EP46 - Family Ties - issues of a family business in relation to an ESOP.

Good afternoon everybody. This is the ESOP guy and we are on a journey to an ESOP. So no matter what part of the day it is for you, I just wanted to say thank you for joining today and welcome to our podcast. We are producing this podcast in order to help folks that are thinking they might want to consider an ESOP as a potential growth, succession or even exit strategy for their business. And if this is your first time joining, I just wanted to point you to our website at journey to an EAP.com for all of our episodes if you have an interest in those. And today's title of this episode is going to be kicked off with this. we For Which Oh The night. You probably don't recognize that theme song and it comes from a show called Family Ties. And I guess I am dating myself, um, because I have turned towards a new decade, um, just turned 50 this past weekend, so I'm getting older and so I used to watch this show all the time when I was a kid, and I thought it would be a cool title for this podcast. So, What we're gonna talk about is family businesses and how they stack up as potential ESOPs. And recently, I read a Harvard Business Review article that said, family-owned businesses are responsible for an estimated 60% of total US employment and roughly 70% of these businesses only last one single. Generation. So what does that mean? It means the family businesses are going to do something in that next generation. And with the way things are going, there, there's definitely a consideration for how does this work for the family business to go into an ESOP. And that's what this episode is going to be all about, but issues related to family businesses are going to be important to discuss. And so if you are a family business, this is going to be a great episode for you to listen to. Um, and I want you to kind of start off thinking for the, for the most part, that you are a good candidate for a NESOP. If you like what you hear, please subscribe to the podcast and share it with a friend, and please rate and review the podcast. That's very helpful for us. And as we get started, I just wanted to just kind of describe this show if you haven't seen it, and if you have, it's probably been so long because it is um something that they created back in 1982. Um, so Family Ties was a show I watched a lot when I was a kid, and I don't know why I liked the show a lot. I liked the character, Michael J. Fox, who played Alex Keaton. And he was a weird kid who dressed in business suits to go to high school. And the TV show really reflected the move at that time in the United States from cultural liberalism, which kind of was born out of the 1960s and 1970s, to conservatism. And as I think about the show now, I think it's super funny. Um, this kid, Alex, who had, you know, he, He was an absolute Republican. His parents were super hippies, um, and, you know, there was this contrast in those kids, but now that I have my own, my own family, I think this is super funny because, um, as I have taken on a conservative approach to life, I am now met with my children who all want to be musicians and artists. And that means, I think that means, maybe I'm in, maybe I'm um inferring too much here, but maybe that means my kids' kids will likely be more like me as the pendulum swings back and forth. So, who knows? Um, that's why I think when you start talking about family dynamics, it, it is very interesting to see, you know, how these types of things play out, but especially when you're, you're throwing politics because politics are crazy. So, family dynamics are a factor in every family, and you know, um, getting together over the holidays with your family as we, as we approach the fall season, um, there's always a stigma, maybe and attention and thinking about, oh, we're going to get together for Thanksgiving, we're going to get together for Christmas. Um, so if, if we're honest, I think there's a tension there. If, and if you're not honest, I mean that's fine. I mean, family can be tough. Some people have perfect family, so I'm sure if that's you, then I, I don't wanna be um super negative. Um, I just want to point out that it can be stressful and when you're dealing with your family. As we apply this dynamic, which is very difficult to really understand, I think for the most part, because it happens in, in a, if family's dynamics happen in childhood and they, and they, and they get um through life, they kind of perpetuate themselves in all kinds of things that were hard to really name and, and understand. So, um, But if we apply this dynamic to a business, I think then it becomes very, very interesting, so much so interesting as you start thinking about um business itself. It's like you're, you're gonna, you're gonna try to tackle issues and problems in a business on a normal level, but when you add this family dynamic where you have a father and a son or a husband and wife, or cousins and uncles and aunts all in the business, then it becomes very, very interesting. In fact, one of the things I wanted to point out early on in the process of doing um a business evaluation for an ESOP, one of the risk factors that we look at is whether or not there are family in the business and That can certainly contribute to more risk because there's a lot of issues and uncertainties related to that. And I don't want to be, I don't want to kind of get on this one side where everything's so negative in the family. I just want to