Tips to reduce succession risks

By George Frier, The CA magazine

21 May 2015

George Frier considers how to address succession risks for family and privately owned businesses.

One of the biggest risks for a business comes when an owner-manager will not face up to his or her mortality.

The longer issues of management and personal succession persist, the longer the risk to the business and to the wealth of the families that rely on it.

In a typical private business, with, say, two second generation siblings as shareholder directors, with different family interests and aspirations, typically there will be no clear idea of succession or exit planning.

The business generates healthy profits, but the directors keep going, enjoying the benefits of healthy dividends, on the basis that they are not yet ready to retire.

Key succession risks

  • The risk of dying "in harness" or suffering a critical illness. If senior directors have not shared the burden of management, their loss could significantly destabilise the business.

  • The risk that the business then loses key customers or staff. Realistically competitors will capitalise on any instability. Are there adequate restrictive covenants on key staff preventing them leaving and transferring the goodwill to a competitor?

  • Lenders and suppliers may be concerned to see the loss of key management. Coupled with loss of customers, there will be increased pressure or even a requirement to address repayment of bank debt.

The variations on the risks are as diverse as private businesses themselves. If the two siblings are years apart, then there may be a dislocation between their retirement plans. What appetite does the younger have to buy out the older, and will the older feel resentment if the younger is not prepared to facilitate his/her exit? 

Addressing the 'disconnection'

There are many ways to address this disconnection and minimise the risk of tension. The shares held by the older retiring party could be repurchased and the proceeds of sale re-lent to the business to minimise cash flow risk.

If nothing is done, the ultimate risk is of death of the older sibling with ownership of his/her shares still unresolved resulting in possible transmission to a spouse or children who are disconnected from the business and may then be resentful.

For many family-run businesses, taking the time to review these structural issues often falls into the "too difficult" box.

How to reduce succession risks

1. Review key areas of business risk, including whether the business would be exposed to sudden change or loss of any key person.

2. Discuss management succession well before it becomes unavoidable; are bloodline candidates necessarily the best, or would a transfusion of external skills assist?

3. Determine what the guiding principles of shareholding should be; for example, bloodline only, working, or what? Consider the pros and cons carefully, particularly if looking at external candidates – how will they be best motivated to make the business prosper?

4. Consider where the owner(s) and family (or families) want the business to be in 20 years' time. What are their ambitions for it? There will be a significant risk to the business and family cohesion if there is no discussion about this or it is left too late.

5. Review the current value of the business – the result may be surprising! Investigate cross option policies, particularly if different workers are key shareholders. On their death the proceeds of such policies, properly written for sufficient cover, can relieve significant tension by allowing a purchase to take place which can be in the interests both of the deceased's family and the continuing business.

6. Discuss the family's thoughts with professional advisers, including how to harmonise interaction between insurable matters, articles of association and estate planning.

7. Formulate a basis for a structured discussion on the future, which might need to be facilitated, and which should take place on a planned, not a reactive, basis (Boxing Day after red wine is rarely recommended).

"Pai rico, filho nobre, noto pobre" is a Brazilian proverb that translates as "Rich father, noble son, poor grandson". The best legacy is to guard against that risk.

George Frier is a corporate partner and member of Shepherd & Wedderburn's Family Business and Wealth Protection Group. This article first appeared in the May 2015 edition of The CA magazine.


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