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Posted on December 13, 2012 

http://www.starwars.com/watch/episode_5_i_am_your_father.html

When discussing this topic, I am taking a broader view of what encompasses a generational transfer to include not just family transfers, but transfers to younger employees. Often, a merger from a third party is not desirable or available. The industry, the nature of the business, the fact that the revenue is tied up in the personality of the employees (common in professional services), the whims of the owners, or some combination of these factors may create a situation where an owner or ownership group will need to explore additional options. Selling or transferring the business to the owner’s heirs or to key younger employees often provides owners with an opportunity to exit.

From a business perspective, these transfers can be difficult. These transactions are personal. In order to accomplish them, the value of both the older and younger generation must be discussed. The worth of both the older generation, as well as the younger generation, must be discussed. With family transfers, the issues multiply; siblings, both in and outside the business, professionals, and family members all cause a myriad of issues. Books have been written on the subject of family businesses, and far be it from me to believe that I have anything particularly insightful to offer on the difficult topic of managing the family business.

However, from a legal perspective, these transfers are not incredibly difficult to execute. Assuming that you do not need to revise your corporate governance agreements, executing this transaction is relatively simple. You execute a transfer document, you pay the consideration, and it is typically all you need. That said, you do need to pay attention to the formalities. There is a good rule of thumb – document all of your agreements. When you are dealing with family, make doubly sure.

While this is a good rule of thumb, it is important to pay attention to what is “legally required” and what is “the plan.” The plan may be that in five years, assuming good business growth, the shares will be transferred for $x (or some formula of $x). However, the owners may or may not be legally required to make the transfer. All parties, but particularly the older generation, will want to have this structure in place for a lot of reasons. Defining “good business growth” or a similar concept is fine from a business perspective, but nebulous for a lawyer. Business conditions and where the people are in their careers may change. Creating a legally binding obligation so far in advance may prove problematic for a host of reasons. You do not want to give up the kingdom until you know how the princes and princesses will rule. This is true for both family and non-family generational transfers.

Structurally, the first step may be the most difficult. Often, you will see an older owner transfer a minority share or small sliver of equity to the younger generation. If the relation was to sour, the shares could be reacquired, and while the process might be painful, it would not be fatal. The parties can see how they behave as shareholders, see how increased responsibility is handled, etc. Again, this is true for both family and non-family generational transfers.

However, the parallel for family and non-family transfers ends when it comes to pricing. For non-family transfers, the price discussion is of a more true marketplace value. Often a business owner will look to the value he or she has created and will want to extract that value for retirement or other financial goals. While they may be generous to an extent, they are not looking to transfer the company without consideration. The discussion between the younger and the older generation focuses on what value has been created, what value will need to be created, and who is responsible for either. These conversations are difficult, and no magic formula exists for a perfect deal. However, numerous companies have gone through these negotiations and strived and survived; it is part of being in business.

In more mature companies with a buy/sell agreement and several owners, the valuation formula in the shareholder or operating agreement often becomes the defining metric. Over time, people come in and people go out based on that metric. Since the metric is presumably tied to some moniker of value, the younger generation is incented to pay out the older generation at the metric and then increase the value for his or her own well being. The valuation formula becomes a self-fulfilling prophecy that allows for a transfer of equity from the retiring owner(s) to the younger owners.

Promissory notes also can provide a good structure to facilitate the transfer of ownership from one generation to the next regardless of whether it is a family or non-family transfer. By selling all or a portion of ownership and then financing the transaction with a promissory note made by the younger generation, the purchase price is fixed. Ideally, the earning of the company – through salary or distribution – will support the payments. This allows the younger generation to make the purchase and incents the younger generation to make sure the company remains healthy so that the note payments can be generated. The older generation is also incented to insure a smooth transition. Without a healthy company, the younger generation’s ability to pay off the note is questionable. The younger generation’s only real asset may be the equity of the company, so if the note is defaulted upon, the older generation will have to take his or her old company back – not the desired result of retirement.

However, with respect to the pricing of family transactions, other considerations come into play. Estate tax is an omnipresent issue that may affect the valuation perspective. Other siblings may affect the transfer. The owner’s spouse may have some thoughts about the transfer. These issues are tricky, but as with all of this, a business is not treading new ground. By being thoughtful and deliberate, seeking good advice, and planning in advance, a company can be transferred from one generation to another. The process is difficult, but not impossible, and the accomplishment of making such a transfer can be a source of great non-economic pride and satisfaction.

Mike Goodrich
Goodrich Law Firm, LLC