What could be easier than transferring your family business to its natural successor, your heir apparent, your offspring? If some of your first guesses were peace in the Middle East, bi-partisanship in Congress, or the Chicago Cubs winning the next World Series, like me, you have probably witnessed your share of family business transfer disasters.

Statistics, widely quoted by estate planning writers, indicate that "only" one-third of all family-owned business are passed on to the second generation, and "only" ten percent of family-owned businesses are transferred to a third generation. Experience indicates that those statistics are wildly optimistic and overstated. My pessimism notwithstanding, some family businesses are indeed successfully transferred to younger generations. For the transfer of business ownership and control from parent to child to be deemed "successful" the parents must achieve all their exit objectives, including:

• Financial independence and security, completely divorced from reliance on cash flow from the business;
• Intra-family fairness regarding distribution of family wealth and businesses; and
• Complete transfer of business operation and ownership control to the younger generation. This usually means the parent is out of the business and is not needed in the business for any reason.

This article describe the challenge: if it is so difficult to successfully transfer a business from one generation to the next, is there a way to improve the likelihood of success? Better yet, is there a no fail "recipe?"
In the checkered, but always interesting, history of nepotism (as it relates to business transfer) we find that parents hope a child will take over a business for several reasons:

• The joy of working together. (At least that's what some owners claim.)
• Greater employment and financial security for family members than that available elsewhere.
• Maintenance of the family's focal point - the business. Parents see the business as the "glue" that helps the family stick together.
• Fulfillment of a childhood dream. The child(ren) has grown up in the business, knows it, and wants to stay in it by acquiring ownership.
• Gradual retirement. The owner can stay semi-active in the business by gradually turning over operations and ownership to the new generation.
• Family pride. The owner takes considerable (and often justifiable) pride in continuing a family business and tradition.

Doesn't this all sound great? It is great, but all too often your hopes and aspirations crash headlong into the brick wall of reality.

• The children, for lack of a more elegant phrase, don't get along with each other.
• The children have substantially different career goals.
• The parents need to achieve financial security before feeling comfortable transferring a business to children. The children, on the other hand, desire significant ownership sooner, rather than later.
• The children simply don't have the same desire, ambition, or aptitude for running the business as the parents.

All business transfers are challenging yet family businesses face significant obstacles. Despite this, it is indeed possible, given the right circumstances, to successfully exit the business by transferring it to your children.
There is a "recipe" for creating a successful intergenerational transfer. It isn't the only recipe that works, but because it depends on six carefully chosen ingredients, its chances for successful completion are greater than others.
There is a "recipe" for creating a successful intergenerational transfer. It isn't the only recipe that works, but because it depends on six carefully chosen ingredients, its chances for successful completion are greater than others.
If any of the following six ingredients is compromised, or worse still, missing, the result will change.

Ingredient 1: Owners Must Undertake The Seven Step Exit Planning Process

Just as baking bread at sea level is not the same as baking at high altitude, this is not a "one size fits all" recipe. Regardless of altitude, bakers use flour, yeast and water but quantities, temperature and cooking time vary. So too, the recipe here may need to be adjusted to your specific circumstances.
All business sales or transfers are challenging, but owners wishing to transfer their businesses to children often find themselves in the middle of their own Desert Storm: your spouse, children (and their spouses) all have opinions about how you should exit and they are not afraid to share them!
If you find yourself in this position, we have one suggestion: get off the rollercoaster. Undertake the process that all savvy owners use to plan a successful exit: The Seven Step Exit Planning Process. In your case, the Process will enable you to craft your exit and take into account the concerns of all family members. Believe it or not, this Process can integrate all points of view into a single, unified strategy. It organizes your priorities and can be easily modified (as illustrated in red below) to reflect additional considerations unique to family business transfers.
Here is that process:
Step One
You may have a number of Exit Objectives but you should establish, at the outset, at least these three:

• How you (and your spouse) define Financial Independence;
• How you and your spouse define "fairness" regarding distribution of family wealth (including the business) among children;
• When you (and your spouse if active in the business) want to leave the business and transfer control according to a timeframe you set.

