The choice of the family ownership type for a business may determine whether it survives the transfer to the next generation. One of the biggest lessons that I learned in both law school and graduate school was that the rules of procedure often dictate the outcome.
In the case of a family business, the structure of the business may determine whether it will survive a transition to the next generation.
As an estate planning attorney in Austin, I help clients secure their assets today and set them up for a smooth transition to the next generation.
Below we will briefly go through the different options family businesses have and their respective benefits and challenges.
With a sole owner structure, each generation of the business is owned exclusively by one person.
This works best when it is the type of business that requires decisive and agile leadership. In addition, to keep holidays cozy, it would be helpful if there were other assets to assign to the other children.
For instance, the sole owner could assign life insurance beneficiary designations to the children who did not assume the sole owner status. Alternatively, the non-business fruits of the business' profits could go to these children. For instance, a family ranch or rental property could distribute to the non-owner children. In this way, they receive an equitable legacy and remain free to pursue their own dreams outside of the business.
If there are no significant assets outside of the business, things could get tricky. In the best case, the current sole owner would distribute some assets out of the business.
Alternatively, they could document plans for the successor's distribution of those assets to the non-owner children. But, relying on the successor sole owner to reliably carry out the wishes of their predecessor carries a significant opportunity for potential strife. This option is not ideal.
Often birth order determines who takes over as sole owner in these situations. However, this rule ignores the possibility that ability does not necessarily match ability.
In a partnership, only those individuals actively participating in the business have ownership rights.
As the sole owner scenario, partnership ownership also works best if there are other assets outside of the business to compensate the children who decide to pursue outside careers or interests.
With the partnership ownership structure, the agreement should have clear rules about entering and exiting the business. It should also define what participation in the business means. That is, what activities specifically constitute participation?
An issue with this type of structure is that it often requires subsequent generations to purchase shares from the prior generation. This presents difficulties because the subsequent generation likely has fewer financial resources than the prior generation. So, you're asking those with high human capital, but low financial capital to purchase shares from those with high financial capital.
This challenge also puts the business at risk due to the likelihood of recapitalization requirements coinciding with ownership transfers. Ideally, you would want the business fully capitalized during such a transition to smoothly ride out inevitable bumps in the road.
In addition, the need for recapitalization may limit the business' potential growth trajectory. I'm reminded of how recessions shift potential GDP curves. It can take years to get back on track in that context. Similarly, it could take years for a partnership-organized family business to get back to the pre-transition growth trajectory.
With the distributed model, any descendant can be an owner of the business.
This works best when there are few assets outside of the business. Everyone shares in the ownership of the business regardless of their participation in it.
The distributed model thus requires either a family culture, internal rules, or external rules that encourage consensus decision-making processes. Without the ability of a single owner to command a majority, the owners must find ways to work together effectively.
However, the increased dispersion of ownership shares over the generations can eventually lead to an unworkable situation. With the growing number of owners, the company may drift without coherent leadership. A strong manager culture within the company can mitigate this risk, however.
With the distributed model, the ownership may eventually become so diffuse that there could be a risk of the family losing control of the business. If there were a strong family culture and identity the family could slow this potential risk. In addition, strong internal governing procedures could help as well.
In the concentrated family business model, any descendant has a potential ownership stake. However, a sub-set of the owners have control of the business. This type of structure can combat the drift described in the distributed model.
However, like the sole owner structure, the question of deciding successor owner-control sub-sets can get complicated. For instance, if the first and third children hold owner-control positions, how should the next generation's owner-control positions assign? Should the business carry forward through subsequent generations through those lines, or should factors like potential ability or interest play a role?
In addition, the family must grapple with the question of how to keep the non-control owners engaged in the business even though they do not have a say in it.
When you have poured your heart and soul into a family business, you have often sacrificed much to achieve success. The risks of going out on your own require considerable grit, planning, and judgment.
The successful transfer of a family business to the next generation requires those traits as well. However, when business mixes with family, it can be difficult to see one's way through clearly.
Despite the upfront efforts, it might be wise to restructure a family business to facilitate a smoother transfer to the next generation. The structure that you started with may have worked for building and maintaining the family business. But, each structure has its own challenges and benefits - as touched on above.
You know your family and business best. Therefore, to ensure that all of your hard work and sacrifice over the years survives a transfer to the next generation, you must work through which structure best fits your family's specific dynamic.
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