point out that there, there is, there has to be, um, you know, an understanding that there's a dynamic here that's different than just normal business people working together. As a consultant working with privately held companies for the last, say, almost 30 years, I can say that I've seen so many different issues as it comes to dealing with this kind of business compared to businesses where there is no family involved. And really, when we're talking about You know, people, um, bringing different values into a business and different experiences. There's already that. But then when you add the, the childhood issues and things that, that, that you can't really understand it, it adds to the complexity. Some common issues that companies include the following, developing a succession plan or exit strategy. Um, grooming the next generation of leadership, finding and keeping qualified employees, growing revenue, uh, the tax burden, complexity of, of compliance, um, access to capital and financing, managing expenses, um, trying to keep pace with technology. Um, as we look at those and, and add to it the family dynamic, um, what's interesting about this is if you don't know this is, this is actually true, there are some psychologists that have dedicated their entire practices. to consulting with family businesses and really to help them manage their companies and manage through all these issues. And, and it's weird to say psychologists when you talk about business, but ultimately, they're really very helpful when it comes to some of these issues, especially because there's so Much on the line when families get into a situation where they, they want, they want the business to survive. They also want the family to be successful and that's why a psychologist can sometimes pull together a lot of the issues so that people can then move forward in these scenarios. There's an article that I read written by Anna Miller, it's called The Perils of the Family Business. This is from back in 2014. But the article focuses on the psychology of family business and addresses common issues for family business. And one of those that um the author brings out is this concept of role reversal. And within this role reversal, um, among other issues, there is a role conflict that happens in family businesses. And what that means is there's a, there's really a distinction between someone's role in the family. In terms of how they operate within the family, but then that gets um placed into the role in the business as well. And so that can definitely create problems as you start thinking about, you know, how people operate and, and function within a family structure or family dynamic. And when they bring that same um structure into a business, there, that is, that's going to bring some type of difficulty or complexity or even conflict potentially. Now, specifically, some of the things that we see are father-son rivalry and those are issues that are kind of um obvious, but the father has started the business and kind of wants to pass the business on to his son. But there's, there's issues between the father and son that are, um, even emotional issues that are, that are gonna possibly get in the way. So that could cause the father to behave, you know, in a way that's unexplainable. And even though he's making plans to groom the son to take over the business. Um, could also be doing things that really aren't helping the son succeed in that role and in ways that can be very obvious, I think, to people outside of the father-son rivalry, um, the, the, I'm talking about the employees, maybe even the leadership team that it's obvious to them that there's issues there, um, but sometimes it's not as obvious to either the father or son. There could be brother brother rivalries, um, where you have, um, again, a very emotional intensity to um them operating in the business, dealing with issues from again, their childhood and bringing them back into the roles. One brother might be favored by the father than the other, um, there might be um clear. Really a um a business, one of the brothers might be clearly better suited for the role of CEO or president versus the other brother and there's decisions that have to be made, and that can create conflict and rivalry between the two of them. So those are, those are good examples of, of issues. Um, so going into this, you know, there, there are There's further complications and when you get to um just outside of just the, the father son and the brother brother or sister sister, then there's issues related to the wives and, you know, the immediate family are outside of that that starts to work in the business too, and they have children and those children work in the business and And so, I know that for me, I've sat into a lot of different meetings with clients over the years, and you know that there's issues related to this specifically, and they're very, I think the biggest thing is they're very difficult to talk about because they're, you're stepping on. Toes and you're talking about things that are that are not necessarily straightforward from a business concept and that's why I think the psychologists have a much better position from a from a professional advisor to step into these consulting roles and really help, um, a family in a business scenario kind of work through all that. So as we keep all of these factors in mind, what I wanted to do in the first part of this is just give some context to the complexity of a family business and I don't want