Grasping the economics around succession

A critical juncture in the life of the family agribusiness is the transition from one generation to the next. One of the reasons for this, explains Trevor Dickinson, is that the capacity of the business to pay any form of remuneration has to be balanced with the requirements of the individuals who own and operate it.

Grasping the economics around succession
During the process of succession (when a business is transferred from one generation to the next), the owners must make sure that the capital base is not diluted to such an extent that it compromises the future viability of the operation.
Photo: FW Archive
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In many family agribusinesses, succession is a period not only of highly charged emotions, but of danger, for it is at this stage that the capital integrity of the operation may be put at risk. Most family businesses that progress through the classic phases of business growth (survival, stable, professional and institutional) have figured out how to transfer ownership down the generations without threatening the capital base.

A major deterrent to building and preserving an adequate capital base for a family agribusiness is the senior generation’s perception that it must somehow harvest its equity during the succession process. That perception is neither right nor wrong.

Family businesses are sold every day to facilitate such harvesting, and, for the senior generation that built the business, selling may well be a natural and highly appropriate culmination of a lifetime’s work. But while the sell option may work for the senior generation, it is not a particularly effective transfer tax strategy and may mark the end of the business as an economic resource for the family.

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Access to a stable capital base is essential for the long-term success of most enterprises. And no business can sustain its market position, let alone grow, when its capital base is dramatically diluted each time the mantle of ownership shifts from one generation to the next.

Fair market value, as traditionally defined, is a poor measure of the worth of the family agribusiness for the purpose of the intra-family succession of ownership. A more realistic and accurate transition yardstick is need, together with ability to pay.

Balancing need against ability to pay results in flexibility. Without such flexibility, the two generations may ultimately have to pay much higher transition costs, such as income and estate taxes.

Need is a twofold concept. Monetarily, it is the sum of money that the senior family members believe they ‘need’ to maintain the lifestyle they enjoy and achieve their financial objectives. However, need also has a powerful social component that ties the vocational and social identification of the senior generation to the business during its transition plan.

On the financial side, the concept of need may begin with a private conversation between spouses about how much is enough. Wanting to be helpful, financial advisers often attempt to define this number for their clients and offend the very people they are trying to serve.

Advisers can, however, help set goals, provide tools to work with, and then get out of the way while the business owners define this benchmark for themselves. The goal here is to arrive at an annual or monthly figure for maintaining their lifestyle, along with the date on which they will turn over leadership (financial advisers should avoid the loaded word ‘retire’).

Determining need
It takes four steps to ascertain need. The first is to discuss the economic demands of the business and what is required to sustain, or re-energise, the company’s growth. The second step is to identify the economic goals of the family and community, with an emphasis on children and grandchildren. The goal here is for senior family members to discuss their children’s share and involvement in the business, each child’s capabilities, and what they (the older generation) want their legacy for their family and community to be.

Step three should be to draw up a budget for the senior family members, working out their current living expenses and what they may need to accumulate outside the business to sustain their lifestyle after succession. People in higher socio-economic brackets often have a poor grasp of how much they spend each year and on what.

It’s also important for the older family members to define what their post-succession lifestyle will look like. To do this, they need to think only about themselves. Many business owners have lived such responsible lives for so long, focusing on the business, their children and their communities, that they struggle to articulate what they personally want out of the transition.

This may mean defining their ideal life; where they dream of living or travelling; how often they want to be in contact with the business; what they have always wanted to do but
never had the time for; and what non-economic needs the family or even the business may have that they would finally like to address.

This ‘dreaming’ is important; unless senior family members believe that the succession plan will work for them personally, both financially and emotionally, it will simply never get done.

Questions to consider
Here are a few key questions that will help you as the business owner to establish your financial requirements after succession.

  • What assets do you have outside the business?
  • What do you believe the rate of inflation will be during your retirement, and what rate of return would you like to see on your traditional investments?
  • What is your target date for succession, and what, if anything, would you like to do for the business after succession?
  • Will you continue working in the family agribusiness after succession? Or will you even be working at all?
  • Do you have children or others who depend on you for economic support?
  • Which of your children do you envisage being involved in the family agribusiness as shareholders and/or managers? Has the family determined how the children will enter the family agribusiness, and has the business determined how the children will be evaluated and promoted?
  • What would you like to do for those children (if any) who are not destined to co-own the business? How do you equate this with the economic opportunity afforded to the children who are involved?
  • Where do you intend to live? Will you be buying a new house, and what will you do with your current residence?
  • Do you have any special goals you would like to meet regarding the community?
  • Would you like to involve your greater family in meeting these goals?
  • Have you discussed these issues with your family?

The final step in this initial process is to determine how much you will have to set aside in non-business assets to meet the following basic needs:
1: Maintain the lifestyle you have worked so hard to achieve.
2: Attain your desired level of personal economic freedom.
3: Depart from the business with confidence.
4: Have sufficient resources to meet your special family and community needs.

A shared family vision
It is important to acknowledge at this stage that the economic model deals with the easier part of the succession process: the economics of the transaction.

The truly difficult work is creating a shared family vision for the future of the business, especially when the departing generation is taking from the succession significantly less than the fair market value.

Rarely is this shift completed in one generation; it takes time, wise governance, good management, and perhaps some luck before a business and a family can progress from ‘professional’ to ‘institutional’.

One generation has to see this status as an attainable goal, limit its own personal financial gain, and set in motion the process of building a family value system that says, “This will be our economic and social centrepiece for generations to come.”

The question then becomes: does the business have the ability to pay for this? This can be answered by first answering the following:

  • Can the business generate sufficient resources for ownership succession to finance the owners’ needs, while still meeting its own capital requirements?
  • Will lenders, suppliers and other equity holders allow existing credit relationships to shift to the new ownership team without personal guarantees from the senior generation?
  • Are members of the succeeding generation willing to suppress their own financial ambitions for the sake of building up the business for the long term?

Trevor Dickinson is CEO of Family Legacies, a family business consulting company.