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SUCCESSION AND THE TRANSITION OF POWER IN A PRIVATELY HELD BUSINESS

The initial article discussed the Succession Dilemma in an overall context, touching upon the key issues facing an owner/operator faced with the prospect of planning for the succession of his or her business. This article will explore the problems that may be encountered in orchestrating the transition of power from one generation to the next and touch upon the key determinants of a successful and lasting succession.

The high rate of failure among second or third generation family owned businesses is well documented and can generally be attributed to a set of complex emotional and interpersonal factors which are distinct from those found within an arms-length business setting. It follows that within this setting it is of the utmost importance that guidelines for the governance of shareholder relationships be clearly spelled out in all respects.

The ‘Plan’

In the context of a privately-held business, the transition of power should represent the culmination of a carefully planned strategy crafted from the input of shareholders, key employees and independent advisers over a time horizon of several years. Yet succession planning is often avoided despite the fact that it arguably represents the most important planning exercise to be undertaken within the context of family run businesses.

Ideally, the succession plan should set out to establish several things. First, it must provide a framework for identifying and assessing a successor. Secondly, it should contain a timetable for the succession including a critical path of key events that need to occur for the succession to take place. Thirdly, it must identify the firm’s long term business plan and attempt to strike agreement on a vision for the future of the company. Fourthly, it must identify the desired ownership/management structure of the company. Fifthly, it must detail how and when the owner/operator will realize on their investment in the Company. Next it should contain a communications policy which will provide a framework for family members, shareholders, key employees and professional advisers to remain apprised of the process. Finally, the succession plan must result in the development of a shareholders agreement that will accomodate the criteria developed during the course of the succession planning excercise.

The need for such detailed planning is driven by many factors, including financial risk. The investment represented by a family business is often relatively illiquid. Hence the succession plan must balance the retirement needs of the owner/operator with the reinvestment and expansion capital needs of the business. It must also accomodate the transfer of financial risk from the retiring owner to the successor in order to achieve the ideal of retirement as opposed to leaving the owner/operator with the same degree of risk after retirement as before. This goal can be accomodated by a number of means including third party borrowings, sinking funds or an infusion of the successors own capital. The traditional estate freeze does not accomplish risk transfer. However, if redundant assets exist the retiree’s stake can be decreased through the sale of such assets with no impact on the business.

The Ownership/Management Dilemma

Assuming that the successor has been chosen from within the ranks of the family, the owner/operator next faces the decision of whether this person will also be called upon to manage the day to day operations of the business or whether this role will be delegated to professional management. The correct decision is dictated by the circumstances particular to each business.

The key to resolving this issue lies in recognizing the distinct nature of the two roles. Often the owner/operator views these roles as one in the same, failing to recognize that the personal attributes that he or she brought to the position are in no way guaranteed to accrue to the successor.

The fundamental advantage of separating the roles of ownership and management lies in the enhanced level of reporting objectivity which it provides. By clearly separating the operational and executive roles, the inherent potential for conflicts of interest will be removed. Separating these roles also avoids having to call into question the successor’s operational skills in the event of future difficulties at that level.

The Shareholders Agreement

The Shareholders Agreement is the single most important element of the succession plan. Ideally it will delineate the roles and responsibilities of the various shareholders and should provide a detailed framework for the resolution of shareholder disputes. An effective agreement will necessarily require the shareholders to confront various difficult issues before they occur. While this will often be a very emotional process, it is to the advantage of all stakeholders to understand the rules that will prevail in the event of a dispute.

In addition to having to choose a successor the owner/operator must also decide how the future share ownership shall be structured. Often, shareholdings are divided equally among the owner/operators family. While this appears to be the simplest and most democratic answer to a very sensitive issue, it often leads to a situation of deadlock. Having chosen a successor who is best suited to the position, it becomes imperative that this person be given the mandate, in the form of voting control, to run the company. To do otherwise will potentially neutralize his or her authority. The transition of voting control can be implemented gradually based upon a series of milestones that have to be met prior to the relinquishing of control.

While choosing and empowering a successor is one of the most potentially divisive decisions to be made, failing to convey control in this way is a decision which many family owned businesses live to regret, as portrayed by the following situation.

The company in question was a well established, second generation family business. Four of the five shareholders were active in the business, and each held an equal share in the Company. The eldest son was chosen to succeed as the President and Chief Executive. Upon the death of the father the strong vision, character and moral suasion that had kept the four sons of common mind disappeared. Two of the brothers later decided to pursue opposing business strategies and the business began to suffer a significant decline. Efforts to reach an accord failed. Closure of the business was narrowly avoided but only after two of the brothers, both in their 60’s, borrowed significantly in order to purchase the interests of the other two. The Company never fully recovered from the financial strain imposed by the borrowing and it was later sold, much diminished in stature. This unhappy outcome could have been avoided had the shareholders agreement been structured to give voting control to the chosen successor or had it contained some strong language on the resolution of shareholder disputes. The failure to confront what were long standing differences of opinion before the transition of power undoubtedly contributed to the Company’s demise.

The Transition

Assuming control in a family run business is often further complicated by the character of the owner/operator. Typically of strong will and possessing a single minded vision of what the Company represents, this person inevitably finds it most difficult to relinquish control. Further, this person will often continue to carry a financial stake in the business for a period of time. Consequently, it is frequently the case that the outgoing owner/operator remains involved in the operation of the business well beyond the contemplated succession date. While the reasons for this are understandable, this situation can be very disruptive and confusing. Again, such an eventuality can be mitigated through open dialogue during the succession planning process.

Where the plan contemplates succession by a family member careful consideration of the ramifications for other employees and the incumbent family manager must be recognized. Often, long serving non-family employees will have a high degree of allegiance to the owner/operator. Promoting a family member can cause the loss of these loyal, talented employees if not handled properly. This is where a policy of open communication will help to minimize the potential disruptions that typically result when planning is carried out under a veil of secrecy. Providing an element of open dialogue with key non-family employees can only benefit the organization in the long run. Where it is clear that the company will always be run by family members, it may be necessary for the owner/operator to implement incentive strategies aimed at retaining these key employees in the organization. In any event it is critical that the owner/operator ensure that the proper environment exists for the designated successor to assume power.

The other alternative is to hire a professional manager from outside the firm. This approach has its own set of unique problems including a lack of understanding on the part of the new hire with respect to the culture of the company; the potential negative reaction of family members and key non-family employees who were passed over for the position and the willingness of owner/operator to allow the new hire to carry out their mandate. Again, such problems can be overcome provided the proper succession planning regime is followed.

Clearly, there is a very large emotional element present in the family owned business. The absence of an arm’s length, negotiated relationship within the context of a family owned business contributes to their characteristic instability. Family relationships in and of themselves are highly complex and unique. In the absence of a well defined structure, the challenge of planning for the succession of the business to the next generation can easily be appreciated.