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Generational succession: Do your kids really want to take over your business?

July 2017


Handing your business across to your family seems like it should be straightforward, but it's important to ensure you to manage it closely and diligently to avoid misunderstandings and disputes.

Generational succession sounds simple enough, but if you're planning to hand your business to your kids or other relatives, there are a few key issues to consider.

Many families end up in dispute right at the point when the parents, the business, and the children are most vulnerable. Managing succession carefully and diligently as if it were being sold to a stranger can help to avoid both misunderstandings and disputes by ensuring that everyone understands what the transition will look like and what their role or responsibility is.

We look at the six most important aspects of implementing and executing a successful handover. 

1. Capability & Willingness: Do the Kids Really Want the Business?

It's not an uncommon desire that parents want to hand over a business to their kids, whether it's to perpetuate their legacy or to provide a stable business future for the next generation. But it only works if there is both capability and wiliness.

Alternatively, it's also common for younger generations to pursue the possibility of continuing to run the family business, however desire doesn't necessarily translate to capability.

There needs to be a realistic assessment of whether or not the business can continue successfully after the transition. In either case, the answer needs to be 'yes' to all of the following:

  1. Is the next generation willing and sufficiently committed to take on the responsibility of the business?
  2. Do they have the capability to operate and run the business?
  3. Can the capital value of the business be maintained and enhanced over time under their management?

2. Capital Transfer: How Much Money Needs to be Taken Out of the Business during Transition?

The transition of business ownership to younger generations usually means the parents exiting the business, which can mean that some capital leaves with them during transition. The higher the level of capital need, the greater the pressure that will be placed on both the business and equity stakeholders.

In most cases, the incoming generation will not have sufficient capital to buy out the exiting generation. This will require the vendors to maintain a continuing investment in the business or for the business to take on an increased level of debt. Either scenario needs to be assessed for its sustainability either at the business or shareholder level. It's not uncommon for the exiting generation to want to maintain a level of equity investment. This might be a means of retaining an interest in the business or alternatively staging their transition. 

In either case, it is important to map out the capital transition both from a business and shareholder perspective. This needs to be documented and signed off firstly from the business's perspective and then by both generational groups. No generational transition should be undertaken without a clear and agreed capital program.

This is where proper business and tax advice can be crucial because not only can your accountant help evaluate the tax implications for the exiting generation, they can also provide an independent lens over the business and its capitalisation requirements. 

3. Income Needs: Ensuring that Remuneration is on Commercial Terms

Many SME owners arrange their remuneration from the business to meet their needs, rather than being reasonable compensation for the roles that are involved in the business. This can result in the business paying too much – or too little.

Under generational succession, there should be an increased level of formality around compensation to directors and shareholders, with compensation matched to roles and, where performance incentives exist, these must be clearly structured.

The compensation for all executives should be agreed at a business level first. Thereafter, all of the parties can assess the adequacy of the compensation to their needs and expectations.

4. Operating and Management Control

When capability and capital assessments are complete, the next step is to look at the transition of control in the business, which can often be very sensitive. It's essential to establish and agree in advance how operating and management control will be maintained.

This is important for both the generational stakeholders and the business. Any uncertainty around management and decision making can create confusion or a vacuum – either will adversely impact the business. Tension easily arises because:

  • The incoming generation want freedom of decision-making and the ability to provide their input on the business
  • Without operating control, they feel that they have management in name only
  • The existing generation believe that their experiences is essential to the business and entitles them to a continued stay
  • A perception that capital investment should equate to ultimate operating control
  • An uncertainty by either or both generations about the extent of their ongoing roles

A plan for operating and management control should be documented and signed off by all parties involved, with either timelines for time-driven succession or milestones for event-focused transitions.

5. Time to transition and setting expectations

Handing the business from one generation to the next is often a process, rather than an event. It is often achieved over an extended period of time, which is quite different to the sale of a business where the owner's active involvement in the business generally stops shortly after the sale.

It's because of this that the transition requires active management to ensure each side of the transition has agreed expectations and to avoid the process being derailed through frustration.

The desire of the existing generation to scale down their business involvement and bring on other family members to succeed them doesn't necessarily equate to withdrawing from the business completely. It's not uncommon for the transition period to be extended and it can help the business to manage the change, manage income, and manage the capital withdrawal requirements.

The critical issue here is to identify and ensure that each of the parties has a common understanding and acceptance of the time period over which the transition will take place. This should be included in the documented succession plan.

6. Greater Formality and Management Structure

Transitioning the business from one generation to the next often means that a greater level of formality in the management and decision making is required. The formality should achieve a separation of function between:

  • Management
  • The Company Board; and
  • Shareholders

In small-to-medium businesses, these roles often converge with few clear, dividing timelines or boundaries. Roles, responsibilities, and clear key performance indicators (KPIs) for management should be agreed and documented. For management, this also needs to include clear job descriptions, authority levels and operating expectations 

Generally, a more formal and functioning board of Directors is required. The process may also be assisted by the inclusion of non-related, non-executive Directors. They should assist to provide some balance between the two generational groups. Where there is a functioning Board, they should meet on a regular basis and receive and direct management in the strategic direction of the company.

Managing and maintaining family relationships

One of the key components of successful transition is the ability for the people involve to separate business issues from family relationships. This can often be bumpy and requires both restraint and discipline by the people involved and leadership needs to be shown by the exiting generation.

Business tensions and differences in view about the direction of the business, and certain management decisions can bring significant pressure to bear on normal family relationships. The roles of grandparents and parents need to be kept separate as much as possible from the roles of fellow Directors and Shareholders. While these aren't business issues, they are significant issues in a generational succession. Any breakdown in family relationships may have some negative impact on the business. 

Need more information about how to ensure the succession of your business goes well? Contact us on 02 9957 4033 for a confidential discussion.

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Disclaimer

This article is provided for information purposes only and correct at the time of publication. It should not be used in place of advice from your accountant. Please contact us on 02 9957 4033 to discuss your specific circumstances.

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