Passing Your Business on to the Next Generation
Written from Episodes 72 & 73 of Business by the Numbers (www.paarmelis.com/business-by-the-numbers)
“Do you want to know what’s harder than buying or selling a business? Buying or selling a business from family members.” Passing your business onto the next generation is a significant milestone that requires careful planning and consideration. Let’s explore the essential steps and key factors involved in successfully transitioning your business to your children. From effective communication to crafting a solid plan and addressing the technicalities, this overview will equip you with the knowledge and insights needed for a smooth and prosperous business succession. Let’s dive in!
Part 1: Strengthening Family Bonds and Setting the Foundation
Communication:
Open lines of communication are crucial during the business succession process. It’s hard to overemphasize the importance of transparent and honest conversations among family members, ensuring that everyone is aligned and working towards the same goals. If you want to leave your kids the business, make sure they want it. If you’re looking to buy out your parents, make sure they have explicitly said they are ready to pass the torch on. Perhaps parents and children aren’t ready to make any moves yet, but if everyone’s feelings are spelled out clearly, it’s harder to misinterpret or misunderstand intentions. One aspect of communication is being open and honest about numbers. It is essential for children to understand what they are taking on. While it’s not always the easiest conversation to have (many people don’t openly talk financials within their family), the last thing you want is for financials to be a surprise. It just doesn’t help anyone. The other thing to be open about is what it’s like to be self-employed. Think about when you first opened your business, likely you learned most things through the school of hard knocks. Being open about the freedoms and hardships of self-employment with specific examples will help your kids avoid learning the hard way themselves. Painting a true picture will ultimately make both parties walk into a deal with their eyes wide open and more specific awareness about what they’re taking on.
Crafting a Solid Plan:
Building a comprehensive plan is essential for a smooth transition. In successful case studies, there is always a detailed, time sensitive plan. I can’t emphasize enough, it is incredibly important to stick to the plan. One of the toughest things for someone passing on their business is to let go of it. I’ve seen clients that hung onto their shop so long past the appointed timeframe of the deal that children ended up walking away altogether. This can damage relationships that otherwise were very good. It’s especially tough when parents have passed on most of the responsibilities for running the shop to children, then are set up to be an investor. Unless this is something that parents and children have planned on, it can put children between a rock and a hard place. This leads us into the next point.
Striking the Right Balance:
“Do not saddle [your kids] with what you need versus what [the business] is worth” Balancing your retirement security with your children’s preparedness can be a delicate task. Let’s look at a couple real-life examples.
Case study A: Dad knew the son wanted to buy him out and finally said it’s time to make it happen. It had been causing animosity between them and was probably the right time to make the move. He got the paperwork together and offered a deal that included the son making a payments in perpetuity to cover the father’s retirement. After the Father passes away, the payments would pass onto the son’s mother. These were also very high payments. In essence, the son was on the hook for his father’s lack of planning. Eventually he walked away from the deal and the relationship was severely damaged.
Case Study B: This was a similar situation to case study A. A father passing the business onto their son. The father had planned the financials of the business so well for his retirement, that he was able to give his business to his son. His plan had always been that his business would never be sold, but passed on to his son. While the son was on the fence about inheriting it, the plan had been in place so the option was available when it came time to make decisions.
Ultimately the goal here is finding equilibrium, ensuring that both your financial future and your children’s well-being are safeguarded throughout the transition. One of the best ways to navigate pricing and perspective is to think “would I do this to an unrelated party?” If you’re a parent, and your business is worth $600,000, and you want to sell it for that price to your child, it’s not weird or unfair. You can always decrease the price, (like selling it at a friends and family discount of $400,000), but it’s very hard to go the other way. If a shop owner tried to sell to a stranger, and calculated what they needed to retire as the price instead of what the business was worth, the stranger probably wouldn’t agree to it.
Recommendation: do not split up the business among family members if they’re not both/all involved in the business. This can create a lot of tension down the road when you are out of the picture or eventually, it’s likely that one of the children will buy the other out. You’re also creating a business relationship between siblings where they have never had one. If you are going to split things amongst your children, the same rules from above apply with communication among and with your children. Everyone must be on the same page.
Part 2: Navigating Technicalities and Ensuring a Successful Transition
Now let’s shift our focus to the technicalities involved in passing your business on to the next generation.
Valuations:
Valuating something is always an opinion. No matter who does it, everyone will have different values because they’re coming from different places with different assumptions. The basic premise of how auto repair shop businesses are bought and sold is a multiple of average net income (check out episodes 14 & 27 for more details). Essentially, you’re looking for a 3-year average of what parents took out of the business. If parents are taking out $100,000 per year, it’s worth around $300,000. There are quite a lot of steps that are included in a true valuation that you would do if you were selling to a stranger, but it’s not always necessary with family. The core idea is to get on the same page about the value of the business. Whether you want to have a valuation done or you and your child have an idea in your head of what the business is worth, make sure you both agree.
