As professional accountants, we often see our family business clients hit a point in their journey where the business is transferred from one generation to the next. In our tax and accounting world, we call this point the intergenerational freeze. It allows for the future growth and control of the family business to accrue to the next generation and freezes the present generation’s interest in the business.
The transfer of the family business from one generation to the next will continue to be a highly relevant topic as the baby boom generation approaches the retirement phase of their business careers or even the “semi-retirement” phase.
Although the execution of the intergenerational freeze is the essence of what we do as tax accountants to help our family business clients achieve this key milestone, it is the background and preamble to the freeze that drives its form and timing. This article shares with you the experiences that we as external accountants see as the business gets to the point where it is effectively transferred to the next generation.
Transferring future growth of the family business
In the transfer, two basic components can be transferred, but not necessarily at the same time. The first component is participation in the future growth of the business. The second component is control of the business. Typically, the one that we see transferred first is participation in the future growth of the business.
When that point occurs, and if the common shares of the business are owned, in some fashion, by the present or first generation, those common shares are subjected to a valuation and those shares are exchanged (at the “frozen value”) for redeemable preferred shares. These shares are redeemable at the option of the holder and represent the nest egg that the present or first generation will have for the next chapter of their lives. The next generation then subscribes for new common shares for a nominal value at issue date. These shares represent the future growth in value of the family business.
Without complicating things too much, in many businesses the common shares are held by a first generation family trust, and while the transaction process for a trust is different from what was described above, the fundamental issue is the same, that being, when is the first generation prepared to cap their financial interest in the family business?
The timing of the transfer of the future growth component is largely a financial decision. The first generation goes through a process to determine how much they require financially to achieve their desired future lifestyle. This sounds simple but it does require some careful financial planning; the timing of this component can be delayed in many cases because the first generation has not set aside the time and effort to do the necessary personal financial planning to cap their financial interest in the family business. This is not a criticism but rather an observation of what we have seen. This is entirely a personal activity of the first generation that does not affect the family business directly but certainly can delay the transition process.
Transferring control of the family business
As noted, transfer of control is typically the second aspect of the intergenerational transfer and although it can happen later, the resolution of this question often drives and inherently defers the timing of the first component. As external accountants, our experience has resulted in us understanding that control is a term that has many layers and factors. While we are not business psychologists, here is a summary of what we have seen, beginning with layers of control:
Operational control. This refers to who has management or stewardship of the family business and how the day-to-day decisions are being made (what are often referred to as the “how to” decisions). In some cases, the first generation still has full control of these matters and in other cases, the next generation has taken over this aspect of control already.
Strategic control. This refers to who has control over the major decisions of the business (e.g., capital purchases, new financing, new lines of business, divesting of unprofitable lines of business) that are more strategic than operational in nature. These are the “what” decisions for the business versus the “how to” decisions.
Read a report titled Effective Tax Strategies for Your Family Business by Pwc.
Voting control. This refers to the legal term of control and this is tied up in who holds the voting shares of the family business. This type of control is sometimes referred to as having the crown. Typically, these voting shares are not transferred until the first two layers of control have effectively transferred to the next generation.
Here are some of the factors we have seen that drive transfer of control:
Emotional attachment to the business. This refers to the level of emotional attachment that the first generation has to the business. We must remember that the business has been the centre of the first generation’s existence for many years and while it is natural and expected that there will be emotional attachment, it is critical that this level of attachment decline as the transfer gets closer. Again, this is a personal issue for the first generation and it is important that, among other things, the first generation has defined a next chapter that involves things that are non-business, such as personal activities that can occupy and fulfill their daily lives.
Management style of the first generation. This refers to the first generation’s evolving management style in the business. To achieve transfer of control, the first generation would have to evolve to more of a nurturing role with successor family members. This sounds simple but it does require a shift in approach for most first generation owners because they likely built the business by taking control and being active in achieving the business objectives that were critical to the success of the business. Now, they have to adapt to no longer being either an operator or even a pilot of the business.
Confidence in the next generation. This can be wrapped up in a number of threads. The personal relationships between the generations can either improve or impair that confidence level. In addition, confidence is tied to trust; specifically, to what extent does the first generation trust the next generation to maintain and grow the family business into the future? The security of the first generation’s nest egg could depend on the maintenance and growth of the family business.
Control is a term that has many layers and factors.
While the intergenerational transfer of the family business involves a complex set of tax, financial, and legal steps, those can, ironically, be the easier pieces of the intergenerational transition puzzle, compared with the other factors that many first generation owners face as they near retirement or semi-retirement. As accountants and business advisors, it is important that we understand these other factors in working with both generations to achieve this milestone in the family business life cycle.
First published in the March 2018 edition of The Business Advisor.