Transitioning the Business to the Next Generation - Addicus
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FA M I LY OF F IC E Transitioning the Business
to the Next Generation
Important Considerations
By: Joshua Sage, J.D., L.L.M. | Gray Edmondson, J.D., L.L.M. | Andrew Adams, MBA
With baby boomers continuing to reach or push well past retirement, there are a voluminous amount
of businesses whose future is uncertain in terms of the next chapter. Will these owners choose to sell
these businesses to a strategic (company in a similar line of business who can absorb your business)
or financial buyer (private equity group buying the business as an investment), or will the stakehold-
ers choose to transition the business to the next generation whether an individual or group of family
members? If you are considering the latter, there are some fundamental things that should be consid-
ered and deliberate planning that should be done to significantly increase the likelihood of satisfactory
results.
We have all heard the horror stories about families who have entrusted their business legacy, their
baby, to the next generation, just to have it ruined immediately or encounter a major business setback
requiring the old guard to take back over if they were fortunate enough to have that chance. Ameri-
ca’s small businesses create over 75% of all new jobs and account for almost half of our annual GDP.
Needless to say, small businesses are the lifeblood of the American Economy. Unfortunately, only
30% of small businesses transitioned to the second generation (G2) survive, and only a paltry 12%
of those that transition to the third generation (G3) survive. Generally, these results have a common
theme. It is not that they “planned to fail, but rather that they failed to properly plan.”
Initial Considerations
There are numerous considerations in shifting the family business from one generation to the next.
Timing can be driven by business, health, tax, or family issues. Nonetheless, if the business is to transi-
tion to the next generation, it is imperative that the business, the next generation, and others affiliat-
ed with the business be prepared for the change. While many business owners would like to control
this timing, and many think they can, transitions can be forced before anticipated due to unexpected
health issues, incapacity, or death. As such, business owners should be in a continuous cycle of succes-
sion planning, even if they don’t have a G2 or G3 waiting in line, or they are too young and not ready.
In this situation, one should consider the management team, advisory team, and/or friendly compet-
itors to help implement a plan to protect and preserve the business for the family, or to maintain and
maximize the exit value.
One of the first considerations is to ensure that the next generation is prepared to receive the business,
whether the next generation is family or key employees. The next generation needs to be prepared and
trained to lead while openly discussing and addressing the reluctance or inexperience to lead. Addi-
tionally, consideration should be given to ensure any other affected family members are supportive
of the choice of the successor(s) to lead the family business so as to preserve family harmony. Will
natural or adopted children take control or buy the business? What about step-family or in-laws, or
©2021 ADDICUS, LLC - Investment Advice Offered Through Addicus Advisory, LLC. 1
even extended family members? Another item to consider is whether the key employees and the man-
agement team of the business will be receptive to their newly appointed chief. Will key third parties
such as lenders, lessors, vendors, franchisors, and manufacturers, extend the beneficial relationship to
the successor management and ownership? What reassurances might they need to feel comfortable?
If family is not prepared to adequately operate the business after loss of the senior generation, will the
current management team be ready, willing, and able or should the business be sold to outsiders? All of
these issues should be well considered prior to developing the plan as these considerations likely drive
the rest of the planning process.
Preparing for the Transition
In preparing for the transition, one must consider the following: (1) who will receive (or purchase) the
business (family, key employee, third party); (2) will the recipient(s) be prepared to receive the business
(especially family and key employees, less a concern for third parties); (3) how will the recipients receive
the business (voting/non-voting, trust ownership, family governance/stockholder agreements, etc.) –
keeping in mind some owners may be active and other inactive in the business and the issues this might
present; (4) the pace of the transition and effect on business value during the time of transition; and (5)
the tax effects of the transition including federal income tax, state income tax, and wealth transfer taxes.