to lean so negatively on, you know, these are all issues because it's also pointed out in this article that, you know, being a um uh a family business can be such a successful component of a business in terms of how they approach. The marketplace and the bond that they have. Um, the article found in a 2008 study, for instance, that family business CEOs tend to be more successful if they possess cultural competencies and understanding family goals, values and norms rather than just living up to formal formal qualifications of, of a job. So that came out of the same article. So, There clearly is a success factor in a family business, and I, and I don't want to, I don't want to minimize that issue. And I, I think we tend to, when we start thinking about family businesses, we tend to gravitate towards the negative, but I wanted to clearly kind of gravitate over to the positive as well, because I have seen absolutely some phenomenally successful family businesses. That, um, that do extremely well in the marketplace and they accomplish their goals, and there is a culture there that becomes, um, very, very um positive and important to all of the employees. And I think that's when it's done really well and, and I think that really is a reflection of good leadership, um, anyways, but So as we go into understanding what family businesses are, and I want to get into questions that might really come up as we start to think about now we have a family business that's moving into um the kind of the obvious questions and goals or objectives that come about as you start to ask the questions of succession and what's gonna happen to the business. And some of those questions are going to be things like how can Um, how can or how will you replace the, the leader, um, when they leave the company? And this question is going as a family business is going to beg other questions like how, how does the new person that takes over the role, um, if they're from the family, How do they fit into that role? And, and, and the real question is, is, are they the most qualified person for that role? And, and I think it's easier to kind of say, let's just talk about the role of being president and CEO and I know there's other specific roles just like that, but I think that's important, um, that's one of the most important transitional movements you're gonna have. And the question is difficult sometimes to say who's going to judge whether or not that person is the most qualified person. And objectively speaking, we all know if that person isn't the most qualified person, there's gonna be all kinds of issues that are going to come down the road that the company is going to have to fight through. Um, they may end up growing their way into that position. They may start off not as qualified. Um, there are a lot of ways to transition a person into a role of a president CEO without, um, just abandoning them in that role. So I think there's a way to do that as a phase and process. But I think there is an issue with companies that have a family member that is in a role that's not qualified, and that can create a lot of difficulty and, and problems for the company that don't necessarily need to be there. I think one of the things that has to happen is you have to ask the question of how did the other employees view this kind of change in control? How do you get that data and how do you get it to be, you know, really honest and um I think as, as a transitional plan when you're thinking about your family business, and, and I'm just gonna use a simple, you know, example of a father transitioning their son in the role of, of a president CEO position. The question is, is, will the employees, will the leadership team really support that move? And I think that, that really needs to be answered um as you go through the process in a way that really supports the decision. And sometimes that could be Um, an, an anonymous survey or an engagement survey or some type of survey that gets their opinion. It could be a workshop, it could be some off-site one on ones, but I think you're, you're, you're gonna need to want to make sure you, you have gained the support. Um, other questions would be, what does the business need for continued success and growth now and after the person that's, that's transitioning out is the maybe the family leader, what does the business need after they retire? So outside of just the movement of change and control, um, does that mean that the company has to re-establish its banking relationships and how is that gonna work? One of the issues I've seen with a lot of family transition plans is. The kids don't get involved in early enough into the roles of dealing with the bankers and the CFO or the CPAs and the, and the attorneys, um, and they need to really understand how the, the professional world works with their business. They really need to understand how financial statements work. Um, they may have done a lot of work in the field, for instance, and done great jobs out there, but they need to be indoctrinated into Um, all of the aspects of the business, especially as we can we move and we're, we're thinking simplistically as you move they move into that role of president CEO. What happens to the business, um, and my employees if you sell the business, you know, to a third party. So this is the question that when you start thinking about a family business, considering going towards an ESOP or considering going towards um a sale. Now, clearly, one of the, one of the reasons