If you’re Mom and Pop and are thinking about transitioning ownership in the business to TWO or more of your children, then you might want to read this. Why? You just might be setting up the family up for conflict and the business for disaster.
Amish Effect: that’s where Mom and Pop, the Amish farmers, own 200 acres and land and leave it to their four off-springs so each has 50 acres. And then that generation breaks the 50 acres up into two or more parts. Essentially they are dividing the land equally between each generation giving each LESS of a chance to make it work. Often that ends up with the siblings in conflict.
Junior and Jane have both worked in the business for a number of years. Shop does $1 million in sales and it’s spinning off 20% Income before Owner’s Compensation or $200k in S corporation earnings to Mom and Pop. Now they are thinking of splitting the business 50/50 between the two children. And note that currently Junior and Jane are paid for in wages and so they don’t come out of the $200k.
+ $200k seems to be a magic number. Owners usually don’t earn more, not because we can’t, but one family only needs so many houses, cars and whatever. After that we tend to relax and look for time instead of more money. Not all do, but most is my observation.
In reality, most businesses are usually run by one member of the Mom and Pop team. Pop does everything and Mom does the financial part. Sometimes it is reversed. But, usually one is essential to making the business go.
Mom and Pop are the “prime” family who receive all the earnings. Their proposal is to turn the business over to two “prime families,” Junior’s and Jane’s.
Now Jane and Junior are paid for the work they do. Assume it is $40k each. So, if they take over the business, ignoring what they should pay for the business, it’s logical to Mom and Pop that they would split the $200k earnings and end up with $140k maximum each which seems good (or less if they hire others as well).
But that’s not enough to avoid conflict or an internal struggle over who gets what because it’s not $200k. In reality, the split can be a lot less if the business isn’t doing $1 million and/or the income is less than 20%.
So, most of the time, the business has to grow to make up for the shortfall.
+ They need $200k in my opinion to self-actualize and they earn $140 each so each is short $60k or $120,000 total meaning sales needs to increase $600,000. But that doesn’t count the perks. Mom and Dad train the two siblings to expect to write off the same “Porsche delivery trucks,” country club dues etc. How did Mom and Pop train them to do that? They just observed it being done. So, let’s add another $80k needed for perks (that’s $40k each) which translates into another $400k of sales or a round number of $2 million that the business needs to be doing in order to provide each $200k of earnings and perks.
Cat Fights in Transition
Know what nature’s way of transitioning is? Say you have a middle aged cat at home and then introduce a cuddly little kitten (I did this). Kitten loves to play. Now it’s time to eat so you put out food. Big cat begins eating and little cat thinks it’s okay to jump right in. Big cat slaps them across the room and the little cat learns to let the big cat eat first. That goes on until one day, the little cat decides to take on the big and now much older cat and the fur flies. Only this time, the big cat is tossed across the room. From that day on, the little cat eats first.
And that’s a transition in nature.
What we should try to do is to avoid “cat fights” in the transition. Or to not leave the successors in a position where there will be a “cat fight.”
That could be avoided should Jane and Junior take the business from $1 million to $2 million. Now that usually requires, I would argue, more drive, determination and focus than Mom and Pop did; as well as having enough “skin in the game” (cash at risk) to get there.
Now, two common scenarios emerge when we transition to two or more “prime” family owners from one.
Scenario One: Coasting in Transition
The most probable is that their increase in income after they have paid for the business (each goes from $40k to $140k in this example) is satisfying and they coast. But you can only coast downhill. So, total sales slips and cuts begin in order to save their income. That begets more shrinkage and that’s when the cat fight begins.
Finger pointing has Junior blaming Jane for not doing her job and Jane blaming Junior for not doing his, ya da, which doesn’t make for Happy Thanksgivings around the family dinner table. Cat fight.
Why does this happen? Usually it’s because the one person driving the business (Pop in this scenario) is gone and now Jane and Junior BOTH drive the business or try.
In many of these cases, I see the pair disagreeing often on even basic things like what filing system to use for jobs. Junior thinks we should do this and Jane thinks we should do that.
And it’s even more complex than that as Junior has a spouse and so does Jane. That means both are being pulled by their spouses opinions as well (you should be paid more money than him/her). And gosh forbid if any one of the four are high consumers. That puts really big time demands on the “partners.” And remember, both are now 50/50 owners. Pop and Mom never really had to deal with the demands of so many other “prime” owners.
Why does this happen? There’s no one in charge because both are in charge. Remember, they own the business 50/50.
Saw in one shop where the two didn’t agree even on the most basic of things such as a proper way to archive jobs. Result there was not one, but two different filing systems; one for his jobs and one for hers. Adds a lot of unnecessary overhead that decreases income signficiantly.
Scenario Two: One is Aggressive
Children aren’t born with equal motivation. In some cases, we do see one who really wants to grow the business and the other giving lip service to the concept.
Again, finger pointing begins as Jane blames Junior for not doing his job and Junior blames Jane for not doing hers, ya da, which doesn’t make for Happy Thanksgivings around the family dinner table either.
Successful Transition
I’m not saying this absolutely can’t work out. I am saying it’s not the norm. What is more probable to succeed in the long-term would be if the business were doing $2 million at the time of transition throwing off $400k which gives the siblings a shot at earning the magic $200k each. Of course, this scenario also promotes the “coasting” effect but it has a shot at lasting through the careers of the siblings. Doesn’t bode well for the following generation but can get them there.
Organization
For the business to really survive and thrive, it must be organized around functions (sales, production and finance) with both accepting the responsibilities and performing their roles.
It also means the successor(s) should be brought up through the Executive Track which I have written about before. Go to www.cprint.com and search on Executive Track for four articles describing such.
Rule of Thumb for Transition
My rule of thumb simply is you need about $1 million in sales for each “prime” family living out of a small business generating 20% Income before Owner Compensation.
If you don’t have that, then choose amongst them. And the best way to do that is to “sell” the business to the next generation and take the highest and most probably bid because you’re probably going to be carrying the financing.
Don’t Saddle the Successor
Usually Mom and Pop are trying to be “fair” with the business. In their minds it means that ownership has to be divided equally. It doesn’t. To be fair, be equal with the opportunity for each of the siblings to step up to their responsibilities. Don’t saddle the prime successor with a basket case for it ends up being a cat fight at some point.
One owner “gifted” the business to the son who had run the business successfully for years and his sister who not only did minor tasks in the business but who had a habit of “throwing a fit and walking out” frequently. Again, I would refer you to the Executive Track articles for more info.
Another owner “gifted” the business to the son who had run the business successfully, again for a number of years but also gave minority interest to the two sisters who never once really worked in the business.
A third owner saddled the son who was running the business (degree in business and years of experience) with his brother who barely made it through high school.
Be Fair with the Proceeds, Not the Business
Don’t do these things and it won’t tear the family apart. Be fair with the proceeds, not the business. If the son will pay you $800,000 for the business, then take the proceeds and split them up among the siblings as you see fit. But don’t split up the ownership. The business needs someone who will look after the best interest of the business and that’s the one who has the most “skin in the game.”
Anyway, that’s what I’ve been thinking about this week.
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At CPrint, we assist owners with internal transitions as well as help get the business ready for sale through improving performance. Should you wish to have a no cost or obligation transition conference with me about your situation, email me at tom@cprint.com. I’ll be glad to chat.
Tom Crouser
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