Passing on the family business

About half of all small businesses will change ownership in the next decade, according to the Small Business Services Global Entrepreneurship Monitor. Among them will be many that are passing a family company from one generation to the next – a move fraught with emotional and financial problems.

“It is a real challenge for families and needs the family to come together and agree on the rules of engagement,” says Grant Gordon, director general of the Institute for Family Business, an independent networking group.

Financial legacies that come via a family business are likely to be much more complicated than those that are a simple pool of assets.

“Even if it’s a quoted company most families would think twice about selling their shares,” says Chris Hancock, family business specialist at JP Morgan. “It’s also harder to protect; with a portfolio of assets you can diversify the investment to manage the risk, but you can’t cover a business in the same way. If you mess it up, the business and the legacy has gone.”

Emotional attachment to a business has its advantages for a family: a company can provide a focal point to bring family members together, and many families are passionate about their corporate inheritance. But passing it from one generation to the next requires careful management.

“It is important to explore the family’s aims and define the family’s purpose,” says Mr Gordon. “You need to define family values and ask what is the family vision?”

One area that can cause many difficulties is employment. Second- or third-generation family businesses may have a mix of owners, some of whom work in the business, and some of whom do not. Income from the family business may be simply dividends for one family member – but both salary and dividends for another.

“This raises quite different issues than a group of unrelated shareholders,” says Nick Gornall, head of private banking and entrepreneurs at Coutts, the private bank. “Shareholders may be looking for different levels of business growth or a different level of return.”

Maintaining a family business requires a level of corporate governance beyond that of a non-family company. “Most families will want to look beyond the regulatory governance and create some kind of family protocol or family charter,” says Mr Hancock.

Such a charter will lay out employment opportunities, remuneration policies and methods of share valuation in a bid to prevent family squabbles.

“You need to put in place the process to take decisions in the future,” says Mr Gordon. “Will there be any form of mechanism for family members to realise their capital – a share buy-back scheme, for example? If family members want to exit the company, can they do so? Is there a market for the shares? How will those shares be valued? Who will decide on the value?”

Getting an investment bank to provide regular independent valuations of the shares may help ensure family members understand what their legacy is. “People need to have been educated and prepared for the responsibility of ownership, and families should start early on educating the next generation,” says Mr Hancock. “Whether the next generation is going into the business or not, it needs to be financially literate.”

Passing on a business to family members raises different tax issues than selling outright. “The original owner may rely on dividends for income; if shares are gifted to a child then that income stream will be reduced,” says Dominic O’Connell, head of tax, trust and estate planning at Coutts. “You may need to be able to replace that income from elsewhere – and be careful not to fall foul of the ‘gift with reservation’ regulations.”

These rules operate such that if you give away an asset but continue to enjoy the benefits of ownership, the gift becomes ineffective for inheritance tax (IHT) purposes – it will still count as part of your estate on your death. So gifting shares to a child but continuing to receive an income from the company may not overcome the problem of IHT.

Succession may be a good time to bring in new capital, possibly to straighten out an over-complicated ownership structure or boost management expertise, says Mr Gornall. “Money is relatively easy to raise at the moment so the temptation is to use that opportunity to bring in outsiders. A lot of family businesses can’t find the next chief executive in the family, so may want to take a fresh look at the ownership; they are unlikely to get someone good without giving that person a stake in the business.”

It may be possible to build in the right to repurchase stock when the individual leaves, which again requires a clear process of valuation for the shares.

A family charter should also consider the requirements for family members to be employed in the company. “There are a limited number of roles within a business, and choosing the right leaders is key to success,” says Mr Gordon.

Talent management policies that are well laid out and transparent are very important to keep families working together. And the effort involved in passing on the business to family members rather than selling out can be worth it.

“If you can get it right and have a happy family on top of a family business then there are big advantages,” explains Mr Hancock. “People like dealing with a family firm, there is a feeling of security in talking to someone whose name is over the door. These issues are common in every family business, so be proactive, face it head on and develop a plan for the succession. Then everyone is happy.”