Business, Too Close To Home

By Laura Koss-Feder

For Paula Marshall-Chapman, 47, CEO of the Bama Companies, a $140 million Tulsa, Okla., frozen-dough-and-pie concern that started in her grandmother's kitchen in 1927, the road to success has been studded with familial potholes. When Marshall-Chapman took over from her father in 1984, her two brothers were furious that they would not be involved in running the show. The business was changed from a corporation to a partnership, with Marshall-Chapman named general partner. Her parents Lilah and Paul Marshall took their equity out of the business to live on. The structure of the general partnership left the business strapped for cash, and for the first time, Bama was forced to take on debt and cut back on its distribution network.

"My father saw me as the most likely person to take over the business," says Marshall-Chapman, and she hasn't done badly at all. Bama employs 750 people and has about a 10% annual growth in revenues. But she acknowledges that "my brothers were shocked that they weren't going to be as involved in the business. If we had all just sat down and discussed everyone's needs and expectations, we might have been able to structure things differently and without such hurt feelings." Marshall-Chapman is in the process of buying out the minority shares of one of her brothers, and time has healed some of the wounds in the family.

For Marshall-Chapman and the other owners of nearly 13 million family-owned businesses in the U.S., the decision about how to pass the corporate torch gracefully to the next generation is an exercise in reason over emotion, usually coupled with legal wrangling and considerable financial finesse. From the elder generation's point of view, you want to make sure you will be taken care of in your golden years. At the same time, the business must be passed on in a way that helps ensure both its continued success and the financial welfare of the younger generations who rely on the venture to pay the bills. The longer a business stays in a family, the harder this becomes. Companies passed on from the first to the second generation have a 40% chance of surviving, second to third generation have a 15% survival rate, and the number dwindles down to 1% from third to fourth generation, says John Messervey, principal consultant with the National Family Business Council, a consulting-and-research group in Lake Forest, Ill. Compounding all this is the fact that as many as 25% of senior family-business shareholders do not complete any estate planning other than writing a will, according to the Family Firm Institute www.ffi.org) a Boston-based association of family-business consultants, financial planners and lawyers.

The most important missing ingredient is usually a strategy. "An entrepreneur needs to figure out years in advance to whom in the family a business will be passed down and why--a major decision that can have so many mixed emotions and feelings attached to it," Messervey says. "Had we known my brothers' feelings more about the business, we might have avoided having their feelings hurt," says Marshall-Chapman. "These are very sensitive issues for families."

Realistically, the older generation should have a written succession plan by the time they are in their 50s, especially if adult children have been working in the business, says Michael Fay, senior partner and estate-planning attorney with the law firm Hale and Dorr in Boston. The plan should offer guidelines for the transfer of ownership if one member of the family wants to sell his shares. This usually involves a right of approval by the remaining owners coupled with a right of refusal to buy out a sibling or other family member before a portion of the business is sold. The elders should also make some dispassionate judgments as to which of their offspring has the skills and experience to take over. The designated CEO should then be given voting control of the business. Owners should never assume that each of their children will have the same role in the company. Each family member needs a definitive title and written job description. "There should be a logical, sensible employment-and-promotions policy, no matter what size the company is," Fay says. "Junior should not automatically have a job at the company."

Another pitfall to avoid is the often made assumption that all children want to follow in their parents' footsteps. They need to be asked about their individual desires, and their decisions need to be respected. "Passing on a business should be a legacy, not a life sentence," notes San Diego financial planner Peggy Eddy. "I was hoping to be a designer and wasn't really planning to run a diesel company," says Victoria Jackson, 45, who took over her father's Nashville company, Pro Diesel, at age 21, after he died suddenly. "But I felt that I just had to see my father's dream fulfilled." Jackson grew the business from 40 to 175 employees, increased its earnings more than tenfold and eventually sold it in 1998. Today Jackson is running her own fine-jewelry design-and-distributing firm, which she launched in the spring.

