A Succession Plan Problem

When thinking about transferring a business to the next generation, a key variable to know about will be ____________.  

I think different people will have different choices here.  I can only tell you what I have found to matter.

The first thing I look for is the ratio of sales to value.

Here’s why:

  1. The obligations that arise on purchase, will be tied to the value of the asset transferred. The principal due will be some percentage of that value and the interest will follow.
  2. The business will pay interest and repay principal from cash flow.
  3. Cash flow available is closely related to revenue.
  4. If revenue is a small fraction of assets, interest and principal will be too big a share of cash flow.
  5. If interest and principal occupy a large share of revenue, then paying will be riskier, expansion will be slower, owner’s living will be smaller and on the plus side, income taxes will be less.

Businesses with high sales to asset ratios are much easier to transfer than ones with low ratios.

For example.

Consider a grocery store and a farm.  The grocery story may create annual revenue of five times value, while a farm may do so at a quarter or less of value.  In the grocery store interest and principal will be a small fraction of revenue whereas in the farm operation, it will be very large.  Therefore, the farm sale is harder unless parents give up potential value. 

That may imperil the equitable settlement of their estate when other siblings are considered.

Other than farms, we have seen the problem arise with resorts, manufacturers, newspapers, radio stations, some landlords, and some real estate developers.  It seldom happens with professionals or retail.

The problem is not insurmountable but it takes time to get it right.  Any succession plan should start as soon as possible, but with low ratio businesses it is especially important to get at it.

Contact: don@moneyfyi.com  

Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

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