Who will Receive the Business
Usually, the family members playing a key role in the operations of the family business are the individ-
uals who will receive the business, or at least controlling interests in the business. Generally, this will
be identified early on in sculpting a plan to transition ownership. Sometimes this will be an individual,
other times, this will be a group of individuals made up of all family or sometimes family and man-
agement combined. Regardless, those assuming control should be familiar with the family business,
confident, and prepared to take control. In the process of identifying the successor, one should con-
sider how this decision will be made. Additionally, it should be determined how and when the family
should be informed so as to preserve family harmony. There may be a recapitalization into voting and
non-voting interests, trusts may own the business with defined decision-making parameters, demands
may be in place to give family the power to control ownership, etc.
Too often we see families that lightly plan the succession of their business in a last will and testament,
thinking they will do something more thoughtful and refined later. Unfortunately, evolution of time
or an event causes this to be impossible and thus the plan that was put in place ends up being the final
plan leaving the family unaware. Alas, this often leads to fights, strife, the family breaking up, and even
costly and taxing litigation.
Preparation
The successor should be intimately familiar with and prepared to operate the business. This can occur
in many ways but is an important item to ensure preservation of family goodwill and the successful
transition of the business. Beyond mere capability to manage and operate, the successor should be able
to maintain key business relationships with a multitude of parties, including key employees and man-
agement, customers and clients, bankers, suppliers, and advisors.
In preparing the next generation, it can be helpful to involve them in the management and operations
of the business as early as possible. For instance, the next generation of managers/owners could gradu-
ally roll into officer positions and some level of equity ownership and voice in the business. Through
their involvement, and perhaps investment, this next generation could become familiar and confident
©2021 ADDICUS, LLC - Investment Advice Offered Through Addicus Advisory, LLC. 2
with the operations of the business as well as comfortable in maintaining key relationships critical to
the business. It is rarely too early to begin getting the next generation involved in, and familiar with
the business and the inner workings of the enterprise.
In some cases, there may need to be formal grooming, coaching, and education process involving
certain advisors, current stakeholders, management, etc. to properly prepare the next generation to run
the business successfully. In a succession, it is critical that those assuming control are confident, capa-
ble, and respected enough to continue the business as well as maintain the going concern, including
maintaining relationships with all relevant stakeholders. These successor managers/owners should be in
place to transition into lending arrangements, franchisor relationships, vendor contracts, etc.. Failure to
do so could cause substantial business disruption and loss of value.
Inside Relationships in Succession
From within the business, there will be several parties that should be receptive to a transition arrange-
ment, including other family members serving in a variety of roles (equity owner, director, officer,
employee, etc.), key employees, and possibly outside owners or relevant parties (trustees, directors,
advisory board members, etc.). If, in the transition, any of these parties lack faith in the successor or
otherwise desire to disrupt the planned transition, they could potentially invite disaster to the business
during and throughout the transition. However, while these persons should not be set on disrupting
the plan, it is often advisable to have a plan flexible enough where the right persons have the ability
to make changes as needed. Unfortunately, succession planning involving a family business generally
presents a smaller pool of potential successors. In addition to the limitation of options, what options
are available can present issues giving rise to concerns involving nepotism and sibling rivalries. Part
of the plan should be for the senior generation to communicate with the next generation (family and
business succession) about the plan in order to avoid any confusion or disagreement about the senior
generation’s intentions.
All too common are issues relating to poor organization, overlooking of internal conflicts, disgrun-
tled family members, and compensation disputes. Family members can be presented with duplicate
functions or an absence of responsibility due to the lack of proper organizational charts or structures
for the family member job positions. This issue can be compounded in larger businesses. The results
can be inefficiencies, poor decisions, and disputes. Family frustrations and conflicts can also present
themselves during the transition. These tensions can give rise to flare-ups in intrafamily conflicts and
second-guessing of successor decisions. In many cases, children are paid the same amount notwith-
standing their duties. Some family members bring more value to the business and can feel underpaid,
or alternatively, others may feel that their non-contributing family members are overpaid, in turn
fanning the flames of family tension. Often family members will tow the party line to some extent,
silently disagreeing, and their energy or sometimes intentions can significantly interrupt the plan and
cause strife in the family and the business. If there is any concern over this, encouraging the family to
be authentic and open in a spirit to come to a resolution is key. Sometimes it is advisable to engage a
family business advisor who is experienced in helping families build and create trust to honestly discuss
issues and create family governance agreements that will foster success of the transition and help keep
the family together.
