Why would someone want to own an interest in a family business rather than invest in a marketable securities portfolio? Family business owners can create a better business succession plan, and a better estate plan, if they understand how each of their children, the "next generation," would answer that question.
What does the question mean?
Hypothetically, if a business owner's child received a bequest of $1 million of cash, rather than $1 million worth of family business stock, the child would invest the cash in marketable securities (i.e., publicly traded stocks and bonds).
A marketable securities portfolio can be fairly predictable over the long term and can be diversified and managed conservatively for investors who are particularly risk averse. A marketable securities portfolio can be structured to provide the investor with a modest but reliable income and appreciation that usually outpaces inflation. Further, the investor can sell marketable securities at any time to produce cash to consume (e.g., pay for college, go on a world cruise), buy an asset (e.g., a vacation home, a yacht), or start a new venture of their own (e.g., make an independent film, start a goat farm).
In short, a marketable securities portfolio can be a low maintenance and flexible investment that can be converted to cash quickly and easily, as needed.
In contrast, a family business can be a very risky investment at times (such as the present). Sometimes, family business owners are required to personally guaranty business debt, which extends the risk beyond their investment in the business. Family business ownership often is not "low maintenance"; it usually is a group project that requires effort to reach consensus or may result in occasional owner discord and disruption to personal relationships. Further, family business ownership is not easy to convert to cash. There is no ready market for family business interests, and usually an owner's ability to transfer his or her interest is restricted by a buy-sell agreement or other governing documents.
The question, therefore, is: Why would member of the next generation be willing to accept the risk, complexity, and illiquidity of family business ownership, rather than choose the relative predictability, simplicity, and flexibility of investing in a marketable securities portfolio?
What is the answer?
There are four reasons why a member of the next generation may wish to own an interest in the family business, rather than a hypothetical investment in marketable securities. The reasons are cash flow, wealth accumulation, occupation, and legacy. In other words, the individual believes that family business ownership can deliver superior results in one or more of these categories than other available investments. These reasons are not mutually exclusive, but they may be ranked from highest to lowest priority for a particular family member.
● Cash Flow. A family business can deliver income or cash flow to family members in many different ways, including dividends or distribution of profits, compensation for services, payment for leasing property, and even payment for redeeming ownership interests.
● Wealth Accumulation. An ownership interest in a family business can grow in value based on the active efforts and skills of family members, rather than simply through passive market forces, and owners can realize that appreciation when they exit ownership through means permitted in the business's governing documents.
● Occupation. A family business can provide family members with an opportunity to pursue an occupation that they enjoy, in an environment in which they are supported, valued, and respected.
● Legacy. A family member's association with a respected family business can be a source of pride and prestige, and a healthy sense of tradition and inclusion, and it can lead to opportunities in the community or marketplace that might not otherwise be offered.
Why is the answer important?
Family members can participate in family business ownership, operations, or legacy in different ways, and to different degrees. They can be owner-operators, minority investors, long term silent partners, beneficial owners through a trust, or owners of affiliated companies. If senior generation owners understand what each member of the next generation expects, or hopes, to derive from the family business, they can tailor their succession plan and estate planning to better address each family member's unique individual priorities and preferences.
For example, if one child prioritizes income and occupation, then his or her piece of the succession plan could emphasize employment and compensation, as well as ownership interests.
If a second child prioritizes wealth accumulation but intends to work elsewhere, then his or her ownership share could consist of non-voting stock held in ac trust with the right to be redeemed at age sixty.
If a third child prioritizes legacy, but does not want the risk of investing in the family business, then that child's share of the succession plan could consist of a few shares of non-voting stock and mostly other non-business assets. That child also could be engaged with the family legacy through involvement in the family's charitable foundation.
In contrast, if each of these children were simply given an equal ownership interest in the family business, they might quickly fall into disagreements about family-member compensation and whether to pay dividends or reinvest profits in growing the business. More dramatically, two of the children might insist on selling the business to the highest bidder outside the family. None of them would be particularly happy about the result.
What's the lesson?
Family business owners should try to determine how their children individually value and prioritize the benefits of participating in the family business—cash flow, wealth accumulation, occupation, and legacy—and then tailor their succession plan and estate plan so that it allocates family business ownership and affiliation in a way that is most consistent with the children's respective priorities and preferences.
Gregory Monday
gmonday@reinhartlaw.com
7/20/2020