Selling Stock vs. Selling Assets:
If I had a shop, “Hunt’s Auto Repair inc.,” Buying the stock of the business would be buying the corporation. The other option Is buying the assets of the business (the equipment, inventory, etc…). Typically, parents would sell the assets. There are 2 big reasons for this;
- Contingent liabilities. If the child buys the stock of the business and the business gets a sales tax audit (even from 3 or 4 years ago before they bought the company), this becomes entirely the child’s problem. Anything that has ever been associated with the business is now the child’s concern.
- Tax considerations. Let’s say my daughter gives me $1 million for my business’ stock. I’ll pay capital gains tax on that, but the downside of that is that it’s not a deduction for my daughter. She could eventually sell the business and lower the purchase price, or gain, by whatever she bought that business from me, but if I’m interested in passing down my legacy I don’t really want her to sell at all.
There are only 2 common situations where stock sales make sense. One is minority ownership, where an owner would sell 10%, then 20%, then 30% of the business, etc… The only way to do this is fractional stock sale, because you can’t sell percentages of assets. Generally, however, it’s going to be better for the buyer (although slightly worse for the seller) If parents pay children like an owner (until they buy the parents out) instead of selling them a little at a time. The other situation is a gifting situation because the child can use the same bank accounts, Federal ID numbers, vendor accounts, etc…
The reason asset sales are more beneficial is because the deal gets broken down into 2 or 3 different parts. First, inventory: If the shop has $20,000 in inventory and a buyer pays $1 million, the buyer knows $20,000 is going to inventory. The second part is equipment. You will find out what the equipment is worth today (not when it was bought). If you’re the buyer, you want fair market value but on the higher side because you can depreciate the equipment all in the first year or in a max of 7 years. This way, after 7 years you will get a full deduction for the equipment portion.
So, if the equipment & inventory are $280,000, that leaves $700,000 leftover. This is called goodwill and is what buyers are wiling to pay over and above the equipment and inventory, what they are willing to pay for the brand itself, customers, team members, etc…
There are a couple perspectives here: Buyers would typically want more of the price to be on equipment because you can depreciate it over 1-7 years, whereas goodwill amortizes (essentially depreciates) over 15 years. Sellers usually want the opposite. They want more of the price to lie on goodwill, because this will all be taxed as capital gains, whereas equipment is taxed at a slightly higher rate. Best advice? Walk through the equipment together and make decisions quickly and fairly. If Mom thinks the alignment rack is worth $30,000 and her son says $20,000, meet in the middle at $25,000 and move on.
Entity Choice
Now that the timeline and price are set, let’s assume the child is buying the assets of the business. The child should go and register their business as an entity (see episode 20 to learn more about entity choice) and then contact vendors and start transferring them to the new accounts. If the parents did not register the name of their business, the child should still be able to use the same name. If they did register, it’s as simple as them releasing the name to the child to use.
Financing Your Child’s Business Purchase:
Determining the loan your child will need to buy the business can be a complex process, but it boils down to essentially 2 choices; get an SBA loan from a bank or from the parents. This choice completely depends on individual situations. If you are a parent and want to be completely out of the picture, it’s probably better that your child goes to the bank. This way the parents don’t have to stay invested in the success of the business. There is a little bit of leverage on interest and taxes when doing the loan from the parents, so it’s not a bad option to explore, depending.
Gifting the Business:
In most of the gift situations that I’ve dealt with, the child is very deserving of being gifted the business. The idea behind a gift is that there is no tax associated. If you gift less than $11 million in a lifetime, you don’t have to pay tax. However, the downside is that the cost associated with gifting correctly (stock and assets) can be expensive. Higher dollar things like a $600,000 shop can certainly be worth getting your ducks in a row to protect that business for your child.
Recommendation: If you’re the parent, don’t stay in the business on payroll if you are gifting your child the business. Let’s say you’ll get $1 million for the next 10 years but you’re on payroll for $100,000 per year. You’ll be paying payroll tax every year on that money and so will your child. Furthermore, it will be taxed as ordinary income. Instead, sell the stocks or the assets at a $ 1 Million and you’ll get taxed at capital gains and your child will get the full deduction in less than 10 years without payroll tax or anything.
Conclusion:
Successfully passing your business on to the next generation requires careful planning, effective communication, and addressing the technicalities involved. In this two-part guide, we explored the key factors and crucial steps for a smooth and prosperous business succession. By implementing the insights and advice shared in this series, you’ll be well-prepared to navigate the complexities of transitioning your business, ensuring a legacy that thrives for generations to come.
Remember, each family’s situation is unique, and seeking professional advice from legal and financial experts is highly recommended. Prepare yourself for this important journey and embrace the opportunity to secure the future of your business and family.
Questions? Contact info@paarmelis.com