why ESOPs are so popular. Is that we can avoid a third party sale and disrupt all of that. Obviously, that's going to negatively impact the family business, especially if they have multiple family members in the business. Um, it may be that. The business really, um, is at a point where the third party sale though, however, is the best option. And so I never want to say that you're, you're going to look at, you know, this is your singular option, just move your business, family business to either sell it to the kids, give it to the kids, or sell it to an ESOP is your only or your only options. It may be that the company is ready to move on and sell to a third party, but it has to, that has to be evaluated as a question. Um, some of the things that come up too I I've seen as well as do my kids even want to run a business? And I've kind of already mentioned, are they qualified to run it, but do they really want to do it? And I think that is definitely, I've seen that happen in, in a lot of scenarios where we may assume that they do, but we haven't really had those conversations. And, and what does it mean that they want to? Does it mean that they want to do the same thing that you did when you took over the business from your, um, your father, or does it, or if you started the business on your own? Will they come in and do it the same way? And the, the, the reality is, no, they're not going to do it the same way. But ultimately, what does the want to run the business mean? What does the want to own the business mean for your kids? And I think it's not just asking the question, do you want to, but you got to ask the question deeper and really understand what is that really, what's the one behind it? What are they prepared to do when it gets down to it? If we move, if the business moves into, for instance, a downturn. And there is an economic downturn where the company has to go through and struggle through. Does it make sense? How are they going to help the business survive? Um, it's, it's when you're putting someone in position of succession, you, I think you absolutely have the responsibility to business. To put the right person in there. So the kids might want it, but there might be a factor there of how much they want it. And this, as I start to split this up a little bit, I think then this gives us the opportunity to talk a little bit more about the, the difference between doing an ease up and doing um a straight up sale to the, the, the kids that are in the business. So the advantage of doing an ESOP though, is what it does is it allows if, if one of my children isn't strong enough, or if I don't feel like it's strong enough, what, what doing either a 100% ESOP or even a partial ESOP with the kids owning a partial part of the company, what that does is it creates an advantage for the business to um move into a stronger overall governance because of the way that the ESOP is governed with a board of directors. And it allows for them to be supported by um a stronger infrastructure around them and them is the the kids that are taking over the business. So, one of the things I'm proposing as you ask these questions is to consider the option of, of having a hybrid where you do part of the company goes to the kids and then part of it goes to an ESOP because I think that could really support this new generation coming in that may not want to do everything that you did in getting the company started. And I think that's something that you, you should definitely consider as you start working through these questions, um, in, in your planning process. Another question that comes up, I, I think frequently and it's, and it's very, very appropriate for ESOP companies is what kind of legacy do I want to leave behind? And family owned businesses, I think for the most part, I could say this is true, they want to, they've, they've created a strong reputation, let's just say in the marketplace, in what they do. And it's taken them years to build that up. And, and I think having that reputation go forward. There is not just the word of pride and, and um accomplishment, um, seeing and there must be nothing greater than seeing your kids take over and seeing them take on that. So even if you don't go in through an ESOP, I think this concept of legacy within a family business succession plan is a very strong concept. Um, the ESOP does provide, again, this a great infrastructure to support that legacy, as well as, as we get into some of the benefits of it, as well as the tax advantages and all these, all these other aspects of it that really do need to be considered in, in the list of options that you have. One of the other questions that's very important that I wanted to point out for family businesses is. How do I divide the ownership? When I'm in a transition with my kids, when there's more than one kid in the business, and that's a very difficult question. And, and then even more complicated is, is, what do I do if I have other kids that are not in the business and what should I do with this asset of my business. And one of the nice things about doing an ESOP. is it can take that, that complexity off the table. And especially if you have, if you have kids that are in the business, and they're really not taking on the strategic managerial roles or the leadership roles. Um, if they're not, then, then it's easier for you, I think, as a business owner. To transition it and then use that as that monetary um benefit of doing an ESOP, which is, you know, effectively your