Children entering the family business straight from school may lack key experiences provided by
outside employment, including formal evaluations against peers, competition for employment and
promotions, formal training, and criticism and stress from superiors. All these experiences provide
©2021 ADDICUS, LLC - Investment Advice Offered Through Addicus Advisory, LLC. 3
opportunity for individuals to grow, gain confidence and capability, and earn the respect necessary to
lead. As such, many family businesses establish a merit-based system for family member employment
that requires outside experience or creates internal controls over family member involvement.
In addition to family, there are the other internal stakeholders, including key employees and manage-
ment who might be suitable for transition. Similar tensions can exist with key employees as exist with
families. Again, these issues can relate to lack of confidence, experience, and compensation frustra-
tions. Some questions to consider are whether the key employees would be receptive to a change in
leadership. Would those employees have the confidence in and support for the successor so as to stay
with the company, not undermine authority, or invite toxicity into the company workforce? As indicat-
ed above, if key employees are to transition into leadership or ownership, similar considerations should
be part of the plan.
Outside Relationships in Succession
Outside stakeholders of the business, such as advisors, customers, bankers, distributors, and suppliers
are all paramount to the continuity of the business. There may also be franchisors, manufacturers,
lessors, or others which must approve successor business management and/or ownership. Maintaining
these relationships and preparing for a transition of these connections to the successor are generally
vital to ensuring continuity of the family business. The founder or current owner typically has working
relationships with these parties, and their support of the business will, in some capacity critically rely
on their faith in the inheritor. A sudden/unexpected or faulty transfer of ownership and the going con-
cern can be disastrous, as key outside parties can lack the confidence in the intended successor.
Vendor relationships will generally involve upstream and downstream parties, including manufacturers,
wholesalers, distributors, or retailers. In certain circumstances, these relationships exist based on repu-
tation and historical interactions. Again, subjecting these parties to an unknown can jeopardize critical
components of the business essential for its permanence. Banking relationships pose similar concerns,
but also introduce credit and liquidity availability into the mix. Specific to banking relationships, if
there is no operating capital with which to utilize, business will struggle and could fail. Should the
current business owner serve as primary guarantor of the business’ debt, what happens when he or she
becomes incapacitated or dies? Will the next generation be in a position to renegotiate that debt with
the same or a new lender? If the lender were to call the debt due and payable, how would this impact
the business, the family finances, or the distribution of the estate among the heirs? One of the key dis-
rupters in business succession can be the inability to continue lending arrangements, which can create
insufficient liquidity at the time of transition, putting the business in a position where it is unable to
smoothly move to the next generation. This could pose substantial jeopardy for the business.
Succession Organizational Structure
Typically, the idea of succession of the family business contemplates the transfer of the business from a
founder or owner-family member(s) to a child, group of family members, key employee(s), or a hy-
brid of family and management. However, transfer of ownership can take several forms. This can be a
transfer to a single owner or multiple owners. Where there is more than one successor owner, structures
should be in place allowing them to effectively manage the business together. This may be through
ownership in a partnership, robust shareholder or operating agreements, or transfer restrictions. Each of
these structures present their own unique benefits, burdens, and other attributes.