Step Two
In addition to knowing what you want, you must know what you have (the value of your company) before you can plan your exit. In the transfer of a family business, not only must business value be determined but the business-active child's (BAC's) contributions must be considered. Often parents reduce business value by the amount of the BAC's past contributions so that he or she does not pay for his or her contributions to value. Also, a current value can be used as a base so that any future growth in value (if not due to the active-parent's efforts) is typically attributed to the BAC. Again, the purpose of this is to keep the BAC from paying for his or her own "sweat equity."
Step Three
Once you know what you want (Step One) and what you have (Step Two) you must think about how you can motivate key employees (including the BAC) to increase the value of the company and remain with the company through the transition.
Step Four
Step Four is a transfer to an outside third party so it does not apply to family business transfers.
Step Five
In this Step, you design the transfer ownership to your business-active child (and possibly some key employees). This is often accomplished through a combination of gifting and sale, depending on your financial needs and other wishes.
Step Six
It is critical to make contingency plans for what will happen if the business-active parent dies before the transfer can be completed. For example, should the business-active child receive the business via a buy-sell agreement or bequest at death? Should ownership first transfer to the surviving spouse before an ultimate transfer to the BAC?
Step Seven
All owners undertake Wealth Preservation Planning but this Step is absolutely critical in the transfer of family companies. It is through estate and gift planning that parents provide for their non-business active children. The considerations in this Step involve a balancing of the fairness issues that arise in every family transfer.

Ingredient 2: One Child Shall Succeed In Business Ownership

It is easy to recognize those business owners who have dedicated their lives to ensuring a successful transfer of a family-run business - they have but one child.
There are two possible ownership scenarios for families having more than one child. The first is that more than one child is active in the business. In that case, the predominant issue is to determine how multiple children are to share the control and ownership of the company. The second is having one business-active child and one or more children inactive. The primary concern in that case is to give the business to the active child while being fair to everyone else (Ingredient Two).
Owners in the first situation must ask themselves, "How can children who couldn't share a ninety-eight cent toy when they were younger now share the ownership, management, and control of a successful, multi-million dollar business enterprise?"
Forcing children to work together ordinarily creates an unnatural coalition of differing talents and desires, united only by bloodline. Contrast that situation with business partnerships that do work: two or more individuals enter voluntarily into a business arrangement for their mutual benefit, each contributing experience, talent, and perhaps money. In return they each receive an agreed upon, negotiated, ownership interest in the business - a proportion they agree upon, not a proportion given to them by someone else. Further, they are likely to have similar goals, aspirations, drive and ability. Desire for business success brings them together, not family ties.
Family ties of a different sort can also create dissension and discord. Adult children who, years before, found sharing a toy difficult (if not impossible) because of sibling rivalry now find another relative introduced into the mix: their spouses. The influence of a spouse on a child's business decisions is similar to the influence gasoline has on fire. Whether the son- or daughter-in-law becomes active in the business or simply offers observations, an already warm brew can begin to boil. For this reason, co-ownership among siblings is rarely permanent, especially once the parents are out of the picture.
Look at this issue another way. As a business owner, you know many other owners. How many of them share ownership equally with a brother or sister?
In many family-run businesses, a parent did once co-own the business with one or more brothers or sisters. Over the years, however, those siblings dropped out or were bought out of ownership. It would seem that co-ownership just doesn't work for most families. It's unlikely to work for yours.
This second ingredient - transferring the business to one child - must now be blended with the quest for the third: fairness to all children.

AFTERWORD

If at this point you still wish to attempt a transfer to more than one child there are several business characteristics that will increase your limited chances for success.

• Each child views business success through the eyes of the family, and each of its members, rather than through his or her own eyes.
• One child has effective day-to-day control over the business operation. Usually control is granted to that child, not because of stock ownership, but because of the child's experience and leadership abilities.
• The business is large (and profitable) enough to support all children and give each child a separate area of responsibility.
• Each child's salary is based upon job description and performance.
• Children have been active (alongside parents) in the business long enough to make each child comfortable with the role each play within the business.
• Alternatively, the business must be large enough to be considered an investment (mature, solvent, stable, usually run by non-family managers as well as one or more children, and sufficient cash flow to handsomely reward the business-active child while providing an income stream to other children who are simply passive investors).

Ingredient 3: Being Fair to All Children

Most parents have a natural inclination to distribute every asset equally to all children. The thought of giving one asset, and very likely the most valuable asset, to one child is considered unequal and, therefore, unfair to the other children.
Yet, upon closer examination, leaving the business entirely to the business-active child (BAC) and making an equitable distribution of the balance of family assets to the inactive children (and perhaps to the BAC as well) is the fairest plan of all.
"Fairness" in this context is usually a judgment parents make about what they think is fair to the children. What it overlooks is what the children deem to be fair to each of them. This perspective is all too often missing in family transition planning. To determine what is fair, assume the point of view of the business-active child and then that of the inactive child.
Let's look at why the business-active child might well resent having a co-owner sibling who is inactive in the business. Perhaps one of these reasons applies:

• It is the efforts of the business-active child to increase the value of the business that should be rewarded. You probably offered all of your children an equal opportunity to participate in the business and become owners. Yet, only one child seized that opportunity. Why force your most ambitious, risk oriented child - the one who chose to succeed you - to share the rewards with children who chose different career paths?
• You had no co-owners in the business because you wanted to operate the business independently. As an entrepreneurial "chip off the old block," your child doesn't want to share ownership any more than you did.
• The controlling vote is not enough! When there are co-owners, the child running the business has a fiduciary duty of due care and loyalty to all other shareholders. That means that the business-active child's actions, such as giving herself a bonus, or increasing her own salary, or indulging in other business "perks" (as you do), must all be reasonable and comparable to what a non-shareholder performing the same duties for the company might reasonably expect. I doubt you would subject your compensation and perks to the same level of scrutiny.