sale of the company to an ESOP. As that frees up your net worth from the business, then that um monetary benefit, which is your promissory note or seller note, or the cash from the sale from the bank, can then be put into your estate planning and then you can use that then to benefit your heirs in a way that's super. Um, straightforward and clean in terms of the way that inheritance could go, um, especially if you're gonna use it like a 1042 qualified, um, uh, replacement property or, or a 1042 account where, where you're gonna be able to put that and defer that away into, into some type of investment. But so my point to this is, it's, it could be very complicated to divide ownership and create issues with your, with your family members. And one of the things you have to think about is an owner of a company has a say so, whether they're a minority or control controlling owner. So as time goes on down the road, let's just say you have 4 kids, 2 kids in the business, and 2 are out of the business, and you divided that business up 25% each. And if the business goes on and two owners are working in the business and they're getting, say, 50% of the net income, and they're working really hard to build the business, and they're growing it, they're doing everything right. The other two owners are getting 50% of the profits, but they're not doing anything. And so clearly there's gonna be some type of, of conflict, and I have absolutely seen this and I've seen it, unfortunately. Um, from a legal standpoint where, where the brothers ended up having a lawsuit between, you know, the fathers passed away and there's all this, all these dynamics. So I just want to point out that that dividing up ownership in is so critical and it's so difficult too because um you're in a position as, say, if it's the father to the, to the children, you're in a position of fairness and equity. But the problem is you have to consider the balance of the business itself. And so I, I just want to say that the ESOP does provide a great solution for that, and it wouldn't be the only driver, but I'm gonna say that that would be a really helpful way to help work through the potential issue of that. So as we go through the, the, that type of concept, it's gonna be helpful to walk through those questions. Um, now the founders of the business may want the next generation to follow in the family business, but the, you know, when you look at the majority of the family-owned companies, um, they're really, as I said, the statistic, there's only, um, there's only, they're only lasting for statistically, one generation. So the the issue here is just that there is a dilution of ownership. Um, as, as we go through the generation to generation to generation, um, of family businesses. And so again, what, what the dilution issue is, is, is if you have 3 kids in the business and then they have families and their kids get in the business and they have families, that just means that they're gonna be the ownership is going to to contribute less and less profit and cash flow to each of the family's households over time. And so that's gonna lead us to also try to look ahead and say, OK, how do we, how do we work through that? And again, we're back to how the ESOP might be a good solution and, and a strategy to solve that. So, as I, as I mentioned, kind of through this very periodically, is that an ESOP does provide a way for a business owner um to create this tax advantaged um purchase for this privately held stock without dealing with third party and disrupting the corporate culture without and and trying to make it as simple from that standpoint as possible. In the world of, of succession planning and looking at an ESOP, it is an alternative to this type of third party sale. And what the, one of the benefits of that is just not having to um have a third party come in and change the location of your business or unnecessarily lay off really key people that have been there for and really helped you build the business. So, so looking at that, there are, there definitely are some industries that I think are common for stops and I wanted to mention these as There is some industries are more family owned than others, but there, there are some common elements within each of these industries that I think are important as we consider how an ESOP might apply. The first is, is the importance of maintaining the corporate culture. I, I believe when you start thinking about whether or not an ESOP is right for you and your, and your family business, I think that has to be one of the things we see all the time as, as we talk to clients about this issue. The, the second is really that some industries are just, they just have less outside buyers and it just becomes a matter of, of, because you have less outside buyers, then the best option is to structure an ESOP. And then the third is just because the companies in some of these industries have um really solid balance sheets that can support the additional leverage that an ESOP is gonna take on when they buy out the owners. So, going into some of these industries, I'm gonna start with specifically with, with a few and just, and I wanted to kind of point out that this is not all the industries, but I think this is helpful um to really kind of understand maybe some industries that, that may be more apt to do in ESOP than others. The first is government contracting and again, this is, there are government contracting businesses that have family members in them. It's not as