March 24, 2014

Preserving family harmony by providing exit opportunities from the family business – part 1

by rwehrle

Every stage of the family business "life cycle" presents its own distinct challenges.

Entrepreneurs commonly give tremendous energy and attention to growing the business during the prime of their own careers, and rightly so. Prudent business owners also look ahead to their own retirement, and transitioning the business to a new generation of management, whether family or non-family.

We think business owners are usually very well served to think even further ahead, and consider carefully not only how the business will be divided and distributed in their eventual estate administration â but also how being co-owners of a business will affect relationships among their children and grandchildren.

Carter had a professor in college, nuclear non-proliferation expert Frank von Hippel, who memorably observed one day in class that "Where you standâ¦depends on where you sit." That's true not only when the stakes are actually nuclear, but also when they only feel that way, in the setting of relationships between family business co-owners.

Let's imagine how the issues might present in the context of a hypothetical case study involving the Widget family. Charlie and Sally Widget started a successful multi-state trucking company, SpeedHaul, in the early 1960s, when they were in their 40s. Charlie and Sally have passed away by now, leaving three adult children in their 50s: Bill, Henry, and Jane. Bill is an unmarried college professor in Seattle without children; Jane teaches school and raises her children in New Hampshire. Henry has worked at SpeedHaul in various roles ever since he graduated from college; he's married with two stepchildren, and lives in central Tennessee, right where SpeedHaul was started over 45 years ago. SpeedHaul is a leading corporate citizen in its small headquarters town, making generous charitable contributions and holding corporate season tickets for a suite at Henry's alma mater, which neither Bill nor Jane attended.

Charlie and Sally's estate plan provided for a 1% voting interest in SpeedHaul to pass outright to Henry. Henry received a 32.33% non-voting interest in a trust for his benefit. Bill and Jane each received 33.33% of Speedhaul in trusts for their benefit. Let's assume the estate plan was crafty and effective from an estate tax perspective, leaving most of Charlie and Sally's wealth available for their family, with only a small amount leaking away to state and Federal tax authorities.

On one level, this sounds like a really successful result: tax efficiency and fairness for the children. Maybe it's a success, but maybe it won't be. Let's look a little bit deeper....

Five years have passed since Sally died (Charlie had died three years before Sally). Henry's been very hard at work revitalizing SpeedHaul, modernizing its fleet of trucks and installing a sophisticated computer and GPS tracking network, to service traffic from expanding intermodal port and rail networks at Charleston and Savannah, the UPS hub in Louisville, and the FedEx hub in Memphis. All of this has been really expensive, along with paying the IT consultants and hiring supply chain management experts. Henry has merged SpeedHaul with two smaller competitors in adjacent states. Those acquisitions were debt-financed on very favorable terms, but debt service still absorbs a significant part of the company's free cash flow.

The company's grown, and Henry's doing a good job, so it's been only fair for his salary and bonus to increase 35% over the last three years. Dividends paid by SpeedHaul have been flat since 2004. Bill is not happy about this, because he sees Henry's lifestyle improving while his cash flows from SpeedHaul stay flat. Jane wants to keep peace in the family, but she's also concerned by the anemic dividends. On the other hand, her daughter Alice is studying accounting in college, and had an enjoyable internship at SpeedHaul last summer. Alice and Henry have talked about Alice coming back to the company as an assistant controller after she works with a large accounting firm for three or four years after college.

The college football team SpeedHaul's corporate largesse supports so generously recently fired its coach after a terrible season. Bill and Jane wonder what the point of the SpeedHaul suite at the stadium is, but Henry thinks its key for entertaining employees, and important contacts at a few significant customers.

Bill and Jane talked recently by phone. They realize no arms-length buyer will be very interested in buying their non-voting stake in SpeedHaul. Bill's neighbor is an aggressive trial lawyer, and told Bill over a glass of wine a few nights ago that his best option may be to sue Henry for waste and misappropriation of corporate assets.

The freeze-in situation we've described isn't looking very good for any of the Widget inheritors, not even Henry. In Part 2, we'll consider how advance planning by Charlie and Sally could have improved the children's relationship and preserved a long-term opportunity for grandchildren to enter the business.

Image above © U.S. Government (Bureau of Labor Statistics)