Liquidity Planning for Family Business Owners

Depending on your perspective, certain statistics can be either depressing or instructive; a glass half-empty/half-full kind of thing. Well, consider these: While nearly 80 percent of family business owners want to pass their business to the next generation, only about a third of family businesses make it through the second generation. By the end of the third generation, only 12 percent will be family-controlled, shrinking to 3 percent at the fourth generation and beyond. The remaining family businesses either go out of business or are sold.¹ While there are many potential reasons for the disconnect between what family businesses want (continued family control) and what typically happens (failure of continued family control), one of the major reasons for this disconnect is the failure to plan for the personal liquidity needs of the family business owners. According to the 2007 Laird Norton Tyee Family Business Survey,² an astonishing 93 percent of family business owners depend on the family business as their primary source of income. This lack of outside liquidity, particularly during times of generational transitions (for example, the need to pay estate taxes on the death of a major shareholder), can have devastating effects on a family business. Under the worst of circumstances, it can result in a fire sale of the business. Fortunately, through proper planning, these liquidity risks can be mitigated, allowing a well-run family business to prosper and thrive into the distant future. 

Before we dive into planning strategies to provide liquidity for family business owners, it’s important to note that there are sometimes very sound business reasons for a family business to be sold.³ Let’s focus here on how to avoid having to sell the family business for a bad reason—the lack of personal liquidity of one or more owners of a family business.

Identifying the Problem

Although there’s a dearth of good advice on liquidity planning for family business owners, one excellent source does exist: Financing Transitions: Managing Capital and Liquidity in the Family Business by François de Visscher, Craig Aronoff and John Ward.⁴ The book uses “The Family Business Triangle,” p. 33, to illustrate why family businesses are fundamentally different from non-family businesses (particularly publicly traded companies). The triangle exhibits the inherent tension between the need to invest in the future of the business to remain competitive versus the need to provide family business owners adequate liquidity to maintain their lifestyles and satisfy large obligations, like the payment of estate taxes or a divorce settlement. If a business is to remain family controlled, the balance between the liquidity needs of the family and the capital needs of the business must be properly managed and planned for. When the balance shifts towards increased family liquidity (for example, excessive dividends and other corporate distributions to shareholders), capital investment in the business declines, resulting in the loss of competitiveness and ultimately, the decline or sale of the business. These risks increase as the business passes through the generations, and there are larger numbers of cousins who barely know each other and aren’t active in the business. When the non-financial reasons for being a family business owner (such as tradition and family pride) dissipate to the point where the glue is no longer there, certain family members will view the business as just another illiquid investment and will either want increased distributions or a sale to diversify their assets. This is why, particularly as family businesses move to the third generation and beyond (cousins’ consortium), when there are numerous family members who aren’t active in the business, the family and the business need to focus on planning for liquidity in advance of a shareholder’s need, as well as to put in place proper governance procedures allowing for financial transparency and non-active shareholders’ involvement (such as a seat on the board). 

Basic Blocking and Tackling

When the stakes are as high as a fire sale of a family business, planning in advance of a liquidity need is crucial. Fortunately, there are many best practices that family business owners should consider to mitigate the risks of a personal liquidity emergency. These include:

• Wealth management. There are three legs to the wealth management stool: investment planning, financial planning and estate planning. If one of these legs is missing, the stool falls down. Given the risks of inadequate shareholder liquidity to a family business, each owner, with the encouragement of the family business, should focus on the three elements of wealth management. 

• Investment planning. Financial literacy is crucial for long-term liquidity planning. Understanding how markets work and the importance of diversification and proper asset allocation helps a family business owner understand that it’s important not to be solely dependent on the family business for income. Family businesses fail. It’s much safer to build a nest egg outside of the business that can be invested with the help of a professional investment advisor. Such outside savings can grow over time and provide for liquidity needs as well as the peace of mind that comes with not having all of your eggs in one basket.

• Financial planning. Analyze whether your client is on track to meet his financial goals and future cash flow needs. Typically prepared by a financial advisor or CPA, financial plans act as a roadmap for dealing with future financial needs. Is your client saving enough? Does he have adequate life insurance for income replacement and estate taxes? Is he financially prepared for a long-term incapacity? Answering these questions in the affirmative or setting a course to be able to meet these needs can help solve shareholder liquidity needs without relying on the business. A particular focus should be placed on funding for retirement. Is the shareholder saving enough, both through qualified plans and other means? If a shareholder is active in the business, should the company consider establishing a funded deferred compensation arrangement?

• Estate planning. Proper estate planning over a long period of time can reduce estate taxes significantly. Taking advantage of valuation discounts for gifting, along with, or in conjunction with, techniques like grantor retained annuity trusts and sales to intentionally defective grantor trusts can be highly effective in moving assets to the next generation in a tax-efficient manner, thereby reducing estate taxes for the senior generation and providing additional liquidity to the junior generation. Effective estate planning should also consider the role life insurance can play in providing liquidity to pay estate taxes and to buy out the shares of a deceased shareholder. If possible,

ownership of the insurance should be held in an irrevocable trust, so that it won’t be included in the deceased shareholder’s taxable estate. Another benefit of proper estate planning in reducing liquidity risks is that the senior generation can take advantage of making annual exclusion gifts ($14,000 in 2016) to the next generation to defray liquidity needs, as well as to pay children’s and grandchildren’s tuition and medical costs without gift tax consequences by paying such expenses directly to the provider. A final benefit of good estate planning is that large blocks of shares can be placed in irrevocable trusts with professional trustees that can work with the company regarding shareholder’s distributions. 

