snowy Newton, Mass., his 30-year-old insurance-adjusting business was growing steadily and was on track to add 50 new customers in 2014.

Berman, 68, is in the process of handing over his business to his son, Jonathan Berman, and Jeffrey Sabel, a family friend whom Berman considers a second son. Last winter, Berman alternated ten-day stays in Palm Beach Gardens with four-day stints in Newton to check up on the business. After about a year of succession planning, Berman says he feels comfortable transferring most day-to-day operations, such as handling claims and managing finances, to Jonathan, 31, and Jeffrey, 36.

That arrangement enables Berman to work fewer hours, often remotely, while still keeping a hand in high-level responsibilities such as networking and marketing. "I'm looking at the palm trees, sitting in front of a laptop and surrounded by papers," Berman says. "I played golf on Monday with a client, which is a nice way to spend an afternoon, and it's also good client relations."

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Most small business owners are so busy running their companies that succession planning continually gets pushed to the back burner. "Many owners haven't thought about the fact that if something happens to them suddenly, all of the value in their business can be lost," says Mark Rosenbaum, a financial planner at Succession Consulting Group, in Portland, Ore. "If you haven't worked out with your senior management team who will take over if you get sick or pass away, you leave your business in jeopardy and risk losing customers."

Identifying a successor is the first step in the planning process. Many owners of family businesses turn to an adult child, a grandchild or other relative to take over the reins. If a family member doesn't fit the bill, an owner is likely to sell, perhaps to a key employee or to an independent third party.

When evaluating a family member, consider his or her attributes as both a manager and an entrepreneur, Rosenbaum says. Someone may be a good manager but lack the ability to focus on the big picture or think strategically—the kinds of skills needed to run a successful company.

Rosenbaum's business partner Leo MacLeod says good leaders must "have the ability to look beyond what they need to do today. That is a skill set many companies don't think about—can this person think beyond just doing their own job?"

Kathleen Richardson-Mauro, co-founder of Business Transition Academy, with offices in Boston and Tampa Bay, Fla., says business owners should not presume their eldest son or daughter is the best person to run the company. A successor could be a younger child or a grandchild. Richardson-Mauro, co-author of Cashing Out of Your Business (Book Publishers Network, $18), says one reason so many family businesses fail to make it to the second or third generation is because many families view the corner office as a birthright, and an unqualified successor may not be able to keep the business afloat.

If you have several children, passing on your business to one of them can spark sibling rivalry. David Karofsky, president of Transition Consulting Group, a family-business consulting group, with offices in Framingham, Mass., and Palm Beach Gardens, Fla., says it often becomes apparent to business owners which one of their adult children is best suited to take over the company. Some children may be uninterested, live far away or be committed to another career.

However, when several siblings or cousins are hoping to take the helm, Karofsky says business owners should consider the needs of the company—not family dynamics—to choose a single successor. "We have worked with businesses that have decided to have joint leadership," Karofsky says. "It's not our first choice, but there is no playbook for running a family business."

Choosing one successor doesn't mean leaving your other kids high and dry, says Karen MacKay, a succession-planning lawyer at Burke, Warren, MacKay and Serritella, in Chicago. She says if you are giving a business to one child, you might give his siblings a larger share of other assets, such as real estate, investment accounts or life insurance proceeds.

However, because a business is usually the largest asset in an estate, MacKay says some parents decide to give children who aren't involved in the business non-voting shares of stock, while the child who runs the company retains the voting shares. This strategy ensures that all of your heirs share in the wealth your business created, but MacKay says it can cause conflict. "Oftentimes, the business owner wants to plow cash back into the business and doesn't want to give it to a sibling who isn't working in the business," MacKay says. "And the sibling who isn't in the business is saying, 'Give me a dividend.' "

Grooming Your Successor

Once you choose a successor, it's important to prepare that person to run the company. Ideally, Rosenbaum says that the process should take place over three to five years. That allows time for the successor to earn employees' respect and to work in different areas of the business. During the transition period, the would-be successor also should develop relationships with key clients and vendors and begin representing the company publicly. "You are giving them a trial run, and it's not impossible that you learn in a year or so that this isn't going to work," Rosenbaum says.

In the case of Larry Berman's insurance-adjusting business, his son Jonathan Berman and business partner Jeffrey Sabel had both been working at the company for several years when Berman began grooming them for leadership. Berman says that the young men were eager to advance in the business, and he embraced the idea because he had previously worked for another family's business that suffered when the founders were reluctant to cede control to the next generation.

The three men worked with a team of professional advisers to draft a succession plan. They decided that Jonathan and Jeffrey would earn equity in the company over a five-year period, at the end of which they would become co-owners. Meanwhile, Larry Berman has a five-year renewable contract that provides for his salary, expenses and a draw against commission.

Berman relinquished his post as president and chief executive officer, but he remains the chairman of the board. Jonathan and Jeffrey were named president and chief executive, respectively, in January. "It's a matter of learning to let go of the things you don't need to do," Berman says.