And what about the inactive child's perspective? Inactive children are unlikely to want ownership in the business, if other choices are available.

• Inactive children generally prefer to own, or receive, assets that are more liquid and less risk-oriented than ownership in the business. This is usually true even if they have to wait until both parents die to receive their inheritance.
• If the inactive child owns part of the business, have they received anything of real value? Partial business ownership will make the inactive child the proud owner of an illiquid security that generates no immediate income or other benefits. Further, the inactive child has no ability to sell his interest, except to the business-active child. Yet, that's hardly a problem since the active child won't, in all likelihood, have the money to purchase it. And, if he does, the business-active child's idea of fair market value is likely to differ dramatically from that of the inactive child. Congratulations! You've created your own Cain and Abel!
• It would seem from the above point that the inactive child's ownership interest would have little value. The (now friendlier) IRS begs to disagree. While a non-controlling ownership interest can certainly be discounted in value, it will nevertheless rise in value as the overall business value increases (due to the efforts of the business active child). Because it is difficult for the inactive child to get rid of the ownership, he or she has to deal with the tax consequences.
• And one last thing. Keep in mind that the inactive child will not be able to make any decisions regarding the future course of the business.

If only one child should own the business, how do you find the second ingredient - fairness to all children - when transferring the business to the business-active child and other assets to the inactive children? Obstacles to a fair transfer of assets include:

• The business value may be significantly greater than the combined value of the remaining family assets.
• If part of the business value is attributable to the business-active child's efforts, is it not fair to consider that part of the business to be that child's interest now? How do you determine the active child's contribution to existing business value?
• And let's not forget the timing issue. It makes good business as well as income and estate tax sense to transfer a significant amount of the business during your lifetime to the business-active child. The inactive children, however, will not likely receive their "share" of the family wealth until after you and your spouse die. The reason for this is simple: the non-business assets are usually retained by you to provide income and financial security to you and, after your demise, to your spouse. The resulting timing difference is mitigated by the liquidity difference in the assets the children receive. The business-active child may receive assets now but his assets are highly illiquid and subject to business risk. The inactive children may have to wait but the assets they receive will be highly liquid and relatively risk-free.
• In addition to the present difficulty of distributing business and non-business assets equally, there is an added complexity of measuring the current value of the business interest given to the business-active child against the future value of the bequest given to the inactive child. To understand the present vs. future value conundrum consider the following:

• Is the business-active child, in effect, paying for the business now through "sweaty-equity" (lowered compensation, more working hours, and greater risk)? If so, the current gift is not really a gift, but recognition of that child's efforts.
• Is the business-active child adding to the business's value through his or her efforts? If so, he should not have to pay for that effort by receiving a reduced share of the ultimate estate.
• Has the active child (by continuing in the business after your retirement) become a critical element in your retirement plan by ensuring that the business can pay you any deferred compensation and purchase your stock? If so, the means by which you tie her to the business - the golden handcuffs - may be the transfer of stock. Again, acquiring stock because it benefits you should not penalize the business-active child when it comes to sharing in the estate.
• Is the business active child paying for part or all of the business?

How can one possibly find the correct measure of this ingredient?
For most families, the decision ultimately comes down to a discussion of fairness vs. equality. Because the difference in contribution to the business and differences between assets being gifted (business vs. non-business and consequent timing difference) it is imperative to be equitable or fair in treatment, not necessarily equal. Parents must strive to be fair. They must communicate and explain this strategy to all of the children. Often it is best to hold a family meeting using advisors to facilitate the discussion.
Finally, be certain to make appropriate adjustments in your will, trusts and buy-sell agreements to apportion assets if your lifetime transfers of the business and other assets are not completed before your demise. As part of those documents, the business active child should have the right to have her share of your estate consist of business interests while the remaining children have the right to have their portion of the estate satisfied with other interests.

Ingredient 4: Parental Financial Security Trumps All

Parental financial security and independence precedes any transfer of ownership and control to the business-active child.
For most owners, the business is the primary source of wealth and income. If this is true for you, you should have all of the desired cash in the bank before you transfer control and ownership.
Financial security comes in three basic varieties: those who have it; those who know how to secure it; and those who have the means to obtain it.

