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For many business owners, the first choice for a succession plan is to keep the business in the family. Usually, this means passing the business down to the children (and we mean adult children). There are a number of emotional reasons why this is the case, not the least of which includes providing a future for the children and maintaining a family legacy. We’ll only focus on the financial considerations of this option, although we will mention some other practical considerations.
From a financial point of view, if you are going to pass the business to your child, it will likely take one of the following forms:
An “estate freeze” may be the most common family succession planning structure. At a given point in time, your shares are converted to “frozen” preferred shares based on the fair market value of the company on that date. Because 100% of the value of the company is in the preferred shares, your child (either directly or through a family trust) can be issued new common shares for $0. The effect of the estate freeze is that the value of the company up to the freeze date belongs to you, and any future increase in value belongs to your child.
As you require cash in retirement and the company has sufficient cash available, you can withdraw cash from the company in the form of preferred share redemptions. You can also receive dividends on the unredeemed preferred shares and a salary if you are still working in the business. These additional dividends and salaries are important if the value of the company on the freeze date is not enough to fund your retirement.
The benefits to an estate freeze include the ability for you to earn additional income through dividends and salaries, and your child not having to pay anything to “buy” into the company. The drawbacks include not receiving the entire value of the company in cash up-front and relying on the available cash of the company to redeem the shares; this can be a significant problem if the value of the business is in non-liquid assets, such as equipment or goodwill.
A gradual sale of shares is exactly how it sounds. Over a number of years (usually predetermined), your child will buy your shares from you. This is different from the estate freeze, as you are being paid by your child, instead of by the company – meaning that your child has to have access to sufficient cash to make the payment.
Similar to the estate freeze, you can receive dividends on the shares you still own and earn a salary if you are still working.
This is the same concept as a gradual sale, except that your child buys all the shares at once. Since you no longer own shares of the company, you would not be able to receive any future dividends. This option will give you certainty in the cash available in retirement; however, it may not be a realistic option if your child cannot afford the payment.
One of the biggest challenges for a business owner is knowing when the child is “ready” to take over. On one hand, you don’t want to turn over control of the company too early and set your child up for failure, especially if you did an estate freeze and are relying on the future cash flow of the business to redeem your shares. On the other hand, your child won’t want you micro-managing once you’re supposed to be retired.
Another challenge is managing the family financial dynamics when multiple children are involved. Do you give all your children equal ownership in the business? What if not all the children are active in the business? If you don’t give all your children shares in the business, will you equalize the other children? If you try to equalize, is it fair to give some children low risk, liquid assets (cash) when other children are receiving high risk, illiquid ownership in the business?
If your succession plan involves transitioning the business within the family, there are a number of emotional and financial issues to consider. These transitions generally work best when there are open lines of communication between you, your family members and your business advisors.