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Financing the transition: Passing the torch in family-owned businesses requires owners to ask tough questions

BY Sunday, August 07, 2016 01:38pm

Sometimes you’ll do things for family that you won’t do for others.

Lenders and advisers say quite often that means sellers will extend favorable terms to a relative or son or daughter who’s acquiring the family business to ease the transition process for the buyer. The tendency reflects some of the unique aspects of transitioning family businesses to the next generation.

“Like anything with family, you produce another element into that equation, and that’s maybe a little bit more love and emotion,” said Matt Hoeksema, chief commercial banking officer at Holland-based Macatawa Bank. “A lot of the other types of transitions are very much straight by the numbers. When you’re dealing with a family sale or transition, sometimes that family dynamic can skew those numbers, both for the good and for the bad, depending on which side you’re on.”

The good side is typically the financing package for the sale, which is more apt to involve seller financing, Hoeksema said. That allows the older generation to spread out their incoming cash from the sale over a period of time, whether because of their personal needs or for tax implications, while reducing the amount of debt taken on by the buyer.

It all comes down to the flexibility that parents, for example, are sometimes willing to show when selling the family business to the younger generation.

“Family members have access to things that a normal deal out there in the marketplace does not have,” said Nicholas Reister, an attorney who leads the trust and estate practice with Smith Haughey Rice & Roegge PC in Grand Rapids and works primarily in family business planning.

“There are a lot of opportunities to be creative,” he said.

Seller financing is common in “almost all” of the financing packages PNC Bank handles to finance the transition of a family-owned business from one generation to the next, said Krista Flynn, the bank’s group manager for commercial banking in West Michigan.

That tendency plays into the seller’s desire to see their legacy continue and the business grow and thrive, Flynn said.

“The outgoing owner generally doesn’t want to burden the company with more than they’re comfortable paying,” she said. “The reason they’re selling to a next generation is they want the business to continue with the same success it had in the past, if not grow more, and they don’t want to strap the company down with debt that’s going to be hard for them to handle if the company falls on a little bit of hard time.

“We all know the economy goes in cycles. So you want to be able to set yourself up for good times and bad.”

PLAYING DEVIL’S ADVOCATE

While seller financing has benefits for both sides, sellers need to fully understand what may occur if things go awry, Flynn said.

Banks involved in the deal want to make sure the buyers and sellers realize the potential that their interest payments may get shut off if the company runs into trouble, possibly stressing the family relationship.

“You don’t want to have a misunderstanding a couple years down the road if the company goes through hard times and the bank says, ‘OK, we’re going to continue to finance you, but you cannot make interest payments to your parents. How’s that going to sit with you?’” Flynn said. “You should talk about those things upfront so there’s no angst down the road.”

Another practice used in financing the sale of family businesses to the next generation is the gifting of stock, whether gradually over time or in large chunks.

A small stock gift to the younger generation up front of 10 percent or 15 percent gives them a stake in the future and begins to prepare them for eventually taking over in the years ahead, Hoeksema said. As the younger generation grows into the business, the two generations can then plan out the full transition of the company with a succession plan that includes a buyout option for the future, Hoeksema said.

While the transition of a family-owned business may come with more flexible terms for the buyer, the due diligence process by a lender that’s part of the finance package remains the same, Flynn said.

The generosity of one generation to the next in how a transaction gets structured also has its limits, she said.

“I don’t think anybody’s going to make a decision that’s going to hurt the business or have real likelihood of hurting the business to support the next generation or child. That doesn’t make sense. That’s not sustainable,” Flynn said. “It’s business. You want to get the value for your company, whether you’re transitioning it to the next generation or taking it out (for sale) yourself. You want to maximize that value.”

PLANNING AHEAD

Regardless of how the financing for the sale of a family-owned business gets structured, experts say business owners need to plan out the transition well in advance. However, few of them do.

In a 2015 survey by PricewaterhouseCoopers LLP, 73 percent of respondents said they did not have a documented or “robust” succession plan. 

The worst thing the controlling generation of a family-owned business can do is to wait too long to start planning, Hoeksema said.

“The biggest mistake we see is that oftentimes they haven’t addressed this and they’re trying to get something done quickly,” he said. “Any time you’re making big decisions like this in haste, you’re opening up the grounds for missing something or a mistake.”

Developing a succession plan should include not only who will ultimately take over and acquire the business, but also whether that successor has the ability to carry on and run the business, said Don van der Zwaag, vice president, M&A adviser, business exit planner and transition coach at The Vantage Group Inc. in Grand Rapids.

“If they have a child in the business, they really need to vet whether that child has the drive and the capabilities and the skills to be successful,” van der Zwaag said. “It’s hard for a parent to think objectively about whether their child is good enough to run a company or to be a partial owner or their leadership role. They may have an opinion but that opinion may or may not be grounded in reality.” 

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