• Those who have financial security can afford to receive less than full fair market value for their businesses. They have typically attained financial security by investing excess earnings outside the business during their active years.
• Those who know how to obtain financial security commonly purchase assets outside of the business, and lease those assets back to the business for use. Assets purchased for lease typically consist of office, warehouse/manufacturing facilities, or equipment used by the business. Keeping these types of assets outside the business lowers the value of the business, thus easing its transfer to the active child by incurring less transfer (gift or estate) taxes. Keeping assets outside of the business also makes those assets (or wealth) available for transfer to the inactive children. Finally, keeping assets outside the business protects them from future creditors of the business after the parent has left.
• Those who possess the means to achieve financial security are able to sell their businesses for cash to the business-active child. A business owner should not consider, even for a moment, transferring control, either operational or ownership, before financial security has been achieved. If an owner wishes to leave the business before accumulating enough wealth to be provided with sufficient independence, then it is incumbent upon the business-active child to obtain financing in order to pay sufficient cash for the ownership interest.

As a business owner, you must determine which flavor of financial security suits your palate. Keep in mind that even if your financial security does not depend on receiving full market value for your business, you must either insist upon it or accept the fact that by accepting less you are giving away at least a part of the business. Once you start giving things away the fairness issue crops up. If you don't handle these fairness issues through your estate planning documents, your recipe has become, at best, unpalatable to some of the children.

Some of you may have noticed our definitions of financial security did not include selling a business, over time, for little or no cash to the business-active child. Although this course of action is all too common, it is fraught with peril and usually doomed to failure. At the outset of this article, we established that we would provide only successful recipes; hence, the omission.

Finally, those parents who sell the business for cash to the business-active child must begin the transfer process before they begin retiring. Under the best of circumstances, the modified cash method requires that the "pump be primed." A child must receive significant ownership before acquiring the balance of the company for cash. If the transfer is to occur over an extended period of time, it is vital that parents retain ultimate control as well as subject the stock transferred to the child to a buy-back agreement should the child leave for any reason. Also, in this agreement the parent will want to be obligated to repurchase any interest from a business-active child so that, if he or she chooses not to complete the buy-in process, you can execute your back-up plan.

Ingredient 5: The Chosen One is Ready, Willing and Able

The chosen child MUST demonstrate the capability and willingness to run the business for a significant time period (at least three years) before the parents leave.

How does a parent know whether a child is capable and willing to run and own a business? One of the best indicators is the parent's past willingness to take extended vacations without calling the business to just "check up on things." Of course, handling day-to-day issues does not tell you if the child is capable of being a long term owner who can handle larger issues of growth, future competition, and economic down-turns. Your job is to prepare the child for future business risks as you would any key employee: with training, responsibility, education and example. It is at this point that the assistance of advisors can be most valuable.

Ingredient 6: Having a Plan B

As one assembles and prepares the ingredients for a recipe, any number of things can go wrong. So it is too with an intergenerational business transfer. That is why having a back-up plan is crucial. Let's look at the most common causes for employing your "Plan B."

• If you die or become incapacitated before the transition is complete, your estate plan (wills and trusts) must effect the transfer of the business to the child(ren) of your choice.
• If the business has increased in value to such a point that a buyout by a child is just too difficult financially, you must be prepared to offer the business for sale to a third party.
• Even if your child is able to purchase your highly valuable business, you may not be able to provide assets of equal value to your other children. Remember that fairness is a crucial ingredient for a successful transfer.
• Similarly, some businesses become too complex or too sophisticated for any one person to run and control. No child can be expected to shoulder that burden successfully. In this case, a better alternative is to sell to a third party (although professional management is a possibility.)
• As time passes, you may discover that the business-active child does not possess the drive or interest to carry the business. His or her desire to please you may have blinded you to his lack of ability or willingness to assume the risk. Or, he may also not have fully understood the personal and financial sacrifices necessary to continue the success of the business. Again, a sale to a third party may be a better option.
• Finally, as parents and child move through the transfer process, substantial differences in management style and practices emerge. Sometimes these differences can be overcome but often they are so great that the transfer cannot be completed. It is imperative that if the transfer falters, the business-active child's ownership interest be reacquired by the company at the lowest defensible price. This is best accomplished through binding buy-back agreements between the company and children.

For all of these reasons, it is important that a back-up plan exist. If the business transfer goes awry you must have a "Plan B."

Conclusion
To increase your chance of successfully completing an intra-family transfer you must focus on the six ingredients shown below.

• Engage in the Seven Step Exit Planning Process™ modified for family business transfers.
• Choose one child as successor, with exceptions as noted.
• Be fair to all children.
• Ensure financial security for you and your family.
• Have the child demonstrate ability and willingness to run the business.
• Create a clearly-understood back-up plan.