©2021 ADDICUS, LLC - Investment Advice Offered Through Addicus Advisory, LLC. 4In a single owner succession, the potential issues discussed above can occur post-transition. However,
in the multi-owner situations, new issues can present themselves continually. There can be issues of
favoritism, compensation, and frustration with some successors receiving equity benefits (distribu-
tions or dividends), with others continuing as employees or serving in other roles. Additionally, issues
related to the direction of the business under the next generation’s leadership can compete against
the ideas of other sides involved. One thing to heavily consider in the situation where multiple fami-
ly members, or key employees own interest in the business is proper governance agreements, dispute
resolution mechanisms, and buy/sell provisions.
Means of Business Transition
There are several ways to effectuate the transition. Among these options are a lifetime sale, gifts to
family, gifts or sales to a trust, or eventual transfer upon death via trust or estate. These options may be
gradual or sudden transitions. Here, tax planning considerations often outweigh planning, especially
wealth transfer (estate and gift) taxes. This will address a few methods for effectuating the succession.
Commonly, a gradual transition would likely prove less risky than a sudden transition. The benefit of
a gradual transition would be that an opportunity would exist for the current owner to ensure a more
thorough, deliberate, and successful business transition to the next generation while at the same time
managing their own retirement planning. Further, this often allows the senior generation to retain
control during transition along with the capability of unwinding prior transfers through a variety of
means, should that be necessary. Further, gradual transfers often are part of a successful wealth transfer
tax plan (such as grantor retained annuity trusts (GRAT), sales/gifts to trusts of minority interests, and
similar strategies).
Operationally speaking, the means of effectuating the succession will usually be part of a global estate
plan of the current owner. The business could be given or sold to the next generation through a variety
of means. Frequently, a controlling interest in the business will pass following the retirement or death
of the current generation owner(s). Thus, if not sold or otherwise given to the next generation in the
owner’s lifetime, the business would likely pass through the owner’s estate, being a potentially sudden
and drastic change of ownership and direction of the business, or worse an abrupt forced sale. In an
estate transfer, it would be critical to ensure that the next generation, as well as the business, are pre-
pared for such a sudden and contrasting change. Here it would be critical to ensure that the intended
recipient be familiar with the business, its operations, and key relationships.
Next, while also sudden, the current generation could transfer a controlling interest in the business to
the next generation while still alive. While potentially jarring, this method can provide the benefit of
ensuring the ability of the prior generation to usher and advise post-transition and phase out when the
new team is ready to have autonomy. This can provide reassurance for certain key relationships and
perhaps some last-minute training for the new owner(s).
Another option is a sale to the next generation. This method is extremely common, providing a means
of retirement for the current owner through the sale of the business while also keeping the current
owner potentially involved (at least as a large interested creditor of the business), to usher and advise
during the transition, protecting key relationships and the business’ income. A sale is effectuated by
purchase via a promissory note, providing deferred tax to the seller and deductions to the new own-
er as potential benefits. A sale also provides the senior generation with proceeds to make transfers to
non-active family members of other assets in situations where the senior generation has insufficient
assets to equitably benefit family through their estate plan.
©2021 ADDICUS, LLC - Investment Advice Offered Through Addicus Advisory, LLC. 5The current generation could effectuate a sale to a trust, which has some similar characteristics to the
previous options, but this option can assist in providing a means of control over the timeline as well
as the business. Further, the next generation may participate on a gradual basis becoming more in-
volved with the operations of the business and ownership of the company, acting as a trustee, assuming
more duties over time and transitioning the business in a methodical and paced manner. This option
may also provide options for the current generation to make changes, if necessary, as well as limit and
protect the business until their death, while at the same time accomplishing numerous other objectives
related to succession in the process. Trust ownership provides a number of benefits, including the abili-
ty to separate voting control (trustee) from beneficial interest (beneficiary), establish advisory boards to
assist the trustee in major decisions, restrict ownership as desired, protect equity interests being trans-
ferred from the next generation’s creditors (including divorcing spouses), and a variety of other bene-
fits. Likewise, trust ownership allows the next generation to potentially avoid gift and estate taxes upon
their death from the assets that accumulate in the trust over their lifetime. Trust ownership of assets
done properly is highly advisable and creates tremendous benefits and planning flexibility.
