In family-owned businesses, what constitutes a risk management plan? Astute executive teams plan a response to disasters that might impede business continuity. Yet interestingly, most risk management plans fail to incorporate one issue that can have dire consequences for any family-owned business: the estate plans of the family owners themselves.
Issues involving succession, tax planning and ownership are among the many challenges family businesses face if the corporate plan does not align with the estate plans of the family owners. Failing to proactively manage these issues can create a domino effect that may permanently cripple a company.
The advantages of proactive risk management became evident to me when I advised a privately held telecommunications company. The company was considering a unique opportunity to quickly expand its regional footprint.
My clients were seeking ways to recapitalize their business so they could bid for assets being divested by a national wireless carrier following the government's antitrust ruling requiring that company to sell assets in the region.
As they weighed financing options, it became clear that the executive team would need to reorganize the business to accommodate potential investors, and their ownership desires. I sat down with the attorney who had been doing the family's estate planning for many years and asked whether any buy-sell or stockholders' agreements existed. From the back room of his office he pulled out a photocopy of a 25-year-old stock buy-sell agreement that dated back to when the company was a very small, family-owned, rural telecom business.
The existence of this document was news to everybody on the financing team—and to half of the family members still involved in the business.
When I read the buy-sell agreement, I realized that this document could potentially derail the company's efforts to recapitalize and expand. Unbeknownst to everyone in the room, the agreement essentially gave all the signatories a perpetual right to buy corporate shares if the stock was ever offered for sale or otherwise transferred to anyone other than a family member. To complicate matters, the agreement provided for a new price calculation if the existing shareholders exercised their option to buy based on the book value of the stock, disregarding any third-party offer or fair market value appraisals.
In other words, if stock were offered to these non-family private equity investors, under the terms of the agreement family members could buy those shares at book value and without the investors' consent. Bottom line: This meant the company couldn't bring in a private equity partner to fund the acquisition of new assets.
Why did this clause exist? First, it was an attempt to artificially depress the value of the stock. The reduced stock price applied to anyone who tried to transfer shares outside the family and would therefore penalize family members who tried to sell shares that had been given to them by their grandfather. The reduced value of the stock was also an effort to lower taxes—a failed attempt, in fact, since the valuation in the buy-sell agreement was not binding on the IRS. The agreement was also designed to keep ownership in the family, since transfers outside the family were effectively prohibited by the way the agreement was structured.
In most family businesses, the discovery of such an agreement could spark a crisis that at best would cause a severe delay in business planning, and at worst permanently throw the business plan off course. In this telecommunications company, however, we had already gone through the exercise of creating a risk management program that analyzed a series of “what-if” scenarios. One of those scenarios involved the steps we might take if we needed to extinguish the rights of family minority shareholders who were hostile to family members managing the business. While the scenario we had worked through centered on the death of a key shareholder, our potential solutions were applicable to this situation.
Because we had the risk management plan in place, we were able to reorganize the company and bring on private equity investors within six weeks, allowing us to meet the deadline for bidding on the divested properties. Without the plan, everything would have collapsed.
Scenario planning
When developing a risk management program for a family-owned business, it's important to create two outlines. The first takes a more linear, traditional approach to business continuity planning; it plots out options for events that can be forecast, or reasonably predicted. For example, you can pro-ject economic growth at different percentages and analyze the impact on the company, and the risk of taking on certain operating expenditures in each growth scenario.
The second outline, however, is the one that's unique to each family business because it involves issues that are not linear in nature, and are often rooted in questions of ownership and control. To plot out this path, you need to brainstorm trends, and scenarios within each trend. Instead of one linear path, you will have branches of potential paths that link back to the core.
Often these trends link back to the family's estate plan and what will happen when that plan is executed. Will the family wealth be broken up and disbursed, or maintained? Will the family keep the business or sell it? Has the estate plan effectively accounted for potential tax consequences, and how will those tax payments affect the business? Does the plan set out steps for succession that are in keeping with the business plan?
In the case of the telecommunications company, the scenarios we had initially developed were based on the estate plan of the grandfather, a second-generation owner of the business. The company managers had discovered that a clause in the grandfather's estate plan that froze the value of his stock for his own estate tax planning purposes had the undesirable effect of significantly increasing the income tax, and required distributions of cash from the company to the grandfather. Further analysis of the estate plan uncovered additional conflicts for the business that would have made it difficult to obtain the capital needed for future growth initiatives.
So we stepped back and looked at the trends affecting the family and the business. What's happening in the telecommunications industry? How is Grandpa's health? Who is going to be the next generation of corporate managers? Where is the money coming from? Do we want to keep the minority stockholders and, if not, how do we buy them out fairly? What if the IRS blows up a creative estate plan? Where does Grandpa's life insurance go?
For each of these questions we plotted out a half-dozen different scenarios, possible actions and potential impact. Some were good, some bad. Some were based on the outcome we wanted; others were based on what we feared.
Our outline allowed us to prepare for a potentially devastating circumstance that would have been difficult to predict: the existence of a buy-sell agreement that would have blocked our ability to recapitalize the company.
Proactive risk management is a process that at the outset may feel like chasing shadows. During this process family members need to envision many different events and scenarios. Most—and possibly none—of these will ever occur. Thinking about these scenarios can easily take you past your comfort zone. But if a crisis hits, it quickly becomes evident that investing the time in conducting these exercises returns major dividends to family business owners and managers.
Once a crisis is upon you, it is difficult to tap the creative resources of the business owners and managers because they are so focused on attending to the added burdens imposed by the crisis. With scenario plans in place, family members can move forward because they have already thought through potential actions and their consequences. A crisis is going to be hard no matter what, but with some thoughtful risk management planning, the family will be well positioned to manage it.
Matthew F. Erskine is principal of The Erskine Company LLC, a strategic advisory firm located in Worcester, Mass., that counsels clients on the management of unique family assets, including multimillion-dollar family businesses, numismatics collections, fine art and Americana collections, commercial and residential real estate holdings, and family compounds (www.erskineco.com).
Copyright 2012 by Family Business Magazine. This article may not be posted online or reproduced in any form, including photocopy, without permssion from the publisher. For reprint information, contact bwenger@familybusinessmagazine.com.