SUCCESSION: THE DILEMMA
One of the most difficult problems an owner/operator must face is whether or not to transfer the ownership of the business to the next generation or to sell the business to an arm’s length party. Each alternative has its own set of problems. Couple the two together and the magnitude of the dilemma is multiplied. In most instances either path is a course in uncharted waters. There are no manuals dealing with what is essentially a personal problem combining and intertwining both psychological and pragmatic questions concerning present and future family relationships. At best, what the owner/operator can hope to have available is the facts or professional opinions as to the process involved in each alternative and the risks attached to both.
The issue of succession is an individual/family problem in which a parent(s) must assess the age, ability, personality, maturity, and so on of the children relative to the size and complexity of the business. If there is more than one child in the business, the problems increase in size and scope. Not only does one have to deal with the question relative to each of the children, one must assess their ability to interact and complement each other. How does the power structure get split and is there an agreement as to how the future operation of the business will be governed? Often thrown into the equation is the question of how to insure that non-active children perceive all parties to be dealt with fairly. Thus, has there been a gift to the children active in the business at the expense of the `passive’ children? This question is valid when the parents are largely finding the transition such that there really has not been a shift in risk to the new generation. Against this backdrop, the parent is faced with the dilemma that the liquidity issue is not resolved and, that being the case, the shifting of power can not take place completely. In most transitions, the parent(s) does not receive a material cash payment. Normally there is a `freeze’ of the existing value and a transfer into non-growth shares. In most cases, one of the main objectives is not being satisfied. That is, liquidity and security for the parent(s) as they move into retirement. Therefore, the family, as a whole, still has the business pressure to cope with. If the owner/operator still has the investment in the business, which is likely the material portion of the wealth, then it is not possible to take an arm’s length approach to the future operation. This is one of the biggest hurdles to overcome and one that causes conflicts to arise and persist. The owner/operator who wants to retire and/or reduce the financial commitment can not do so very readily with the traditional estate freeze. While the children want to commence to obtain operating control, the parent(s) must maintain an active involvement to protect this investment. In most cases the expected shift of control and power does not occur in funds.
To reach the goals of an owner/operator, the succession must be viewed as much a financial decision as a personal decision. That is, the likelihood of success increases as the succession plan starts to mirror an arm’s length transaction. To the extent that third party funds are required to make it effective, this must be viewed as a prerequisite to the effective accomplishment of the transition. As the proportion of cash to value used in the equation increases, the owner/operator can begin to satisfy the goals which typically are:
- a reduction of the investment risk by obtaining some liquidity,
- relinquishing some control to those who are also sharing the monetary risk,
- availability of funds to provide some measure of security and balance the equation with other siblings,
- the transfer of control to the next generation with the transfer of risk, and
- satisfaction that the business and its culture will survive and be maintained and that the long-term employees are dealt with in a fair and equitable manner.
Most owners of privately-held businesses do not want it to be known that their business is for sale. The reasons most often cited are the confidentiality of profitability and performance, the uncertainty the potential sale causes employees and the effects on the normal day-to-day business decisions that the sale process has. These problems associated with taking a business to market are further complicated by the emotional difficulty of selling a business. It is a decision, once consummated, that normally cannot be reversed. Accordingly, it is often a decision that can not be easily resolved. Experience has shown that for a sale to be consummated the owner/operator must overcome the psychological hurdles of independence, ownership, employment, prestige and so on. More often than not, a sale is not completed because of emotional concerns as opposed to price considerations.
The decision to sell is often triggered by a negative set of circumstances as opposed to a sale in reaction to strong market conditions for a particular business. Often the erosion that the vendor anticipates is from shifts in the market, competition or required capital investment. These typically mean that an owner/operator will have to re-double the effort to sustain existing profitability in the face of increased risk. As a result, there is normally a high level of anxiety associated with the selling process. To the extent that these reasons exist when considering a sale versus succession, the dilemma often increases in intensity.
The selling of a business is both an expensive and an emotional process. The uncertainty carved by the potential transition tends to cause a slowdown in the decision making process. The business tends to stagnate during the selling period. The management focus is on the sale process. Accordingly, to go down the path without a real commitment to the sale is generally a mistake and costly to both the participants and the business. The conclusion, in my view, is to deal with the succession issue first, and if it can not be resolved to everyone’s satisfaction, then one can consider an arm’s length sale.
The overriding problem ultimately faced by an owner/operator is what will the business actually fetch on the open market? This is most often the missing link in the decision making process. That is, what would a strategic buyer pay for this business, in cash, relative to what could be reasonably expected to be realized, over time, through an orderly transition to family members. The only way one can truly answer the question as to what a special buyer price is for a specific company at a specific point in time is to put the business up for sale through an open market auction. The number of legitimate potential purchasers that exist in the market for a particular business at a given point in time is the driving factor as to the price achievable. As the number of purchasers increase the price will normally follow. Liquidity for companies in specific industries tends to change over time. An increased level of take-over activity in a specific or related industry is often an indication that rationalization is taking place or about to take place. A classic example of this is the consolidation in the computer software industry in the 1990s and more recently, the software consulting firms in 1995. Clearly, there has been a value enhancement in this software consulting sector that was not present in the early 1990s.
The dilemma in the decision making process is to understand the difference between an internal value for succession purposes and an external price that may be achieved through an arm’s length sale. How does one `price’ a business without exposure to the market? The tendency is to test the market during the decision making process. However, a half-hearted attempt normally does not constitute a resolution of the `price’ issue. Industry analysis and research coupled with valuation advice should provide as much information as a superficial `testing’ of the market by a limited exposure of the business. This analysis must be done in as thorough a manner as possible to assess adequately the expected net realization from an arm’s length sale. It may, in fact, end up to be a probability analysis developed pursuant to a series of variable assumptions. To the extent that there is only a nominal difference between an arm’s length sale and an internal sale, the decision can be weighted based upon the merits of the succession planning in and of itself. As the gap increases between the two values, an arm’s length sale will have to be given greater consideration. It is not absolute values by themselves that are the only consideration. One must also consider whether the business, if transferred internally, can increase the capital appreciation such that the future growth potential is significantly in excess of what can be realized by an arm’s length sale today coupled with reinvestment. It may be the case that growth is available and that the continued expansion will raise the capital value to a strategic buyer by multiples of what could be reasonably sustained currently. There are no crystal clear answers to many of the questions. However, a vigorous analysis of all of the issues should provide sufficient information and insight to the owner/operator that the owner/operator can make these decisions with the knowledge that the issues have been rationally presented and assessed. With this background information and communication between the parties with a vested interest, hopefully a consensus can be reached as to the appropriate path to take.