common, but um there are, there are companies that do federal government work. That have, because the government has done a lot of different set aside programs, these are typically small businesses with these um special designations and what happens is when a small business government contractor goes into the marketplace, um, to sell their business, they typically have to sell to another small contractor because they're needing to nova over these contracts to another small business because that's the way the government has set up those contracts. This specifically is going to reduce the number of buyers and create, you know, this becoming a popular way the this specific industry would go towards an ESOP. Uh, construction would be another industry I'd say is, is popular with ESOPs. Um, many construction companies are family owned, and as the industry has a large concentration of small to mid-sized firms, um, the SBA reports that there are more than 2 million construction firms in the United States with 500 or more employees, um, because of the size of the companies and the nature of their non-recurring revenue. A contractor also has less options on the outside to sell their companies as well. So this makes them a prime industry for potential ESOP. Manufacturing and distribution companies are another. mid-sized companies with revenues between $10.01 billion dollars are expected to outpace larger companies in the growth in growth over the next 12 months. This was according to some research done by Ohio State University, Fisher College of Business, and GE Capital. These companies account for a third of the nation's GDP, more than 41 million jobs and are considered a leading indicator of America's future competitiveness. Mid-sized companies, um, added 2.2 million jobs between 2007 and 2010, and this is compared to larger businesses, big businesses that actually shed $3.7 million jobs in that same time period. So manufacturing companies are great candidates for ESOPs and one of the reasons is because they do have very strong balance sheets. And again, as family-owned companies, this is a very popular family owned type of industry. Um they make perfect candidates to become potential ESOP companies. Um, and then the final one I'll mention is this idea of professional services and professional services could be very popular as architectural and engineering firms for ESOPs. Um, one of the reasons this is very popular for professional services companies as ESOPs is because they're able to maintain what's really an important critical success factor for their businesses, which is their culture. And as we know that if, if, if those types of companies sold um in the marketplace, the culture is gonna change completely and they're gonna, they're gonna potentially lose the, the real talent they have in that professional services firm, um, to meet the demands of that client base. So they become very popular as ESOP candidates as well. And so I didn't want to exclude any other type of industries because certainly there's a lot of other industries. Those are just ones that kind of pop up and I wanted to point out. So going into kind of finalizing this episode, I just wanted to kind of point out one of the, one of the concerns you might have as a family business is dealing with uh the way an S corporation is done as an ESOP. And I wanted to point you to episode 35, which is um an episode that I did on this podcast to discuss 409P, which is a um an IRS ruling to support anti-abuse when it comes to ESOPs. And the issue is, is that when you have a family ESOP, when you have a family business that's going towards ESOP, and you have existing family members that that are going to be in the company that are gonna earn ownership, there is a potential issue of them becoming disqualified persons. And so, without having a lot of time to go into it, I just wanted to point you that is a concern, and that really needs to be addressed early on with your adviser in terms of Um, whether or not this type of approach towards going towards an ESOP would be favorable. And so that, that isn't that difficult to answer as you go through the number of employees that you have, the number of family members, but it does need to be answered. So, other than that, I think that for family businesses, you know, ESOPs are a great option. And as you look at the options, you know, in terms of what you can do with your company, um, you certainly definitely want to look at that as, uh, as a potential with all the reasons that we talked about as we went through this episode. And as you start thinking about your management team, you can't do that early enough. As you start thinking about your evaluation, you can't do that early enough. Um, I think that, that is very, a very helpful process to just understand, um, whether or not you, you know, you have a good plan in place. And I would say I kind of finalize this episode by saying, you know, you know, I think please start that process 5 years out. I think that's a very healthy thing for any company to do. Um, it doesn't mean you can't do it if you're one year out. It just means you have a lot more, um, decisions to make that need to be, they're very important decisions that need to be made early on in the process. So with that, I will close out, say, please subscribe to the podcast if you like it and share it with a friend. Um, if you can also rate and review the podcast, we appreciate you listening today and I look forward to our next step on this journey.