Combining the Transition with Tax Efficiency
Taxes are usually a large consideration in the transition of the business from one generation to the
next. Be it gift tax, estate tax, income tax, or a combination of the foregoing, taxes can drive (although,
in practice this should not drive the decision-making) the transition. Gift and estate taxes arise to the
scope the current owner is not paid fair market value for interests in the business (valuations are often
disputed by the IRS). Therefore, in a gift or inheritance scenario, consideration should be given with
respect to the tax liability and means to mitigate that liability. While a tax liability may arise as a re-
sult of the transfer, liquidity might not be sufficient, or use of available liquidity could interrupt estate
balancing between the heirs who receive the business interests versus those who receive other non-busi-
ness assets. Life insurance is often a key component of transfer planning, to provide liquidity to pay
anticipated estate taxes, balance the estate among the heirs, as well as to provide liquidity in dealing
with lenders.
In a sale to family, income tax is often generated while losses have the propensity to be disallowed due
to related-party loss limitation rules. Planning properly can help navigate these types of issues. While
a sale for fair market value may avoid gift and estate tax issues, the creation of a tax liability without
outside money available to the family effectively reduces family wealth, again presenting liquidity and
family balancing concerns. However, taxes may be deferred in certain circumstances with a sale in ex-
change for an installment note. A sale of the business after death should benefit from a step-up in the
tax basis of the business interests, (assuming that it’s not changed through future legislation) which can
create favorable tax benefits, but may cause a great deal of additional issues discussed previously. The
business owner may sell to a grantor trust, which is ignored for income tax purposes, allowing the sale
to be made on a tax-free basis while also creating a trust which can be designed to provide several of the
benefits described above. Sales to third parties, including key employees, present similar issues but do
not necessarily raise related party tax limitations, loss of global family wealth, as well as other concerns.
Some Practical Advice and Strategies to Consider
Before beginning to develop a plan for transition, it would be wise for the ownership group to method-
ically think through their desires and objectives of a transition, paint the picture of how they would
like to see things unfold in a transaction or series of transactions. We advise doing this without limiting
thought based on rules, taxes, financial constraints, or other issues that will certainly need to be nav-
igated. Make sure you understand what you must have from the transaction and issues that are hard
©2021 ADDICUS, LLC - Investment Advice Offered Through Addicus Advisory, LLC. 6boundaries as they are of the utmost importance to you and the family. Ensure everyone is clear on
those “must haves,” and establish why they are so important. Make sure you are clear on anything you
would have to come back from the grave to correct if it were to ever occur.
During a transition, a skilled team of advisors is critical in making sure they understand your vision
while helping you navigate the legal, tax, and financial boundaries to achieve the objectives. This team
will also be there to ensure tax optimization and a successful transition occurs. Often, the succession
ownership group will want to have some of their current advisors, or advisors that they seek out rath-
er than relying solely on the incumbent advisors. While the current stakeholders may have their own
advisors, it might make sense for the current stakeholders and next generation to consider interview-
ing some additional advisors for the transition ownership to use that will work well with both current
stakeholders, current advisors, and the next generation.
