An (edited) transcript of some of the spirited discussion that took place during the ROI-NJ Thought Leadership Series: Family Business — Leadership, Governance, Succession.
It was held recently at The Grain House in Basking Ridge.
Jason Sobel, member, Sills Cummis & Gross:
He is a member of the 35-person Real Estate Group at the firm, which is based in Newark. Sobel chairs the FORE (Family Owned Real Estate) practice group, which focuses on an underlying asset of most family businesses. “What people don’t realize is that the real estate underneath their business is possibly the most valuable asset they have — and may drive what they do today or in five or 10 years,” he said.
Gerry Shanker, partner, KRS CPAs:
He specializes in helping entrepreneurial businesses at his firm, which is based in Paramus. “I can tell a lot of stories about people who came to me with a loose-leaf binder business plan and sold their business for $10 million or $50 million or $100 million,” Shanker said. “But the stories I’m most proud of are the ones where the client was ready for bankruptcy and we met with them every week and they are flourishing again.”
George Lee, vice president, MassMutual:
He focuses on family business at his company, which has offices around the state. More specifically, future planning. “Often, we are so busy running our business — making sure the business is running right, making sure that employees are happy, making sure that we are expanding our marketplace and not being left behind — we forget our exit strategy,” he said. “Who are we passing our business to?”
Q: Let’s start with a big-picture question: What’s the biggest challenge in working with a family business?
George Lee: The greatest pain and frustration is conveying the message to business owners to take action. You are successful for a reason, you take charge. But very often, advisers can’t force you to take charge. Let’s talk candidly: Who are you leaving your business to? We all think, informally, we know who that successor will be. But I’m the guy who challenges you and says, ‘Are you sure that’s the right person?’ Is that son, is that daughter, is that nephew, is that sibling the right person? What type of conflict does it create? I have regular meetings and very candid conversations with clients who say, ‘We talked about this … over Christmas dinner or Thanksgiving dinner.’ A lot of these so-called understandings are not set.
Q: Here’s the next biggest question: How much is a business worth? How often should a family have its business valued?
Gerry Shanker: Maybe, informally, once a year. You don’t need a 75-page business evaluation report. I can do a business evaluation on a spreadsheet and we can meet and discuss it. I think you only need a business evaluation when you have to execute a shareholders’ agreement, when you are getting ready for sale or on the departure of an owner.
Q: Everyone knows every business owner does his own evaluation. How accurate are business evaluations when they are made by business owners?
GS: Often, business owners, especially business founders, are not realistic about the value of their business. They’ll say: ‘I started this business, it’s worth a lot of money.’ Or, ‘My neighbor sold their business for $50 million, my business is worth a lot of money, too.’ But a business’s value is all about cash flow and risk. The higher the cash flow and the greater the risk, the greater the value of the business. And someone who is making $100,000 or $200,000 or $300,000 as the main owner? All they own is a job if the business isn’t profitable.
All the buyer of the business is going to pay for is the value of that business, the future cash flow, and they are going to evaluate the risk of whether that cash flow will be realized. The lower the risk, the greater the cash flow, the higher the business value. Once you establish the business value, then it’s necessary to come up with an agreement. An understanding that, ‘Someday, Johnny is going to take over the business’ is not enough. When the first generation retires, becomes disabled or dies, without a written document, there’s undoubtedly going to be a dispute. Having no written document is the same as having no plan. And no plan is a plan to have a court decide what is going to happen to your business.
Q: Let’s move to the actual buildings these family businesses are located in. Some say these are forgotten assets. How should you look at your real estate in steady times?
Jason Sobel: I call those static times, when everything is good and nothing is forcing you to do something right away. In that state, you’re really just worried about your financing, making sure you’re with the right lender, and you need to find a lender that can really handle your needs. Maybe that mom-and-pop relationship with your local bank is no longer able to service you. You also may want to take financing out of your building. You may want to use it as an asset to expand your building.
Or, maybe you have two children coming into the business. It supported you and your family well, but now you’re going to be supporting two families. Maybe you use that real estate as a tool that enables you to expand the business. Those are your static situations, where nothing is happening.
Q: OK, what about active moments in real estate?
JS: The more exciting topic to talk about are your fluent situations. Either your business is cramped in a building and really needs to expand, what do you do? Or, your building is underutilized: You have a 100,000-square-foot warehouse and you’re only using 50,000 square feet of it. Do you sublease, do you bring a neighbor into your building? And, maybe you don’t want to do that because you have sensitive business going on.
Maybe you move — and, when you move, do you just sell the property or maybe we’ll bring you a joint-venture investor? You’ll contribute your land, they’ll turn your one-level office building into a multistory mixed-use project, which is more of what’s going on here in New Jersey. You take that one-story office building and turn it into a five-story building, ground floor retail, maybe some residential above, and now you are a joint-venture partner with someone who does this for a living. You’re a partner, but you have a 50 percent stake in the building and now you have an income stream coming in for generation after generation while you can move your business to another location that’s more suitable and maybe a lot cheaper and fits your budget on real estate better.
