Family Business Succession Planning: Current Obstacle to Business Sale?

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In Business Transition Posts

Family business succession planning: Are financial markets a current obstacle to business sale?

Where business owners have all or most of their financial eggs in the proverbial one family business basket many business transition advisors advocate that over time those owners diversify their investments into financial and other markets – see, for example a recent article titled If Your Business Is Your Largest Asset, It’s Time to Diversify. This is sound advice for business owners who plan to keep their business pursuant to adopting generational business succession as a family business succession planning strategy. These are family business owners who presumably are satisfied that over time they will be able to keep their business growing and remaining financially sound, while at the same time building a diversified asset base external to that business.

Other succession advisors advocate resolving the asset diversification issue by advocating that as part of family business succession planning all or part of the family business be sold, with the after-tax proceeds then being retained within the family unit and invested in a diversified asset portfolio.

Current financial markets obstacle to business sale

I have been concerned for some time that there currently exists a major obstacle to business sale that private company owners may be far more conscious of than are their professional advisors – including their financial advisors.

That obstacle is comparatively simple to understand, and in my view is but one more reason private company owners must immediately stop procrastinating over family business succession planning, strategizing, and implementation if they currently are doing that.

The views expressed herein are based on my beliefs that:

  1. successful business owners typically have a good working understanding of the strengths, weaknesses, opportunities, and threats related to their privately held company
  2. successful business owners typically do not have a comparable working understanding of the strengths, weaknesses, opportunities, and threats related to public financial markets investment, trading and hedging strategies
  3. many business transition advisors seem to be pushing an aging population of business owners to sell their businesses, their thesis being that every business ownership interest will be sold at some point, so sell while you are alive, in good health and can make decisions rather than let others make them for you
  4. we live in a new economic and financial markets normal
  5. after the 2008 (and in my view ongoing) financial crisis, central banks have run out of most of the restore economic growth and stability arrows they had in their respective quivers as late as 2007
  6. every day seems to bring further negative economic news from countries including China, France, Greece, and Italy to name but four
  7. in our ever more globalized economic and business world contagion arising from negative economic news seems to be an ever increasing risk
  8. if the investment banks were too big to fail in the fall of 2008, their influence today is such that many now are too enormous and influential to fail
  9. the financial markets increasingly have become computer-generated trading markets that very likely are broadly over-valued
  10. financial market yields are in the order of 3% – 4% before financial advisor fees in what broadly are assessed as stable and dependable long-term investments but in the end may prove not to be
  11. in the fall of 2008 through March 9, 2009 the financial market indexes generally dropped by about 40%, and there is no reason to believe that at some future date a similar thing won’t happen

The arithmetic

Following from the foregoing, assume:

  1. all of the outstanding shares of Private Company A could be sold to an arm’s length purchaser for $10 million
  2. the owners of Private Company A collectively realize annual pre-tax remuneration from their business of $1 million
  3. if they sold their shares in Private Company A they collectively would realize after-tax proceeds on the sale of $9 million, and some of them would enter into a two-year transitional employment contracts that would collectively pay $400,000 per year
  4. if the owners of Private Company A invested their net proceeds on sale in the financial markets they collectively would realize annual pre-tax income of 3.5%, or $315,000, before financial advisory fees – or just over 30% of the collective remuneration amount they had realized from Private Company A prior to its sale
  5. as shown in the following table, assuming $1 million of tax on capital gains, and assuming no gains or losses on the resultant marketable securities portfolio, a 100 basis point (1%) annual fee, net of advisor fees pre-tax income would be $225,000, not $315,000
Assumed business ownership sales proceeds $10,000,000
Less: assumed tax on capital gains      1,000,000
Net proceeds – assumed to be invested in the financial markets     9,000,000
Assumed 3.5% annual yield before gains, losses, and advisor fees          315,000
Less 100 basis point advisory fee on $8 million marketable securities portfolio           90,000
Pre-tax income to business owners         225,000
Assumed pre-tax income earned from the business      1,000,000
Short-fall in pre-tax income before consideration of assumed two-year transitional employment contract pursuant to which they would be paid for services rendered       $775,000

Another way to consider the dilemma facing those same Private Company A owners who sell their ownership interests is to consider the amount of annual interest that might be earned on $9 million deposited in a bank account that pays 75 basis points per annum in interest. Those business owners would:

  1. collectively receive only $67,500 in pre-tax income
  2. potentially face what I like to think is the remote issue in a western developed country of finding their deposits all or partially confiscated in the event of a further world financial crisis where as depositors they were treated as ordinary bank creditors

Even accounting for differences between tax on earned income and tax on dividends, in the current economic, business and financial markets environment it strikes me as unlikely that many owners of viable businesses with long-term growth potential will not be as attracted to selling their business as they were in the pre-2008 economic and business environment. Evidence of this exists where many M&A advisors claim in the current environment there is far more money looking for private company investments than there are private company business owners looking to sell – see Private equity firms are aggressive buyers again!

This does not mean that private company owners ought to defer family business succession planning. It means exactly the opposite. In the current economic and business environment private company business owners should be focused as never before on:

  1. maintaining strong balance sheets
  2. a business strategy at will enhance business viability and promote growth in business value
  3. their family business succession planning strategy

Ian R. Campbell

Ian R. Campbell is a leading Canadian business valuation and transition consultant. He recently wrote and published the book 50 Hurdles: Business Transition Simplified. You can reach him by email at icampbell@ircpost.com, or by telephone at 905 274 0610. You can find out more about him, register for the free Business Transition and Valuation Review newsletter at BusinessTransitionSimplified.com, and purchase the 50 Hurdles family business transition planning book at 50Hurdles.com.