3 Ways to Prepare to Pass the Family Business to the Next Generation
Reports of the deaths of family businesses before they make it to the third generation have been greatly exaggerated. Three ways to plan for the succession of your family business.
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Owning a family business, and planning the succession of your family business, is as much a part of the American dream as white picket fences and two cars in every garage. But is handing your business down to the next generation a good idea or just ideal? You see, there’s been a long-standing stigma around family businesses. The three-generation rule, as it’s come to be known, suggests that family businesses rarely make it to the third generation. But let’s take a closer look.
According to the SC Johnson College of Business at Cornell University (opens in new tab), only about 40% of family-owned businesses transition to the second generation. Meanwhile, just 13% are passed down successfully to a third generation, while 3% survive to a fourth or beyond. So, it seems that the three-generation rule is accurate, right? Perhaps, but the reality may not be as bleak as these numbers indicate.
The three-generation rule is actually based on a single study conducted in the 1980s. In the study, researchers examined manufacturing companies that operated in Illinois during a predetermined period. They then grouped these companies into 30-year blocks to represent generations. While the study provided some valuable insight, the findings could be skewed by flaws in the way the findings have been presented over the years.
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A Lack of Comparable Data in Family Business Study
The first major flaw in this study is the lack of a control group. The researchers failed to compare their findings to other types of companies. According to Josh Baron, co-founder and partner at BanyanGlobal Family Business Advisors (opens in new tab), and Rob Lachenauer, co-founder and managing partner of BanyanGlobal, family businesses hold up quite well when compared to their counterparts.
The duo cites a study of 25,000 publicly traded companies (opens in new tab) from 1950 to 2009 that found that the businesses lasted an average of 15 years. That's not even a single generation. Meanwhile, the SC Johnson College of Business study found that the average life-span of a family-owned business is 24 years.
Failing to Describe the Findings Accurately
Since the original study took place, it has been cited in countless white papers, research documents and business columns. However, the findings are often described inaccurately. Subtle changes to the verbiage used when describing the findings can drastically change the truth of what was uncovered.
For instance, it's often said that only a third of family-owned companies make it to the second generation. However, the study actually states that one-third make it through the end of the second generation. In the context of the study, that’s 60 years. That is a huge difference!
Why Did the Businesses Close?
Another failure in the 1980s study is the lack of insight into business closures. The researchers didn’t investigate the individual reasons that the companies shut down. This might seem like nitpicking, but if some of the businesses sold, freeing the business owners to start new companies, that isn't the same as failing.
When we look at the flaws in this study, it becomes clear that the three-generation rule isn’t quite as dire as it has been packaged over the years. So, with that, how can you prepare your business (and your family) for an eventual transfer to a family member?
1. Be Mindful of Time and Finances
On average, it takes much longer to receive the full sale price when transferring a business to family members. Longer return times can increase your risk and leave you susceptible to sustained exposure. This can be exacerbated by transferring the business to an unprepared or unqualified family member. The wrong choice could destroy the business and your financial security.
You can avoid this blind spot by properly training and vetting the family members who will be succeeding you. A lengthy and involved, hands-on training period should be built into your exit plan.
2. Choose the Right Successor
Choosing the correct family member is crucial to continuing success. As part of the vetting process, you should ask yourself the following questions:
- Does their vision for the future of the business align with your own?
- Will the rest of the family be happy with who you've chosen? If not, what's your backup plan?
- Are they as passionate about the business and brand as you are?
- Do they have the skill set to at least be as successful as you've been?
- Will they be able to run the business without getting bogged down by family squabbles or disagreements?
The answers to these questions are vital to the sustainability of the business and to the satisfaction of your clientele. Remember, this decision affects far more people than just you and your family.
3. Don’t Overlook the Importance of Tax Planning
Begin working with your tax adviser/planner now to prevent being blindsided by negative tax implications associated with transferring to family members. Depending on how your business is transferred, it could leave you on the hook for various taxes, including income, estate, gift and capital gains taxes. Therefore, it’s important to work with your advisers to create a succession plan that is as tax-sensitive as possible.
Transferring a business to a family member is an emotional and stressful time. Without comprehensive exit planning and seamless implementation, the experience could cause division. Because families are so closely connected, communications can become much more emotional during the transfer than they would in a third-party sale.
Although it presents unique challenges, owning a family business can be a rich and rewarding experience. However, family dynamics require an extra level of planning and consideration.
With the right attitude, proper planning and even a little luck, you could leave a legacy that extends well beyond the three-generation rule.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC (opens in new tab) or with FINRA (opens in new tab).
Justin A. Goodbread is a CERTIFIED FINANCIAL PLANNER™ practitioner and an adviser with WealthSource® Knoxville. After years of working in a large firm, he ventured out on his own in 2009, starting Heritage Investors, and eventually joining WealthSource® Partners LLC in 2022. As a serial small-business owner, Goodbread has bought and sold multiple businesses. He uses this experience, along with his continuing education, to help business owners grow and sell what is often their largest asset.
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