Q: Sounds like a lot of planning. And that’s just real estate. Overall, how many people, how much time does it take to create a plan for the future if you own a family business?
GL: You need to create your golden triangle. Your team of elite advisers. You want to win a championship; you can’t do it by yourself. We all have different skillsets, experience and talent. Leverage that talent. Your team should consist of a great attorney, who will draft that documentation, an accountant who can run the tax implications of the planning strategy we are looking at, and someone who can be creative and give you great solutions that are appropriate. A lot of our clients think planning is inadequate because they think it’s a one-time process. It’s not. It’s a continuous process. To do this well, you should really be thinking about it five to 10 years before you sell your business.
Q: Of course, all family business owners assume their children will one day take over. How realistic is that?
GL: One of the things we see is that family business owners assume, and assumption will kill you. One of the leading problems is the lifestyle that the parents often generate through the business is very different than the work that is involved in running the business. It’s an illusion. Children see the byproduct of what the parents have done, but often they don’t see the pain, the frustration, the endless sleepless nights that they have to go through to get there. We, as parents, want to shield our children from those pains and frustrations. But, are we actually doing the right thing? Very often, I encourage my clients to get their children involved in the business at an early stage. Why do you want them to intern for somebody else when they don’t truly understand what you do?
Owners often think: I make a good living, why wouldn’t my children want what I created? It’s because the children see all the negative aspects when you come home — all the headaches and the frustrations. They don’t want to deal with the headaches.
Q: And all family business owners assume their children will have the ability to take over the business. How realistic is that?
GL: We all look at our children and think that they are all special. But are they? Are they going to be that key person that takes care of that business and propels it to a different level? Do they have the talent? Do they have the capability? This is the biggest frustration that we have as advisers.
The assumption always has been made: I have my heir. Very often, the children are afraid to voice the opinion: ‘Mom, Dad: I really don’t want to do this.’ And they get very disappointed. And that conversation isn’t taking place 10 or 15 years ahead of time. Very often, that conversation is taking place or came about because a life event happened. Mom and Dad got sick. There’s a sudden death in the family. There are liquidity issues. Who do we sell the business to? The whole context of this conversation becomes very costly and one that needs to take place with attorneys. All of these things could have been prevented by having a simple conversation years earlier.
Q: Just deciding to pass the business along doesn’t end the problems. What do you do when there are intransigent partners, and one is productive and the other one isn’t. What do you do before you get to protracted litigation? Do you use mediation to solve acrimonious situations?
GS: We try to get them to talk. In the tax courts, there’s a concept called hot-tubbing, where the parties meet, and the attorneys aren’t allowed to speak. And they try to negotiate and come out with a reasonable solution. The person who is not productive might be willing to just take a payment.
Q: What if the next generation cannot decide how to take over the business and they need/want to split it up? How do you split up a building?
JS: This is why you need to have estate and trust planning. You may have trusts for your future generations or spousal trusts. One of the key aspects is sort of a buy-sell option. Some of your family business may not be immediate families, there may be siblings or first cousins or uncles. Maybe some of the kids are going to go into the business, but others are not. Now, you have to realize, ‘How do I deal with these assets?’ And in your partnership agreements, or your LLC agreements, there needs to be some mechanisms with passing on those assets. And you can separate the business from the real estate.
If you own a million-dollar building and the next generation is taking over, perhaps one cousin is in California and the other is here and they are going to run the business. The cousin in California is going to say, ‘Look, that’s half my building.’ We can have a business evaluation scenario where the cousin who is staying in the business will say to the cousin who isn’t, ‘I’ll buy it from you for X.’
Q: What other real estate options are there?
JS: We also have a property management group. They are going to help us with, ‘How are we going to maximize this property? Each site is unique, how are we going to handle all of that? Maybe the business should be located on one? Maybe this is the best site to sell and just get out? And maybe we use cash on one to redevelop another?’
The question is: What kind of income are you looking for? We can go grand scale and bring in a REIT and developers who will turn your small building into something large.
Q: Let’s have an honest discussion about what to do when you know you have no one to take over. You’re going to sell. You need an exit strategy. When does the process start when you know you don’t have someone who wants to take over?
GS: I say five years. During that five years, you clean up the business, you clean up the balance sheet, you make sure the books are perfect. When you sell your business, especially to private equity, you want books that speak for themselves because they are going to ask questions you can’t even dream of. You set a budget, you set a plan, you meet with your quarterly advisers to make sure you are adhering to that plan and you build up the business value by increasing cash flow. You decrease your risk. You diversify your customer base. You diversify your suppliers.
And maybe the owner doesn’t have to buy a Ferrari. And maybe everyone with the same last name doesn’t have to be on the payroll. You laugh, but that’s the way of the world. This is how you increase the value of your business so when it’s ready to be sold, you’re ready to go.