How can the equity succession be managed from the second to the third generation?
This is one of an ongoing series of 10 articles on this topic. This article is the seventh in the series, and follows on from Transitioning the Current Generation out of the Business, Employment and Equity in Succession to the Next Generation, Sale of the Business as an Option in the Succession plan, Succession Planning: How to Bring Non-Family Members into the Business, How to Create a Succession Plan and Understanding Business Structures for Succession & Asset Protection.
In practice, many of the problematic issues in the succession of a family business arise in the transition from second generation to third generation. The first generation may have started the business with common goals and values, watched by their children. The second generation therefore may have inherited those goals and values, and in living in close proximity may have formed a close bond. It is unlikely that the third generation of cousins will ever have lived together, as their parents did, and may have watched business tensions arise between their parents, uncles and aunts. Their goals for themselves and for their own families, may be vastly different from the original goals and values of the first generation. To prevent a divergence, it is imperative that a Succession Plan and Code of Family Business Principles, mentioned in previous articles, are put in place as soon as possible, to set out the business values and “rules” so that everyone knows what is and isn’t possible, what is expected of them, and their expectations are managed from a very early age.
The Succession Plan and Code of Family Business Principles should be clear as to how equity in the business will pass, and when
It may be that equity can only be held by bloodline relatives who work in the business, or are directors, which will assist the second generation to decide which of the third generation can hold equity. There may be provision for compulsory buy-out of shares owned by non-management equity holders, in certain circumstances. It will also depend on the structure of the business, the wishes and needs of the current equity holders, and of course tax.
If the business is a company, and if, for example, three children of the second generation are to receive equity in the business and become shareholders, and then each of their three children in the third generation are also to receive equity, and so on, the shareholder base can become unwieldy from a management perspective, and the business can become susceptible to takeover. If the Succession Plan, Code of Family Business Principles and corresponding shareholder agreement provide that equity can only be held by bloodline relatives who work in the business or are directors, this narrows the shareholder base, and shares can be offered for sale to those who work in the business or are directors, pursuant to the shareholder agreement.
The structure suggested in, Understanding Business Structures for Succession & Asset Protection, would allow distributions to be made, for example, from the Blue Sky Wines Trust to one or more of the three children in the second generation or their family trusts. After transition to the third generation, distributions from the Blue Sky Wines Trust could be made to one or more of the grandchildren or their family trusts if they receive equity. The shares in the corporate trustee of the Blue Sky Wines Trust could be held, for example, by the children receiving equity, or their family trusts, and latterly the grandchildren receiving equity, or their family trusts. Control of the Blue Sky Wines Trust truly passes with the role of Appointor, who can remove and replace the trustee, and therefore the Appointor role must be dealt with in any transfer of equity, as well as the role of trustee. If equity can only pass to bloodline relatives who work in the business or are directors, then control of the trust and distribution streams will narrow.
As for the third generation succeeding to governance roles and employment in the business, this is when the skills and experience of the next generation must be weighed against the set requirements of the available roles within the business, and the best candidate selected. A robust board skills matrix for directors, and employment policy for employees, are essential at this stage to decide who, from the third generation, is the best fit for a role in the business. Independent board members may be of assistance in the selection process and can assist in identifying further training, mentoring and development needs. In fact, the employment policy or skills matrix may specify that an individual must have certain qualifications and external experience for a particular role, and that board approval is necessary to make an offer to a family member.
Communication is Imperative
The Succession Plan and Code of Family Business Principles should be regularly reviewed. Family Council meetings should have involved the third generation from an early age. The third generation should be fully educated in the requirements to enter the business, and the business should be fully aware of, and properly managing their aspirations, so that neither the individual nor the business is disadvantaged as a result of misguided expectation. If an individual wishes to enter the business, qualification, external experience and training standards and timings should be set, and if they are not achieved, then steps must be taken by the individual to explore other avenues, and by the business to fill the role.
In the case of many family businesses, the business simply cannot financially support multiple third generation families and viable, authentic roles are not available for everyone in the family. The following aspects of the Succession Plan and Code of Family Business Principles can assist:
- Family members can only apply for authentic roles which are available within the business, not created for them;There are clear qualification, experience and remuneration criteria for each role;
- Decisions must be made on merit;
- The board are required to approve an offer to a family member;
- There is independent representation on the board; and
- Equity can only be owned by those employed by the business, or who are directors, who show commitment to the business.
The statistics are horrifying;
approximately 30% of family businesses survive in the second generation, 12% in the third generation and 3% in the fourth generation.
Clearly the first generation, who built the business to provide a better future for their children, need to give equal commitment to a proper succession process to safeguard the financial future of their children, as well as their ongoing relationships with each other.
This was originally published in Australian & New Zealand Grapegrower & Winemaker.
This article is intended as general information only. It does not purport to be comprehensive advice or legal advice. Readers must seek professional advice before acting in relation to these matters.