Matters Column

Preparing the next generation to purchase the business

November 10, 2012
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West Michigan has a rich tradition of successful family-owned businesses, and ensuring they pass from one generation to the next is often very challenging but important to the future of our local economy.

There are a number of challenges that may prevent the next generation from being successful. Obstacles like proper business acumen, work ethic, an understanding for the business, respect from peers and employees, and the complicated family dynamics that can impact managing a family-owned business (imagine discussing the next big project over Thanksgiving dinner) are all common challenges family business owners face when they decide they want to sell their business to the next generation.

One of the obstacles that is often overlooked and is commonly dealt with by the business’s banker is preparing the next generation financially to purchase the business.

The meetings are quite common. Picture mom and dad coming into the bank with their chosen next-generation purchaser. They outline for the banker the plan that has been carefully discussed over the last few weeks. They have decided to retire at the end of the year and, as part of that retirement, they want to sell a large portion or all of their business to the next generation. They would like to meet with their banker and discuss what they need to do in order to borrow the money that is required for the transaction.

This is a very typical meeting and conversation for a banker. Sometimes the planning and preparation have been thorough and this meeting was expected. Unfortunately, this request often comes with no preparation and can jeopardize the ability to complete the sale, slowing down or even stopping the plans to retire for mom and dad.

How do you prepare for selling your business to the next generation and facilitate the retirement you have worked so hard to achieve over the years?

Communication is the key. The dynamics in a family business are usually complicated, but the earlier you can communicate to the next generation what your plans are the better. The plan should involve your attorney, CPA and insurance agent, in addition to your banker. Planning a minimum of three years in advance would be my recommendation, and involving your professional team in the process is critical.

Financially, the next generation needs to be ready to take ownership of the business. Have they developed a relationship with the banker? 

It’s important to involve the next generation in the financial matters of the business, including meetings with the banker prior to actually asking the bank to finance the next generation. It takes time to develop a relationship, and this will be critical for the banker.

The most common way to finance the sale and transition of the business to the next generation is by leveraging the business. This often has a large, unsecured component to the loan structure, and the banker is going to be asked to believe in the ability of the next generation to manage and run the business.

The success of the business and, ultimately, the repayment of the loan depend on the ability of the next generation to successfully take over and run the business. If the next generation has built a relationship with the banker over a period of time, the banker will be more inclined to believe in the abilities of the next-generation owner and, as a result, help with the bank financing.

Is the next-generation owner financially sound? Too often the next-generation owner has been earning a base wage in the business and hasn’t developed a sound financial picture. Proper financial planning for the next generation will provide enough personal income to demonstrate sound financial decisions. Next-generation owners should develop a growing net worth with good savings, maintain excellent credit history, and be ready with liquid assets to inject into the business or the purchase when the time is appropriate. 

As the new owner, they will most likely be required to guaranty the loans personally, and that guaranty should provide some substance. For example, they may be asked to pledge equity in their residence as additional collateral. If next-generation owners haven’t developed a sound financial base as employees of the family business, their ability to be a borrower and purchase the business will be limited.

As sellers of the business to the next generation, you also need to be prepared to provide some seller financing and/or personally guarantee the new bank loans for a period of time. The bank will appreciate your willingness to delay some of your payment and stay committed to the business, at least until the next generation has demonstrated an ability to successfully manage it.

Preparing the next generation to purchase the family business is critical, and it starts with communication. Discuss the future plans with the next generation and be sure to involve outside professionals through the process. If the next generation has had time to build a relationship with the banker, save money, develop a sound personal financial base and benefit from seller financing and/or the personal guarantee of you as the seller, they will increase their opportunity for bank financing.

Family-owned businesses are critical to the economic success of our economy, and proper financial planning will help your business successfully pass to the next generation.

David H. Kinsman is vice president of commercial lending at Founders Bank & Trust.

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