In last week’s post, I shared the story of my son Adam breaking the news to me that he didn’t want to become a lawyer and join me at The Blum Firm. Like many family business owners, I had to come to grips with the fact that the next generation (G-2) wouldn’t be taking over the business. What are the business transition choices when G-2 isn’t the solution? As I concluded last week, there are a lot of options. Let’s explore some here.
As I’ve expressed numerous times, I’m in the camp with many others who often look to Warren Buffett for guidance. The “Oracle of Omaha” is adopting a blended approach. Although none of his children will step into Buffett’s shoes and take over management of Berkshire Hathaway, G-2 will still play an important role. Son Howard and daughter Susan are on the Berkshire Board of Directors “not for operational decisions, but to retain the ‘culture.’ … All three of my children are devoted to maintaining the culture of the place…. They have an unusual amount of devotion to that.” (Eric Rosenbaum, CNBC Leadership Insights, Nov. 14, 2021). Son Peter will also play a role in the family enterprises as director of the Susan Thompson Buffett Foundation (named for Buffett’s late wife) which oversees the family’s charitable giving. This hybrid approach is instructive when the business ownership remains in the family, yet someone other than G-2 handles the day-to-day operations. G-2 can still play an influential role on the board of directors, helping to preserve the family legacy and protect the all-important business culture.
There are numerous other solutions to consider when exploring the options for transitioning a family business. PNC’s Editorial National Practice Group provides an excellent overview of choices in the article “Lowering the Hurdles to a Successful Family Business Transfer” (PNC Insights, Nov. 5, 2021). Here’s a recap of their ideas, as well as some others:
- Leveraged Buy-Out: If the goal is for some or all of the next gen to purchase the business (as opposed to receiving it as a gift or bequest), G-2 could borrow from a third party, pledge business assets as collateral, and use profits to repay the loan.
- Installment Sale: The business owner carries a note, and the buyer uses profits to pay off the note over a term of years. The terms are ideally pre-arranged in a Buy/Sell Agreement entered into long before the event that triggers the buyout.
- Self-Cancelling Installment Note (SCIN): The seller receives a cash flow until the note is paid in full, but any unpaid balance of the note is forgiven when the seller dies. The buyer pays a premium (either a higher price or higher interest rate) for the cancellation privilege.
- Sale for a Private Annuity: This is similar to a SCIN, except payments continue for the life of the seller, and then terminate at the seller’s death.
- Non-Qualified Deferred Compensation: The business continues to pay compensation to the owner after retirement. Such payments are deductible by the company, whereas installment payments aren’t. However, the recipient pays ordinary rather than capital gains tax rate.
- Charitable Solutions: Transfer the business to a CRUT (Charitable Remainder Unitrust) which makes an annual payout to the owner, with the trust assets passing to charity at the owner’s death.
- Sale to a Grantor Trust: Do a “freeze” sale for a note to lock in the value in the owner’s estate. Explore a sale to an Intentionally Defective Grantor Trust (IDGT), Spousal Lifetime Access Trust (SLAT), and/or 678 Trust (also known as a Beneficiary Defective Trust or BDT). Because of Grantor Trust tax rules, there is no tax on the sale, and the owner continues to pay income tax on the trust’s income for as long as he’s willing, further reducing his estate tax.
- Retain Key Employees: Using Equity – Grant to employees stock, stock options, restricted stock, non-voting stock, ROFRs (Rights of First Refusal). Using Non-Equity – Grant phantom stock, SAR (Stock Appreciation Rights) Plans, non-qualified deferred compensation, executive bonus arrangements, Stay Bonus Plans/Golden Handcuffs.
- ESOP (Employee Stock Ownership Plan): An ESOP is a qualified employee benefit plan that buys stock from the owner. Through careful structuring, the owner can defer tax on the sale of his stock by reinvesting in qualified securities. If the owner holds the replacement property until death and gets a basis step-up, the owner’s family completely avoids income tax on the sale.
- Sale to a Third Party: In many cases, this is the choice that makes the most sense for the family, yet hardest when there’s a strong emotional attachment to the business.
In upcoming posts, we’ll dive into the practical and psychological issues at play in selling a family business. As a foreshadowing, I’ll offer some words of wisdom from Denise Logan, author of The Seller’s Journey. Logan speaks of the feeling you have the day you drop off your oldest child at college. I remember that pit in my stomach when Adam left for UT. Per Logan, that’s the same feeling a founder has when he sells his business. For that reason, more than 70% of owners fail to follow through with selling their businesses. To improve the odds of making it to closing, Logan stresses that advisors must tend to not only the transaction, but also the owner’s transition, helping the owner cope with the prospect of life after selling a business.
As we explore both the “head” and “heart” side of selling your business baby, I’ll offer examples and tips. There’s a way to get there. Even the Rockefellers sold Rock Center.
Marvin E. Blum
Marvin Blum gives a shout-out to his hero Warren Buffett for his wisdom on transitioning a business.