By Maurie Cashman
Fairness in a family business transition can be a difficult subject to discuss, much less resolve. It is critical that this occurs however, if a family transition is to be successful.
I am working with a transition involving the parents transferring their business to a son who has been active in the business for some time. Another son is far removed geographically and has no interest in the business. I had lunch with him last week and it quickly became clear that he had a very strong interest in making sure that the business transition was successful and that his parents were properly taken care of. This was not a difficult conversation as we have a strong plan and team in place, but others like it might well be.
â€œOrganizations are built around the successes of teams and the individuals who make up those teams.”
— Chris Martin, chief technology officer at Pandora
Fairness From the Parentâ€™s Perspective
Most parents have a desire to distribute assets equally to all children, since parents love all children equally. The thought of giving what may be the most valuable asset to one child is thought of as unequal and unfair to the other children. The first question for parents is: can your children share ownership? Here are some things to look for:
- Does one child have day-to-day control over the business operation? Often control is granted to that child because of the childâ€™s experience and leadership abilities.
- Do key employees manage the business that are not part of the family and are they compensated on the same basis as a family employee
- Does each child view the business success through the eyes of the family, or through their own eyes?
- Does the business generate sufficient cash flow to support each of the children, give each separate responsibility and opportunity and the possibility of earning cash or stock by reaching business metrics?
- Is each childâ€™s salary based upon job description and performance?
- Has each child been active in the business long enough to make them and their parents comfortable with the role they will have?
Depending on the answers, your family may associate powerfully with the business, as an investment. The family may receive benefits based on their ownership, which is passed on by lineage, not performance.
Again, depending on your answers, leaving the business to the child who is active in the business and making an equitable distribution of other family assets to the non-active children through estate planning may be more fairly. If the child has earned ownership through attaining business performance, you should consider how that affects the distribution of family assets.
â€œFairâ€ in this context is usually a judgment parents make about what they think is fair to the children. They overlook that children make their own judgments about what is fair.
Fairness to the Child Operating the Business
- The child in the business may have no interest in sharing ownership. Entrepreneurs generally prefer to operate their businesses as they see fit.
- Granting ownership to several children, some of whom are not active or as active? Giving the active child the controlling vote is insufficient. When there are minority owners, the majority owner has a fiduciary duty of fairness to their sibling-owners. Courts will enforce minority shareholder rights. This may make life very difficult for the child who is daily running the business.
- The parents may have offered each child an opportunity to take part in the business and become owners, but only one child grabbed the opportunity. Should parents now force the one who chose to remain in and grow the business to share the rewards with children who chose different career paths? Rewarding the efforts to increase the value of the business by the child in the business is what an owner would do for any key employee, except that the award would likely be cash instead of ownership.
Fairness to the Non-Business-Active Child
Often children donâ€™t want business ownership if they are offered other choices and they know they will receive their inheritance through gifting and the estate plan.
- Children with minority interests generally cannot sell their interest, except to the other children or possibly only the child controlling the business. The others may not have the money to purchase it, and if they do, they may have a different idea of fair market value from that of the inactive child.
- Inactive children generally prefer to receive assets that are liquid and less risky than owning a closely held business.
- If inactive children own a minority share of the business, they may perceive they have nothing of real value, since they cannot make any decisions regarding the business.
- Minority owners own an illiquid security that may produce no current income. However, if the business distributes cash based on ownership, a child may prefer it to other investments if they have confidence in the controlling child and the business.
It would seem that the inactive childâ€™s ownership interest would have little value. The IRS is likely to disagree. While a minority ownership interest can be discounted in value, it will still rise in value as the business value increases due to the efforts of the child running the business.
I reviewed an agreement this morning that was written specifically to keep a business in (and controlled by) the family. The agreement does not provide for a definite successor but rather leaves it to each ownerâ€™s heirs, presumably for them to determine who will do the work of operating the business. The agreement made it difficult to impossible for the inactive children to get rid of the ownership without selling to other family or the company. Their heirs might have to deal with the estate tax consequences of owning a valuable, illiquid asset.