Selling to Junior: How Private Equity Can Fund Family Succession and Foster Success

From Thomas for Industry on April 22, 2021

By Dickinson Bransford

If after reading yesterday’s article “Should My Kid or My Key Employee Take Over My Business? 10 Questions to Ask Yourself Before Deciding” you determined that your child is the best future leader of your family-owned business, one of the first decisions you must make is whether to sell or gift your company to the next generation.

Carefully Consider Succession Planning 

The question of whether to sell the business to offspring or simply give it to them is not as easy as it sounds. The first questions retiring owners should consider are whether:

  • Passing the business along to family is even the best idea. (For more on this topic, check out “10 Reasons Why Your Kids Probably Won’t Take Over the Family Business.”) 
  • They want maximum proceeds from the transaction (generally suggests selling the company to outsiders, not family)
  • A repayment schedule – the normal payment mechanism for a sale to the family – is acceptable in lieu of lump sum proceeds of a sale
  • Gifting more or less than 50% of the stock is contemplated
  • Their attorney’s practice area includes estate planning (because owners will need that expertise)

Each consideration is an input toward your final decision. 

Family Succession Tax Considerations to Keep in Mind 

Transferring a business to offspring raises concerns about tax consequences that should be evaluated by professional counsel. To some, the decision to gift or sell will be strongly guided by tax considerations, the expected remaining lifespan of the retiring owner(s), business value, and other variables. Implementation of estate planning mechanisms in advance of a transfer is crucial to managing tax obligations. These can be quite complex but are worth the effort.

Gifting allows the transfer of the business over time with the focus being minimizing gift and estate taxes, which can be up to 40% of the value gifted, or more if the donor dies within three years of the gift and the tax obligation passes to the estate. In a few donors’ cases, it may be prudent to make a fully taxable gift.

Most exiting owners want and/or need the liquidity and proceeds of a sale. To some, it need not be all cash at once, but perhaps an annuity payment from a tax-advantaged trust into which the stock of the business had been previously transferred, then later sold by the trust.

Consider Entitlement Perception Risks with a Gifted Business 

Another consideration is whether the next generation may perceive the business as less valuable if gifted than if purchased.

Not only could a sense of entitlement be cancerous to the business infecting all decision processes and employee relationships, but a need to purchase would also ensure that the younger generation really wants to own the company and is emotionally vested.

What Are the Downsides of Selling to the Next Generation?

Typically, the younger generation does not have the substantial capital required to buy the business and may not have enough to even finance the sale through a third-party lender. In that situation, the older generation must consider financing the purchase over a period of years. Not only is the sale to offspring unlikely to generate as much as a professionally managed sale to outsiders in a competitive market, financing it prompts other concerns in which the first generation’s interests are averse to the second. Risks can include: 

  • Lack of full liquidity upon turnover of ownership
  • Exposure to economic, market, and general business risks, plus the inherent risk of as-yet-unproven leadership
  • Asking for personal loan guarantees may threaten family harmony and relationships
  • The opportunity cost of tying up the money in the financing further reduces the attractiveness to the owners. For over sixty years, the S&P 500’s average annual return has been about 8%. Unless the loan charges an 8% interest (high today for low-risk debt), they would lose money. If instead, they invested sale proceeds in an S&P 500 index fund which generated an 8% average annual return, they would double their money in 9 years, according to the Rule of 72.
  • The younger generation’s need to repay the debt will reduce cash flow, which could compromise the company’s ability to grow or maintain its market share

Private Equity Financial Sponsorship Could Offer an Alternative Solution

High performing, growing companies in attractive industries that have adept next-generation leadership may qualify for private equity financial sponsorship of the transaction. This approach can fully fund the buyout, cashing out and eliminating the risk for the selling owner and need for the second generation to scrape together everything they have.

The older generation harvests their wealth while the younger generation and management team maintain control of the day-to-day operation to grow the business over the next several years using the resource of highly skilled investors and operators.

How Private Equity Sponsorship of Family Succession May Work

Typically, the investor acquires all the older generation’s shares and structures the deal so that the younger generation is in a minority, but meaningful, ownership position with very substantial wealth-generating opportunity. Special trust structures to mitigate capital gains can be accommodated, too.

The key point here is that both parties’ interests are aligned, as both will share success or failure.

The equity sponsor invests in the company and its management to grow organically and by the acquisition of other, smaller businesses. Four to seven years later, they will collaboratively sell it. 

At the end of the investment cycle, both parties’ share should be of a larger, more valuable company.

Private Equity Resources Can Help the Next Generation Succeed

The relationship dramatically increases the likelihood that the acquiring management will succeed, as they will have the board level guidance of highly educated and accomplished investors, often with significant experience across industries, focused industry knowledge, and experience proficiently managing growth.  

A few examples of how they would contribute to the new management’s success would be:

  • Help the team clarify and accomplish their vision of how to grow, aligning resources to support the vision
  • Establish a capital structure that attracts favorable banking relationships and a line of credit, minimizing, if not eliminating, personal guarantees
  • Advice on software systems and other tools the company will need to achieve and manage growth
  • Recruitment to fill important management gaps

How to Choose the Right Investor

There are thousands of private equity investment groups, including variants like family offices, independent sponsors, and search funds. Culturally, they can be vastly different. While all require board representation, some investors operate hands-on, others hands-off between board meetings.  Investment experience in specific industries will vary widely.

There are many other variables to consider, too, such as the nature and timing of the fund.

Investment bankers working as M&A advisors to closely held companies will have access to numerous and different types of strategic and financial investors and/or debt providers. They are the best conduit for owners considering transition options to evaluate them, then manage the transaction process.

This article is part 4 of a 6-part series on Thomas Insights. The other articles in this series include: 

  1. Family Businesses Rarely Transfer to the Next Generation – Here’s Why It Matters
  2. 10 Reasons Why Your Kids Probably Won’t Take Over the Family Business
  3. Should My Child or Key Employee Take Over My Business? 10 Questions to Ask Yourself Before Deciding
  4. Selling to Junior: How Private Equity Can Fund Family Succession and Foster Success
  5. The Secrets to Setting Your Family Business Up for Success
  6. What Are the Alternatives to Selling a Business Besides Family Succession?

Note that these articles will be publishing throughout the week. If a link above does not yet work, the article has not yet been published but will be available within the next few days. 

This article was written and contributed by McGavock Dickinson Bransford, CM&AA, who focuses on advanced manufacturing companies as managing director with investment bank Mid-Market Securities, LLC. He advises and writes articles pertinent to owners and shareholders of mid-sized companies. Contact him here.

Read the original article here.