Communication is the next key aspect to consider. It is vital to a successful transition to communicate
with all key stakeholders in the business, which as we discussed goes far beyond the present owner-
ship. This is true of the business’ key employees and leadership, the incumbent advisors, the lenders,
key suppliers, and customers, and potentially regulatory or other industry needed partners. We would
encourage active and in-person dialogue to strengthen and build upon current relationships, thus
establishing confidence in the transition team and their ability to take the business forward. One of
the most important groups, if not the most important, to have deep discussions with is family. We
often recommend holding a formal family meeting to discuss the Family Wealth Enterprise (FWE),
the business, and the estate and transition plans. It is so important for family members to understand
the current wealth owners’ desires and vision and most importantly the “why.” Also, it is important to
hear and understand the family members who may be surprised or even upset that they aren’t getting a
chance to take over and run the business, and actively work through those grievances. Often this does
not come down to money, rather the child’s conflicting disparity surrounding their parents point of
view, and confidence in a child/children, your approval, and predominantly the notion of weather you
love your children equally. This is a great place to get a specialized family business counselor involved
to assist if you don’t feel comfortable navigating these topics. Whatever you do, please don’t ignore
these challenging conversations simply because they’re hard.
Your retirement plan, both practical and financial is key consideration in all of this. First, the transi-
tion plan should be clear and communicated clearly to all key stakeholders. The transition team needs
to be noticeably supported visibly and verbally, which will require a lot of change and reinforcement
and will likely be uncomfortable until it becomes the new normal. One of the main persons it will be
most uncomfortable for is you as the current stakeholder(s). The financial element of your retirement
is also obviously essential. Do you have enough resources, cash flow and assets to live independent
from the business? Will you need health coverage, salary, or other benefits from the business? Are
you confident that you totally understand not only the cash compensation you draw from the busi-
ness but the other things that are paid for through the business, and how all of these things will be
transitioned and included post transaction? Will you need some form of cash down payment? Can
the next generation come up with that through personal assets, ability to borrow personally, or some
form of leveraging the business? Based on where the business lies, can we get the current stakeholders
released from any forms of guaranty for bank financing, contracts, leases, etc. to protect them from
having substantial contingent liability post-closing?
We would recommend that substantial modeling, forecasting, and stress-testing be done to ensure
that an owner(s) transitioning their business understands the financial impacts of various scenarios so
©2021 ADDICUS, LLC - Investment Advice Offered Through Addicus Advisory, LLC. 7that they are prepared for anything. One thing to also consider is the business and it’s transition to the
next generation may not occur among all of the children. In this event, will there be enough assets to
balance the child/children not receiving the business with one or ones that are receiving ownership of
the business? How will you balance any gifting of stock or discounts used for estate planning with those
children who may have to wait to receive their inheritance? Something to consider when striving to bal-
ance amongst family, when it comes to businesses versus more passive investments and publicly traded
securities/cash, “fair is not equal and equal is not always fair”. When one child inherits a business worth
$10 Million (fair undiscounted value) and one gets $10 Million of cash, that might not be equal in the
eyes of those two parties. One comes with significant responsibility, risk, tax consequence, stress, etc.
while the other gives complete freedom and flexibility.
Conclusion
If there is one thing we would want you take away from this article, deliberate thought and planning will
dramatically increase the chances of success in transitioning your business. Even if aren’t actively con-
sidering a transition to a child at this juncture, make sure to think through and plan a succession or liq-
uidation plan for your business in the event something suddenly happens to the ownership group. We
would encourage you to seek out, interview and hire quality advisors who spend their energy focused on
clearly understanding your objectives and finding ways to accomplish those, rather than explaining all
the things you cannot do. Lastly, communicate with all stakeholders, address the issues head on, and
work to resolve them for the greater good. Don’t hide or ignore the hard stuff.
We love interacting with business owners who are serious about thinking through and planning their
businesses for optimum enterprise success. We welcome you to reach out if we can ever be of assistance.
HERE TO ASSIST
Andrew B. Adams, MBA S. Gray Edmondson, J.D., L.L.M. Joshua W. Sage, J.D., L.L.M.
Founding Partner, Partner Partner
Chief Enterprise Architect Edmondson Sage Allen, PLLC Edmondson Sage Allen, PLLC
Addicus 662.371.4110 662.371.4110
662.371.4125 Gedmondson@esapllc.com Jsage@esapllc.com
Drew@weareaddicus.com
WEAREADDICUS.COM
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