Official Publication of the Minnesota State Bar Association


Vol. 62, No. 10 | November 2005
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Planning to Pass Down the Family Business
By Timothy Ridley

Transferring a family-run business to a second generation, whether it is a hardware store, a restaurant or a business-to-business organization, is intricate and one should not underestimate the complexity of transferring ownership from one generation to the next.  A proper business transition requires significant thought, time and effort. 

Often times the key to a successful transfer is appropriate and competent legal counsel.  While it may seem obvious enough, the most seamless transition is often based upon a comprehensive plan that ensures that all the legal aspects are being considered. The unfortunate thing is that in most cases, the common trend is to not have a plan at all. This can result in all sorts of negative issues for the new business owner and her predecessor.

For most transferring business owners, the primary need is to explain how the transition will be executed while also including contingency plans should outcomes vary from initial expectations. Therefore, the more detail provided around each action, the better. Frequently, older generation business owners do not adequately prepare for conflicts with the next generation, which can stem from opposing views on how to handle the business itself, the staff, and external relationships.

THE RIGHT QUESTIONS

Asking the appropriate questions and having the answers outlined in a plan is crucial.  The proper business transition will answer several essential questions.  Who will be the succeeding owner?  Will it be one child, some of the children, or all of the children?  If one child, will the transitioning generation provide for the others in some alternative manner?  If two or all of the children, will all be active in managing the business or will some be silent shareholders? If some will be inactive owners, will the plan provide some measure of protection for those inactive members? Will the new owners be only those children who have previously been active in the business?  If more than one child will be involved in the newly transferred business, is the transferring generation assured that those children are capable of working together?  Will key staff from the previous regime be retained or will the new owners bring in their own key staff members?  Is the buyout of the business adequately financed? Are financing terms favorable to the transferor, the transferee, or both?  Should the transferring owner be retained as a consultant to ensure that essential previous business contacts are retained so the business can continue to prosper? Does the financing of the transition provide sufficient liquidity to allow for the potential estate tax liability for the transferring owner?  Are all income tax complications for the transferor considered?

As can be seen, the issues to be examined are numerous and complex.  The optimal plan is the one that takes into consideration all of these issues.  Additionally, because of all of the potentially conflicting issues, flexibility in the plan can be an asset.

ELEMENTS OF THE PLAN

In addition to asking the right questions, counsel should be sure that the plan includes the appropriate documentation required to transfer the interest of the owner, whether it be a corporation, limited liability company, or partnership. It is vital that the plan include all documentation required to properly transition the owner’s interest.

Counsel must also make sure that there is adequate funding of the plan, both to ensure the success of the business and to safeguard the financial well-being of the transferring owner. Often times, companies might have an appropriate transition plan in place, but the capital needed to sustain the ongoing business is not fully secure. If the financial foundation of the newly acquired company is at risk in any way, not only the new owners but the old owner may be at risk.  If the transition is financed, the seller may not receive payment if the continued success of the business is not assured.  The viability of the financing must be discussed in detail with the transferring owner.

As mentioned earlier, reasonable contingencies need to be outlined in the plan to address the possibility that unforeseen circumstances may arise. This tactic will ensure that the parties won’t be caught in a situation without alternative corrective actions.  For example, a parent may transition his business to his children.  After a few years, one or more of the children may decide that an alternative career better suits them. Documentation for the transfer of ownership should thus contemplate how each child’s interests should be protected or purchased in such circumstances. The last thing the parent wants to create is animosity among his successor children.

Counsel should also make sure that reasonable arrangements are being made with business customers to ensure that the business thrives after the transition. For example, if a client is in the service business, keeping the lines of communication open with customers will help ensure that they will remain with the company through the transition.  The transferring owner will be able to assist in this transition of the relationship with customers.

A primary consideration is having an adequate legal/accounting team to guide not only the transition but also the business into the future. Generally, this transition works best if the current team is left in place. However, the new owners may have their own advisors that they prefer to work with. This should not be an issue if the new team is kept abreast of all facets of the transition.

HANDLING THE TRANSFER

Generally, business owners who transfer the business to family members will do so by virtue of a buy-sell agreement, a Grantor Retained Annuity Trust, or an outright gift through a recapitalization of some sort. A buy-sell agreement is a contract between the transferring owner and the transferee.  It generally will provide for contingencies such as death, disability or retirement. It is the essence of the plan. When using a buy-sell agreement, the financing issues are of paramount importance and the new owner should be sure to fully understand the different options. In most cases, the business owner will want to be cashed out. If not, financing terms should be understood and to the greatest extent possible, guaranteed.  In transitions to family members, does the owner fund her own buy-out through an insurance program, or a gift to the next generation? Or does the parent insist on some stake for the next generation?  Asking the right questions usually means less confusion down the road.

One further issue must be considered. It is important in representing a client that all parties understand who is being represented.  An ethical dilemma can be created if the attorney does not make it clear that he represents either the transferor or the transferee. The attorney should not represent both even where that is the preference of the family.

There are always going to be extenuating circumstances that might impact the outcome of transferring ownership (e.g., industry changes, market oscillations), but having a well-thought plan in place for transitioning ownership is the best way for business owners to avoid legal roadblocks once the ink is dry. c


TIMOTHY RIDLEY is a partner with Meagher & Geer. His practice focuses on wills, trusts, estates and related litigation.