This month, I was asked to cover “the steps contractors should take to ensure a smooth succession for a family-owned business without overburdening the next generation.” This topic is a tough one because of economic conditions in general, but also because we are dealing with construction, which — depending on what field you are in — is either in the dumps for some time to come or just starting to recover. One last factor to add to the mix is the family business and transitioning this business to another family member.
While the topic is tough, getting reasonable results is “do-able” unless your business is so far in the red that it would require a large capital infusion to fund future operations. If this is the case, the part about “without burdening the next generation” would require a different plan to move the business to another owner.
Is the next generation ready?
So let’s assume we have something that we can transition to a family member, and that the business can support both members of the family in some way, shape or form. What we are assuming here is that a “parent” is transferring a business to a “child” and expects to get paid for the value of that business, most likely over an extended term.
Should you decide to entertain such an agreement, the first thing you will want to know is “What’s it worth?” Well, we are not going to get into business valuation this month because it is worth what it is worth, which isn’t as much as it was four years ago and may not be again for some time. You will get a better understanding of what I’m talking about when you go to your bank and ask them to support this transaction with a loan.
Probably the most important thing to consider is the ability of the child to manage the business and generate enough cash flow to pay the parent out, whether making bank note payments or direct payments to the parent. If the child does not understand the industry, including how to review bids, manage a project or job, read the job costing schedules and generate the billing and collection process, it is unlikely you will have a successful transaction. In short, if the parent and child don’t understand the books and how the industry works to the extent that they can assess risk and make the corrections necessary to reduce it, then we have a problem.
Steps to minimize risk
If you really want to explore selling the business to a child, here is what you need to do:
1. Build a file with the last four years’ financials, including statements and tax returns. What you prepare for the annual tax returns will probably be a good place to start. If you don’t have a professional set of financials that are prepared using consistent methods, then get one prepared because you will need it. You can have someone prepare a comparative schedule with four years of data in it.
2. Get a realistic assessment of what the child knows and what he or she needs to know to be able to make financial decisions about the company. You may decide the child will need some help to make these decisions, which is okay and better than the alternative.
3. Determine how much discretionary cash flow has been and will be available from the company if you put this transition program in place this year. For the parent, it may not be enough to fund the lifestyle you’re looking for, and you may have to work for a couple of years before the funding is available. If you can do this without interfering with the child, then it should be considered. In short, you will get what is available, which should improve once business improves.
4. For the parent, review your bank arrangements and personal guarantees, because you will want to transfer out of these arrangements when you enter into the deal. This may be tough to do, so you better be comfortable that your child understands the business. Otherwise, your risk under the guarantees will increase when you can least afford it.
5. You will need both an accountant and attorney who understand the industry and related financial transactions. Your local associations should produce some candidates in this regard.
This transaction will make your bank very nervous. Try not to scare them with payout amounts that are unreasonable.
Cash flow is king
This whole transaction centers on cash flow, cash flow and cash flow. Both parent and child have to understand how it is generated and what they have available for payments to the parent. Having this understanding ensures that both sides will come to a reasonable understanding working with what is available.
As you can tell, this is a complicated topic. You can make a transaction like this work if you have the cash flow to support it, and there are limits on how the company uses discretionary cash. But without understanding the accounting and business issues, success is unlikely. So if you need help, let me know.
