Family businesses are a dynamic source of wealth. Oftentimes, business owners will maintain relatively low liquidity due to constant reinvestment into the business. This makes the timing of a sale critical. First, business owners want to ensure that the reinvested sales proceeds can produce sufficient cash flows to replace their distributions and maintain their lifestyle. This is especially important for younger sellers to consider given their relatively longer estimated lifespan. If nearly all of a family’s net worth relates to a business, shifts in the economy and interest rate environment can have significant impacts on the potential sale price and overall wealth in any given year.
Additional considerations are required when owner-operators desire to pass on family businesses to their children. Frequently, the second generation doesn’t have sufficient funds necessary to buy out the prior generation upfront at a true fair market valuation. Further, there may not be sufficient cash flow to support the lifestyles of both the first and second generations exclusively from the business. As a result, the first generation needs to be especially mindful of building liquidity to support their lifestyles post-transition if passing on the business to the next generation is the goal. There are multiple ways to structure a transition. However, the higher the liquidity of the first generation, the less pressure there will be on the next generation to pay a top valuation entirely at the point of sale.
Before a transaction, our firm focuses on developing targeted savings rates for our business owners that reflect a specified percentage of the overall annual income. This is important both from the perspective of building liquidity and backing into true spending levels. Many business owners are largely unaware of how much they are spending, which is a necessary component of financial planning, particularly for retirees. Expense levels, however, simply reflect what is earned less what is saved. Therefore, once we know the income number (adding back any personal expenses run through the business) less the savings, we can help owners calculate their current lifestyle needs. It also helps force business owners into a budget where one may not previously have been needed due to excess cash flow from the business. Through this exercise, business owners can quickly determine if it is feasible and/or desirable to live on $X/ year once the business is transitioned to the next generation.
Even if we assume that the selling generation has built sufficient liquidity to be comfortable with potentially below-market sales to the next generation, there are many qualitative factors to consider.
- How many children are in the next generation?
- Are all capable and do they have a desire to run the business?
- Is there an intention to provide alternate opportunities for the children who may not run the business?
- Will the business be able to function with multiple owners?
Questions such as these are critical for determining potential pathways for families.
Sometimes, families may realize that there is no way to equitably divide a business between multiple siblings, especially in blended family scenarios. Instead of providing an advantage to one sibling over others, they may decide to sell to a third-party buyer. Through this strategy, the first generation receives the full fair market value for the business (compared to a potential discount to children). This allows for a larger sum of money (1) to maintain the lifestyle of the first generation and (2) to ultimately be more evenly divided amongst multiple children. Families can determine if they would like to pass on wealth to their children during their lifetime through direct gifting or endowments of irrevocable trusts or after death. Different estate tax considerations exist for both scenarios, which should be carefully contemplated before execution.
Emotions are typically high whenever funds are exchanged within families and there is a beloved business involved. Therefore, any preparation on the front end that can ease potential anxieties can be very beneficial from both an emotional and financial perspective. For help with this process, and to understand more about your family's cash current and future flow requirements, please reach out to us.