• Buy-sell agreements. This is a contractual arrangement providing for the mandatory purchase (or right of first refusal) of a shareholder’s interest, by: (1) other shareholders (in a cross-purchase agreement), (2) the business itself (in a redemption agreement), or (3) some combination of the shareholders and the business (in the case of a hybrid agreement) on the occurrence of certain events described in the agreement (the so-called “triggering events”). The most important of the triggering events is the death of a shareholder, but others include disability, divorce, retirement, withdrawal or termination of employment or bankruptcy of a shareholder. 

• A buy-sell agreement’s primary objective is to provide for the stability and continuity of the family business in a time of transition through the use of ownership transfer restrictions. Typically, such agreements prohibit the transfer to unwanted third parties by setting forth how, and to whom, shares of a family business may be transferred. The agreement also provides a mechanism for determining the sales price for the shares and how the purchase will be funded (for example, life insurance on the deceased shareholder or a long-term promissory note or a combination of the two). A properly drafted and funded buy-sell agreement can go a long way in alleviating major liquidity needs of a family business owner. 

• Premarital planning. You can mitigate the risk to the business of a shareholder’s divorce in a few ways. A properly drafted prenuptial agreement should be protective in the case of divorce. If your client can’t obtain one, or even if he can, it would be prudent for the client to place any gifted shares in a discretionary irrevocable trust (for the benefit of a child or grandchild getting married or in a bad marriage) with an independent trustee and proper spendthrift provisions. Properly drafted, such a trust should be highly protective in divorce. A trust set up by a shareholder for himself (a self-settled trust) and funded with company shares has little protection in the case of a divorce in most jurisdictions, although some states’ laws (for example, Delaware and Nevada) may provide protection, particularly if the trust is established prior to the marriage. 

Inside Sources of Liquidity 

In addition to the basic blocking and tackling already discussed, it’s crucial for family businesses to consider what forms of liquidity are available to shareholders from within the business. Some of the ways that family businesses can provide liquidity to shareholders are: 

• Dividends. To shareholders, these are by far the most common way that family businesses provide regular liquidity to owners. While a dividend policy that doesn’t interfere with the company’s capital needs is prudent, one that does is fundamentally imprudent and could put the business at risk. It’s a delicate balance, but financial transparency and proper communication by the business to shareholders can go a long way in keeping shareholders informed of any bumps in the road that may impact dividends. 

• Annual redemption plan. If the business can afford to set aside a portion of its cash flow each year to redeem shares, this can help deal with disgruntled shareholders, particularly minority shareholders who aren’t active in the business. 

• Installment sales. Pursuant to the terms of a buy-sell agreement, there should be a process whereby shareholders who want to sell can go to the company or to the other shareholders and sell their shares at a set price for a long-term promissory note. Such a process gives shareholders who want to sell a set of rules to follow. 

• Loans to shareholders. Under certain circumstances, the family business may want to consider making loans to shareholders collateralized by their shares. Such a policy can help deal with a shareholder’s short-term cash flow needs. 

• Employee stock ownership plans (ESOPs). An ESOP is a qualified defined contribution plan that invests primarily in the company’s stock. It’s basically a profit-sharing plan that permits employee ownership of some or all of a company’s shares. Although complex to structure and administer, an ESOP can serve as a tax-advantaged vehicle for providing liquidity to business owners while still, under certain circumstances, allowing the family to control the business. 

Outside Sources of Liquidity 

Although most family business owners try to avoid looking outside the family or the business to satisfy shareholder liquidity needs, sometimes, particularly in a large multi-generational family business, it’s necessary. Some of the sources of outside liquidity include: 

• Outside debt. Third-party borrowing by a family business is often necessary and effective to permit the business to grow. Taking on outside debt to buy out a shareholder is potentially detrimental to the success of the business. It’s far better, if possible, to provide the selling shareholder with a long-term promissory note from the corporation or another shareholder. Private debt is typically far more easily negotiated in a default situation than bank debt. 

• Sale of assets. Sometimes, it’s prudent to sell certain business assets, including real estate, to provide shareholder liquidity. If the assets aren’t necessary to execute on the company’s core business strategy, a sale shouldn’t be a problem. Selling assets that are core to business strategy to satisfy shareholder liquidity needs should be avoided, if possible. 

• Selling equity. A family business owner sometimes deems it necessary to take on outside shareholders to provide liquidity. When doing so, it’s crucial for the business to understand the goals of the outside purchaser. What kind of income stream does the outside purchaser want? What’s the time horizon for holding the shares? Typically, the best match is a family friend, a family office or another family business. The goal is long-term patient capital. In recent years, private equity firms have taken an interest in investing in family businesses, typically purchasing equity or providing mezzanine debt. These firms bring management and industry expertise that can make the family business more effective. One concern with private equity funds is that they typically like to be able to liquidate their investment over a five to 10-year period.    

Endnotes

1. Family Firm Institute, Inc., Global Data Points, www.ffi.org/default.asp?id=398. 

2. “Family to Family 2007,” Laird Norton Tyee Family Business Survey, www.familybusinesscenter.com/public/files/resources/laird-norton-tyee-survey-2007.pdf.

3. See David Thayne Leibell, “Selling the Family Business,” Trusts & Estates (March 2015), at p. 25, wealthmanagement.com/family-business/selling-family-business.

4. François de Visscher, Craig Aronoff and John Ward, Financing Transitions: Managing Capital and Liquidity in the Family Business. 

—This article provides general information on the topic discussed and is not intended as a basis for decisions in specific situations. The views expressed herein are those of the author and may not necessarily reflect the views of UBS Financial Services Inc. UBS Financial Services Inc., its affiliates and its employees are not in the business of providing tax or legal advice.