The transfer of business ownership from one generation to the next can be a challenging task. There are many variables and factors that require careful consideration. Who will be the next leader of the company? Who will form the executive team? How will shares be transferred? Will control be retained by the current generation until death or transferred when the next generation takes over management? Families that are serious about multi-generational ownership transfers also should consider establishing a formal governance system to facilitate share transfers among family members. Without this governance, the risk of a shareholder or family dispute increases, which will be disruptive to the both the management of the company and family harmony. This risk magnifies as the business transfers through successive generations and the ownership group comprises increasingly distant relatives.
Benefits of an independent valuation in family succession
- can be used to set the price at which family members can transfer shares, without dispute or acrimony
- holds active shareholders (i.e. those on the executive team) accountable to passive shareholders (i.e. those not involved in management) in the sense that passive shareholders can periodically assess the performance of active shareholders on the basis of value creation, or lack thereof, over time
- manages the value expectations of passive shareholders on an ongoing basis avoiding unpleasant surprises at the time of a liquidity event
- mitigates any friction that can build between active and passive shareholders of a family business
- mitigates shareholder disputes arising over the fair market value of the shares of the company if and when a liquidity event is triggered
- allows family members to opt out of the company at an independently pre-established price if the business is going in a direction that is not consistent with personal goals and objectives
Implementing an annual (or other periodic term) valuation is neither difficult nor onerous in respect of the ongoing operations of the business.
How a valuation mechanism works
- select a date at which the annual (or other periodic term) valuation is to be determined
- select a defined period during which shareholders can offer their shares for sale to other shareholders. This period should terminate prior to the date on which the next valuation is to be completed
- define a process by which any shares for sale can be acquired by other shareholders (i.e. if more than one shareholder is a buyer, how the shares get allotted between the buyers)
- determine whether the corporation can be a potential buyer if a shareholder wants to sell shares but no other shareholder wants to buy
- consider whether it is appropriate to limit the percentage of shares that can be transacted in a given year. Setting a limit may be appropriate, especially if the corporation is a possible buyer of shares. A limit mitigates against the risk of over-leveraging the corporation to fund a share purchase
Other logistics to consider
- depending on the size and complexity of the business, budget 4 to 6 weeks for the valuation. If there is more than one business within the family holdings, more time may be required
- it may be valuable to form a special committee on the board of directors of the company (preferably an independent committee) to be responsible for the valuation process and the ultimate acceptance of the valuation. Potential conflicts of interest and any perception of bias in the valuation process are best avoided by having non-family members govern the valuation process
- distinguishing between compensation for management effort and return on capital is important for family harmony. This means salaries and bonuses for active shareholders ought to be set at market rates. The amount by which any such compensation exceeds market rates is a return on capital and ought to be shared proportionately by all shareholders, both active and passive
- consider an annual presentation of the valuation by the valuer to all shareholders and the next generation of family members (at the right age). This type of presentation enhances transparency and family harmony, and also provides an open forum for the next generation to gain insight into the family business from a valuation perspective. Such presentations also assist the current generation in their assessment of potential business leaders arising from the next generation of family shareholders
Multigenerational family succession requires ongoing and continuous value enhancement. For this reason, family business owners ought to consider the implementation of an employee stock option plan (ESOP). Such plans reward non-family executives when value is enhanced. As such, the interests of non-family executives and shareholders become aligned. An annual valuation can serve two purposes for the price of one: (a) to set the value at which shares can be bought and sold among shareholders; and (b) to set the amount of stock options to be issued to management annually and the setting of the strike price at which those options can be converted into shares or so-called phantom shares. Stay tuned for future blogs on ESOPs.
Families serious about succession need to consider more than just who will be the next leader of the family business. Systems need to be put in place to ensure the fair transfer of shares, with mechanisms that ensure shareholder liquidity can be achieved without business disruption or family disharmony. Independent valuations serve this purpose as they ensure all family members, both active and passive, fully understand the fair market value of the business.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.