While he is still active in the business, Berman is making sure his protégés reap the benefit of his experience. He frequently copies his successors on important e-mails. He also makes a point to share stories from his 40 years in the adjusting business, which he says Jeffrey affectionately refers to as "Larry lessons." "They are earning the business by 'sweat equity' and by taking care of my salary and expenses," Berman says. "And at the same time, they are the beneficiaries of learning from me."

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When you're passing on a business to a family member, you and your successors will need to find a way for you to be compensated or create a stream of income for your retirement. Steven Faulkner, head of private business advisory for J.P. Morgan Private Bank's Advice Lab, advises business owners to review all of their assets and income sources during succession planning to determine how much money they'll need from the business to live comfortably in retirement.

Some owners decide to work on a consulting basis for their former companies and collect a salary. You can require your children to purchase the company, either with their own capital or with a bank loan. Faulkner says another option is a seller-financed buyout, in which the company, the seller or both finance a loan for your successors to purchase the business, thereby creating an income stream for you.

Estate planning is another important aspect of succession planning. Susan Link, an estate-planning lawyer at Maslon, Edelman, Borman and Brand, in Minneapolis, says gifting shares of stock in the family business is one of the most tax-efficient methods of transferring the value of a company from one generation to the next. A well-executed plan will enable you to pass on your family business—while you're alive or after you die—and minimize the estate-tax bite.

You can transfer shares worth up to $14,000 ($28,000 for a couple) to an individual each year without having to file a federal gift-tax return. Any amount above $14,000 counts against the estate-tax threshold when you die. The threshold in 2014 is $5.34 million for an individual ($10.68 million for a couple). If you have a number of years to plan, you may be able to use these gifts, as well as certain trusts or partnerships, to transfer a large portion of your business to your successors while enabling you to retain control until you are ready to give up the reins. In the meantime, you'll be removing taxable value from your estate.

The IRS also permits people who are gifted shares of privately held companies to discount the value of that stock if certain standards are met. That allows owners to shift additional shares while limiting their gift-tax exposure. Link says appraisals cost about $8,000.

Selling to a Third Party

For some small business owners, selling to an independent party makes more sense than choosing a successor from within the family. That was the case for Peter Fairbanks, 66, who sold his Norwell, Mass., energy engineering company to a private equity firm in 2011.

Fairbanks and his wife started their company in 1990, and it grew to a 30-person operation. Although the couple's two sons were working for and had ownership interests in the business, the family decided that selling was their best option.

Fairbanks says he had declined previous offers to sell his company, but this firm made an offer that caught his interest. "It seemed like these folks could provide us with the value we thought the business had," Fairbanks says. "I made sure my sons benefited at the time of sale as well."

Getting a business ready for sale requires a different kind of preparation than when you're passing it on to a relative. Early in the selling process, Fairbanks realized he would need professional assistance, so he hired Richardson-Mauro's consulting firm, and it connected him with other advisers. The consultants helped Fairbanks prepare the financials in the format that the prospective buyer wanted. "We also engaged an investment banker who helped us with the negotiations and with presenting the company in the best way," he says.

If you think you might want to sell your business to a third party, you should begin getting your financials in order two to three years ahead of time, says Mark Ferm, a certified public accountant with Tronconi Segarra & Associates, in Williamsville, N.Y. For example, you should stop writing off club memberships and vehicles as business expenses. Ferm says companies are usually valued based on a multiple of earnings, so if your business income is being reduced by personal expenses, that could lower the selling price.

Richardson-Mauro says that it's particularly important for small businesses to have organized financial documents because the current resale market is competitive. With baby boomers hitting retirement age, she says there's a surplus of small businesses for sale, creating a buyer's market. And while lending restrictions have eased since the recession, she says credit is still tight when it comes to buying a company. "Buyers are more discerning and there are more businesses to choose from, so you really want your company to be dressed for success," Richardson-Mauro says.

Whether you're selling to a third party or passing on your business to the next generation, you need to prepare yourself for a life without a company to run. Amelia Renkert-Thomas, co-owner of Withers Consulting Group, in New Haven, Conn., and London, says she helps retiring business owners come up with a plan for how they will spend their time and for ways that they can redirect their energy. She says the kinds of people who have the ambition to build successful businesses often are unhappy when they have too much downtime or aren't working on meaningful projects.

That is why Renkert-Thomas recommends that retired business owners get more involved in philanthropy or put their business experience to good use by volunteering for an organization such as SCORE, which connects new business owners with mentors. What you don't want to do is name a successor, but then show up at the office every day. "I see business owners who do that for 20 years, and everybody defers to them," she says. "That can be really dangerous for a business because the senior person isn't running it full time, and the next generation can't run it because no one will give them the respect and power they deserve."

Berman says he had watched too many friends fail to thrive in retirement because work had been the sole focus of their lives. He says he wanted to be more deliberate about how he will spend his retirement years, and for him that includes leisure time with his wife and warm weather.

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