Part one: Succeeding with succession

Adam Bernstein looks at the thorny issue of handing a business to the next generation

Published:  12 September, 2018

According to the Institute for Family Business (IFB), two thirds – 4.7m in total of UK businesses are family owned. Crucially, the IFB believes that around 100,000 of these firms change hands each year.

It’s not hard to find examples involving the trade. In March 2017, Baz Finney retired and closed his garage, TFM, in Pickering after 47 years of business. It’s unclear why the business didn’t carry on under his son John. Last August saw Wedgnock Car Sales close because the owner, Robert Buswell, wanted to retire and had received a good offer from a third party. He had bought the garage from his former employer.

Difficult discussions
David Emanuel, partner at law firm VWV and head of its Family Business team, considers succession issues to be the elephant in the room: “Current and future generations often find it incredibly difficult to talk about succession, and can make assumptions about each other's intentions which lead to misunderstandings and tension.”

Relationships can exacerbate the problem. Nick Smith, a family business consultant with the Family Business Consultancy, says families need think about relationship dynamics: “Will my children want to take the business over? Are they capable of running it? Is there room for more than one child? Will they fight? How do I deal with ownership if some want to work in the business and others don’t?”

The main issues
Every business needs a succession or exit plan. In the case of a growing business, family or not, there will also come a point when the current owners need to hire external talent to maintain growth.

One solution is for the family to find time away from the business to discuss the future. Family members must know that meetings are convened on neutral territory and that they are expected to speak their minds freely and honestly.

There are two fundamental issues for David Emanuel. Does the current generation want to retire, when, and on what terms? Conversely, does the next generation want to take the business on, and if so when and their terms? Nick Smith wonders about an inability of the senior generation to let go of the reins of the business: “This can be for a variety of reasons including a lack of faith in their successor, a belief that only they can steer the business forward, or a fear of just what life after the family business holds.”

Starting the process
Interestingly, David Emanuel sees many established family businesses wanting the next generation to forge careers of their own: “The decision to join the family business should be a conscious decision, rather than a sense of obligation, and it should bring with it the skills and experience learned elsewhere.”

For Nick Smith, there is a tricky balance to be struck between creating opportunities for the next generation and generating inappropriate expectations so that family members who, in reality, are neither suited for or motivated towards the business.

If the family aren’t committed to the future the best answer is likely to be to sell the firm. And it’s for this reason that David Emanuel says advice on value and likely exit options from an experienced corporate finance adviser is necessary. Smith believes that families often choose to sell to a buyer who they believe is most likely to preserve the culture and ethos of the family business; often another family owned company.

Plan also for the unexpected
Death and divorce are just as obvious risks for a family business. As David Emanuel notes, the death of a co-owner can lead to an interregnum and loss of vital skills and experience, as well the risk of shares passing to an unknown quantity, or a need to fund the purchase of those shares to provide some value for the deceased co-owner's family. Divorce principally presents the risk of shares passing outside the family, or a need to sell shares to finance a divorce settlement. “Families must think about what should be done in these circumstances and consider a shareholder’s agreement to cover these issues.” For Nick Smith, this is “infinitely preferable to having the divorce courts decide the fate of the family business.”

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  • part TWO: Succeeding with succession 

    Businesses change hands for all manner of reasons, but crucially for family businesses, change has the potential to damage family harmony as well as destroy the future wealth of all concerned. But what happens should no family members want to take on the business and the business has to be sold?
        
    In this instance David Emanuel, Partner at law firm VWV and head of its Family Business team, says the family should take advice on the options. He advises seeking recommendations and says to “think hard about engaging people who work principally on a success fee percentage commission-only basis – the overall cost may be higher, although you may be insulating yourself from costs if a deal doesn’t go ahead – but there can be a conflict of interest for people remunerated only if a deal goes ahead.”
        
    One step that will ease the process is to undertake some financial and legal due diligence as if the seller were a buyer, to identify any gaps or issues that may affect price or saleability.

    Seeking a valuation
    Businesses will generally be valued on one of three bases – the value of net assets plus a valuation of goodwill; a multiple of earnings; or discounted future cash flow.
        
    Nick Smith, a family business consultant with the Family Business Consultancy, sees some families seeking the next generation pay the full market value for their interest, and other situations where shares are just handed over.
        
    “In between the extremes,” says Nick, “there are a raft of approaches and solutions including discounted prices and stage payments. There are also more complicated solutions such as freezer share mechanisms, where no sale takes place but the senior generation lock in the current value of their shares to be left to the wider family and the next generation family members actually working in the business receive the benefit of any growth in value during their time in charge.”
        
    What of an arm's length sale? Here David says: “The family will ideally want to be paid in cash, in full, at completion, rather than risk the possibility of deferred consideration not getting paid because the business gets into difficulties under its new owners, or a dispute arises over what should be paid.” However, he says that may not be possible, and there may be many good reasons why the retiring shareholders keep an equity stake or agree to be paid over time or agree that some of what they get paid is subject to future performance. Even so, he suggests starting with the idea of the ‘clean break’ and working back from there if you have to.
        
    It’s important to remember that in a succession situation, where one generation is passing the business to the next, and the retirees are expecting a payment of value to cover their retirement ambitions, deferred payment risks may be looked at differently depending on the circumstances – families will be more trusting.
     
    Tax planning and family succession
    As might be expected, tax planning is important and should always form part of the decision-making process but it should never be the main driver. That said, no-one wants to hand over, by way of inheritance tax, 40% of the value of what they have worked for.
        
    Both Nick and David consider tax planning key. Says Smith, “the most important point is what is right for the family members and the business itself.” He believes the UK offers a fairly benign tax-planning environment for family business succession so that most family businesses can be passed on free of inheritance and capital gains tax to other family members. However, the risk of paying a bit of tax pales into insignificance if passing on the family business to the next generation means passing on a working lifetime of misery and a failing business. David points out that if Entrepreneur’s Relief is available, the effective rate of Capital Gains Tax is just 10%.

    In summary
    Family businesses are peculiar entities, caught by both the need to compete in the marketplace and the need to keep familial factions onside. Whatever course is taken to secure the future of the business, one thing is certain – everyone needs to keep the lines of communication open.


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