Archive for February, 2012
Is the Next Generation Ready to Take Over Your Business?
Having your child work in the family business that you helped grow from the ground up may be the thing you are most proud of, possibly in your entire life. Knowing your business will not die with you can be a truly liberating feeling. But when you do not own 100% of the company, and you have a business partner to answer to, that means that your child has to answer to him, as well. Of course, the same goes equally for your business partner’s child, who has to answer to you. But if neither of you sees everything that the other’s child does, how do you evaluate their performance?
For example, suppose your business partner’s child works on the plant floor, learning the business from the ground up. How do you know if he is doing a good job? Even if your supervisor tells you that he is, is it true? Or, does the supervisor believe that your business partner’s son is his future boss? If he does, can you trust that you are getting an independent assessment of his skills and talents? Or do your current employees simply want to curry favor, leading them to give favorable reviews out of a sense of self-preservation?
The question goes both ways, of course. If your child is receiving “rave reviews” from your supervisory staff, is your staff just sucking up to you?
The ability to accurately assess the talents of the next generation may not be important to you, especially if it’s your own child being discussed. Not surprisingly, many small-to-medium-sized businesses think this is a greater issue when it’s their partner’s child under the microscope. But this issue may be more critical than you realize.
The abilities of those who will take over from you will directly affect whether the company remains a success while you are supposed to be enjoying retirement. One set of clients learned the hard way that their own children were incompetent. The clients decided to sell the business to the children over time, rather than to an independent purchaser for cash up front. Within two years, it was apparent that both of the founders would have to come out of retirement to save their business, as well as their retirement income, from ruination.
Ensuring quality management into the future can also avoid ruinous shareholder dispute litigation. Allotting equal pay and responsibility to both succeeding children, when one is a superstar, and the other is incompetent, is a recipe for disaster; resentment and expensive litigation between business partners often results from such a situation. Sometimes, it is far better for one child to manage the company, while the other has a lesser role equal to his talents. As long as both have an equal ownership stake, they would be serving the company’s best interests.
Obviously, if there were a way for you to determine for yourself how well your respective children are performing, that would be ideal. But this often is not possible for a variety of reasons. Or one partner may think that his child is fantastic, but that his partner’s child has much room for improvement – while the other partner sees it exactly the opposite way. Then what?
In my last posting (discussing Second Generation Shareholder Litigation), I discussed the wisdom of setting up the successor generation with a mechanism to have compensation set by an outside consultant, to avoid shareholder dispute litigation over salaries taken. A similar thing can be done with performance evaluation, although it may not be easy, depending on the type of business involved. If an outside consultant is impractical, having reviews and assessments performed by your most trusted senior manager, who has no fear of retribution from the next generation, can also lead to a more impartial result. If at all possible, having an assessment performed by someone truly independent, who does not fear reprisal, could save you and your business partner from literally putting the company, and your respective futures, into the wrong hands.
Protecting the Second Generation from Oppressed Shareholder Claims
In my last post, I addressed how you and your business partner, as equal 50% shareholders, can protect yourselves from claims brought by the next generation once you begin to turn over the company reins. This time I want to discuss other difficulties that can be encountered when turning the company over to your children, and how to protect your children from oppressed shareholder claims.
When only one of you has a child who will work in the business, but ownership will still be divided between both your offspring, problems – although not insurmountable once – may arise. The biggest area of dispute is likely to be compensation. The next-generation shareholder who has worked in the business for years, and who knows the finances inside-out, will likely wind up setting his own salary. And every dollar that he gives himself as a bonus is one dollar less that can be paid out as a dividend and split evenly.
How is the shareholder on the outside supposed to know whether he is being treated fairly? If you and your business partner have passed on the company to your children, should you care how they get along in the future?
I don’t have to tell you that you should care, because if you’re reading this article, you probably do care. And why shouldn’t you? You worked for years building up the company. Why would you want to see it torn apart by shareholder dispute litigation between your children?
You can take steps now to prevent such fights, including making sure that mechanisms are in place for transparency, especially with respect to the finances. One client set up a mechanism for an outside consultant to set all salaries for the company, providing in the shareholder agreement that all shareholders had to agree on the choice of consultant. This particular client and his business partner had never had a disagreement in over thirty years in business, so some people thought that having salaries set by a consultant was unnecessary. But he saw that his son and his business partner’s son did not see eye-to-eye on several things, and he knew that only one of them would work in the business.
This approach might be a waste of $5000 per year. Or, it just might be the thing that prevents shareholder dispute litigation from tearing the next generation apart – and with it, the company that the partners spent the better part of their lives building.
Surviving in business is difficult with a business partner, especially when you are both 50% shareholders, with neither of you in total control. Cooperation and trust are critical, and the relationship could have fallen apart at so many different times over the years. Disagreements about the future direction of the company likely have occurred, but you survived them all. As you approach the age where you can begin to see your retirement on the horizon, questions inevitably arise about the future of the company once you are no longer there. When you are a co-owner, you also have to consider whether your business partner has the same vision of the future that you do.
You would be surprised to know just how many savvy business partners have never addressed – or even discussed – a succession plan. Do you both want to sell at some point? If so, when? Do you both want the next generation to run the business? What if one of you wants to sell, but the other wants the children to take over? If your children run the business, will you give away all your shares first, or will and your partner continue to maintain ownership control?
It is critical that these issues be decided as early as possible, certainly before it’s time to implement a succession plan, whatever that plan may be. Although these are corporate planning issues, the statute (at least in New Jersey) governing shareholder oppression and minority shareholder rights has a large impact on how these issues should be addressed.
If the plan is to leave the business to the next generation, it is quite common to gift shares over a period of years as an estate planning tool. To protect the founding generation, shares are often gifted as non-voting shares, so that control is maintained. But, in New Jersey, those new minority shareholders now have certain rights – even if they are your children. They may sue for shareholder oppression, which is defined in a variety of ways, and, under the statute, includes the broad category of “unfairness” towards the minority.
One recent client gifted his shares to his son, while his business partner did the same with his daughter. Instead of being grateful for the windfall, both children (in their 30’s) felt entitled, and complained about the large salaries being taken by the majority shareholders who had not only gifted them their shares in the first place, but still ran the company, as they had for three decades. Those complaints turned into a lawsuit, and the majority shareholders soon wished that there had been some way to address this issue up front, rather than through expensive shareholder litigation.
Even if you are correct in your belief that your child would never sue you, are you as confident that your business partner’s child would never sue him? Or you?
Although it is unavoidable that a minority shareholder would have certain statutory rights in New Jersey that cannot be waived, there are ways to craft a new shareholders’ agreement that can limit the exposure to such a suit. For example, the new shareholder, when he receives his shares, could acknowledge in a new shareholder agreement that he is aware of everyone’s salaries, recognizes such salaries to be fair and justified, and concedes that he is to have no role in the future in setting salaries. This one precaution would protect, to a certain degree, one generation against the claims brought by the next. But, what of the second generation itself?
How to prevent claims between or among the members of the next generation – claims that could tear apart your business, and your legacy – will be dealt with in my next posting.