Miscalculations and Entitlement Traps?

What exactly is a “Legacy Payment”? Legacy Payments are those payments made to the prior generation when the next generation buys a family business. These payments include the debt service, principal and interest, on the purchase of the family business and possibly the real estate too; in addition, there are other types of Legacy Payments that can add weight to the total payments expected by the exiting family members. In this article, the author discusses what could go wrong and how legacy payments and an entitlement mindset can lead to the demise of the business.

Ok, first things first. What exactly is a “Legacy Payment”? Here is what I think—Legacy Payments are those payments made to the prior generation when the next generation buys a family business. These payments include the debt service, principal and interest, on the purchase of the family business and possibly the real estate too; in addition, there are other types of Legacy Payments that can add weight to the total payments expected by the exiting family members.

For some family business owners, there is nothing more rewarding than handing over the ownership reins to the next generation. Those fortunate enough to have two or even three generations of family business ownership take delight in a fourth or even fifth generation under one name or one family. Sometimes family businesses survive multi-generational succession—sometimes they do not. Not everyone is cut out to be a successful business owner—even if born into the family business.

Still, the transfer of any business comes with a multitude of challenges, including “the purchase price” and financing. Just over 60 years ago, IRS Revenue Ruling 59-60 established guidelines in determining fair market value for estate and gift tax purposes. The guidelines and methods remain the foundation for valuing businesses today, including the passing of a business to related parties—parents to children or sibling to sibling, for example. Prior to that point, many owners “sold” their business for one dollar or for negligible amounts, bypassing estate and other taxes. The IRS stopped that practice with the fair market value requirement.

The passing of the torch in a family business should consider fair market value when determining a selling price to the next generation. If the selling price is reasonable and the terms are fair, those Legacy Payments should be affordable without too much pressure on the company’s profitability. What might cause those Legacy Payments to go awry, placing the future of the family business in doubt? Let us examine a few of those Legacy Payment calamities resulting from miscalculations and entitlements:

The Miscalculations

This is where the rubber meets the road—what do the next few years hold in store for the next generations? What should the buyer expect year -n and year-out in sales and expenses; in business valuation parlance, what is the expected cashflow from the business?

If forecasters simply use the past as a proxy for future revenues, without factoring changing consumer preferences, they may overstate income, and it will have a direct impact on the sustainability of the family business. And if income is understated, were the exiting family members treated fairly? How can we boldly forecast revenue growth of old for a family business today considering an uncertain future? Small businesses many times do not reach beyond their local or regional communities. What about forecasting for communities with decreasing population and sub-par household income? Unless the incoming owners can figure out how to increase or at the least maintain income, reaching a reasonable growth rate of 3 percent annually may be challenging.

Often, advisors unfamiliar in forecasting family business financials, err on the side of a more positive return for the parents (or senior family members exiting), assuming the “good times” will continue. The parents have not deliberately hung their children out to dry in the sale of the business but has unknowingly created a scenario of adversity—paying more for the business than it can reasonably afford.

Entitlement Traps

Unfunded retirements represent, perhaps, another crucial miscalculation by the parent or selling generation. Relying almost entirely on the sale of a family business for retirement funding is ill advised. Too often, the senior family owners fail to save enough money (or in some cases saved nothing) for their own retirement, placing undo pressure on the need for the sale of the business to fund retirement—either to a third-party or their own kin.

Unrealistic expectations on money (i.e., net proceeds) from the business sale may hinder the actual sale, keeping an aging and often diminished owner in charge, simply wanting to allow him/her to retain their lifestyle. Owners who have not saved for retirement create more obstacles in the eventual change in ownership—sooner or later transition happens.

Truly, some owners are realistic about their business worth and do not handicap their kids, but some embrace the entitlement legacy—they paved the way for the family business and now expect to retire in grand style. Although they may not see it this way, at the expense of the next generation of owners—“Well that’s how I was treated,” is the mantra many owners use.

Next generation owners who paid a premium for the business many times get excluded from their parents’ estate to treat non-business owner family members “equally.” Rarely does that work fairly for all concerned if the appropriate value of the business is not part of the equation; this often leaves a bitter taste for the succeeding generation.

Adding insult to injury, some exiting family members also demand an on-going compensation for little work, or require an office and perhaps a secretary, and even a callable bonus of additional hundreds of thousands of dollars as part of their agreement. Certainly, some of these “leftover perks” may be possible but not if they place undue hardship on the business.

Another weight of entitlement anchors the succeeding generation into exceedingly long-term payouts. Is a 20-year payout realistic? How about a 30-year payout? As mentioned previously, expecting the next generation to fund a negligent retirement plan is unacceptable and expecting them to pay out for the foreseeable future limits the next generation’s ability to make decisions.

How can the succeeding generation grow a business when tied down to such unreasonable demands? In truth, handcuffing the succeeding generation in such a fashion restricts their ability to properly manage today’s family business. One of the supposed strengths of small business is that they can react more quickly to changing consumer preferences.

If the younger generation is strapped for capital because of misguided legacy payments, they lose their ability to experiment with new ideas or try something new simply because there is no money left over to fund such activities. A family business hamstrung by entitlement payments cannot succeed and will not prevail at a time when flexibility and new thinking are sorely needed.

So why is this important? As business appraisers, we are able to inform and educate—if we do not take the opportunity to help, we can become part of the problem. While there are internet-based and other low cost “valuation calculators” available to all business owners, who will be the teacher and maybe the creative force behind the family business transition? True, there are many that work just fine without our help. But what about the others who do not know what they do not know? 

What about me? Every day my transition planning practice grows across all phases; I have saved my share of businesses that “wanted” to be saved. What about you? Your experience may just save a few of those promising family businesses from ruin, helping present and future generations escape the miscalculations and entitlement traps.

Steven Egna, ASA, CBA, CVA, ABAR, CM&AA, is a leader of Valuation Resource Group, LLC, an Albany, New York M&A Advisory Services, valuation, and litigation support firm. He has over 30 years of diversified financial leadership and management experience specializing in transition planning and valuation analysis of all sorts. He brings a practical, hands-on approach to all of his work.

Mr. Egna can be contacted at (518) 479-1008 or by e-mail to segna@valuationresources.com.

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