Along with a strategy, those passing on businesses need to follow an organized plan. They should seek advice from an estate-planning attorney and a financial planner who are experienced in working with family-owned small businesses. Experts say each family has to evaluate which method of succession is best for its particular needs and for its type of business. A trusted board of directors, of whom half are family members, should assist in the succession plan. "Too many entrepreneurs work in the business, not on the business," says Eddy. "This is where an impartial board can help with a strategy that's based on logic and sense and not emotion."

It's very important to know how much the business is actually worth. A good appraisal should take into account about five years' worth of financial statements, public comparables and the performance of competitors, says John Connell, an accountant with the financial-planning and valuation firm Causey Demgen & Moore in Denver. An appraisal can cost anywhere from $5,000 to $15,000 and take anywhere from two weeks to two months to complete. "Given the competition and your particular market niche, you want to know that there is really a viable business to pass on before it's too late," Connell says.

The older generation also has a responsibility to look out for itself, if for no other reason than to avoid becoming an unexpected burden later. Entrepreneurs should determine how much they will need for retirement, after taxes and adjusted for inflation, and make sure they have the funds. "You don't want Mom and Dad to have to come back to work at age 80 because they need the money," says Drew Mendoza, president of the Family Business Consulting Group in Marietta, Ga. There are any number of ways to ensure continuing income. Parents can receive compensation as advisers or consultants, with a set salary or retainer, notes Diahann Lassus, co-owner of Lassus Wherley & Associates, a New Providence, N.J., financial-planning firm. Or parents can lease the site of the business to the children and get a rent check, Messervey says. In some cases, children may choose to give their parents a share of profits or an annuity.

Business owners can also enhance their financial security by making sure they do not sink all their assets back into the business. "You do want to have a varied financial mixed portfolio that includes items like stocks, IRAs, T-bills and the like," says Tom Zanecchia, president and founder of Wealth Management Consultants, a Denver firm. "If the business should sour with the next generation and you're planning to live off only those proceeds, you may run into some hard times."

Probably the best way to lower the tax burden of succession is by gifting shares of stock over a period of years to the next generation. If the business is going to remain in the family and has a sizable worth, gifting should be done over as long a time as possible, Messervey says. A maximum of $10,000 in stock may be passed down annually to each child by an individual. Currently there is a lifetime exemption of $675,000 for tax-free gifts. Any offspring who is not going to be involved in the business can still receive a minority interest and nonvoting stock--or, upon the parents' death, can be given other assets, such as homes, IRAs, stocks and life insurance. Another option is to sell the business through a promissory note, payable over a specified number of years.

Many family businesses are passed down through a combination of promissory notes and gifting. This worked best for Karen Caplan, 44, president and CEO of Frieda's, a Los Alamitos, Calif., marketer and distributor of exotic fruits with more than $30 million in sales last year. Caplan and her sister Jackie Caplan Wiggins, 42, who is vice president, bought the 38-year-old business from their parents in 1990. Almost half the transfer was paid with a 10-year note, and the rest came through a one-time gifting of $600,000 from each parent after a company valuation. Karen Caplan, who has been working in the business since high school, has 55% ownership, and her sister has the rest. "We got a great deal, and we knew our parents would be well taken care of this way," says Caplan, whose 77-year-old mother still holds the title of chairwoman and comes to the business five days a week.

In other cases, partnership agreements can be drawn up between family members. That was how Bruce Carlow, 54, took over Trio Hardware, a store his father Bernie started in 1963 in Plainview, N.Y. With 15 full- and part-time employees, Trio Hardware currently generates $1.2 million a year in revenues. The deal prevented the elder Carlow from selling the store out from under his son, by giving Bruce the right of first refusal should a sale be contemplated. In return, Bruce agreed to pay his father $2,500 a month plus 7% interest over a 10-year period and to retain him under the company's health-insurance policy. "My father has been very generous with me, and I know that he will be taken care of," says Carlow, who bought the store in 1990. "I also know that I have some security for myself and my family."

Equally important, Bernie says, was knowing that his son wanted to take over the business in the first place and keep Trio Hardware in the family. "Bruce is a fantastic merchandiser, a really good businessman. But what makes him so good at what he does is that he really enjoys running this store," Carlow says. "And when all is said and done, that's what makes all the difference in a successful family business."