Sweet smell of succession

Over the next five to 10 years there will be a tectonic shift in the nation's wealth,

as baby boomers sell or retire from the businesses they either founded or inherited from their parents.

The value of these family businesses tripled in the five years to 2003 to a staggering $3.6 trillion, a study by RMIT University found. Anecdotally, their wealth is still rising on the back of 14 years of unbroken economic growth.

With eight-in-10 owners now aged more than 50 and one-in-five over 65, many will soon try to unlock that wealth.

How this is achieved will not only determine the owner's quality of retirement and the future wealth of their children - it will also have major ramifications for the national economy.

Small businesses generate more than half of the country's employment growth and account for about 40 per cent of private sector output, the RMIT University report's author, Professor Kosmas Smyrnios, told Money.

Most people will be familiar with the adage that the first generation establishes wealth, the second develops it and the third destroys it. Smyrnios cites US academic Kris Frieswick, who argues this can easily be avoided.

Frieswick attributes the rate of failures to the lack of succession planning, the owners' inability to let go, reluctance by parents to choose a successor from among their children, and owners who see no life beyond the business.

Smyrnios says owners approaching retirement should start "working on the business, not in the business" and develop a succession plan about five years before they plan to exit.

"Succession is a process, not an event. It is something that requires medium to long-term planning," he says. "It involves dealing with the structure of the business, the financials and all the issues relating to the successor."

According to KPMG/Family Business Australia's Survey of Family Business Needs 2005, released last week, 30 per cent of business owners plan to retire in the next five years, with another 27 per cent after 10 years.

What is most disturbing, says Philippa Taylor, Family Business Australia's chief executive, is that 34 per cent have no formal succession plan, 68 per cent have not chosen a successor and 27 per cent were unsure of an exit strategy.

Cautionary tales

Graham Connolly, the managing director of the Family and Private Business Advisers Group, says names such as Belgiorno-Nettis (Transfield) and Murdoch (News Corp) should be seen as cautionary tales of what family businesses should not do.

"There are many cases that confirm when generations cannot develop a succession plan, the real beneficiaries are the lawyers," he says. "What a dreadful reward for the time, effort, commitment and passion of the founder or current owners."

Connolly is one of a handful of consultants offering advice tailored to families. He says speaking to all the family members and their spouses - whether they are active in the business or not - about their hopes, ambitions and concerns for the company is crucial.

In the process, he says, all family members understand each other and how they stand in relation to the company. Too many families have been tragically ripped apart by financial disputes. The key to business succession plans is to foresee the problems and resolve them, drafting and adhering to a family constitution.

"You are dealing with the two largest assets that any family generally has - the business they have created and the family they have got," Connolly says. "The problem is that they don't sit comfortably side by side when things get tough or when generation change occurs.

"Family businesses without a constitution where all signatories are committed and have been involved in the process of drafting the document have little chance of it being observed when things go wrong."

Smyrnios says a family constitution outlines strategies and solutions that can be implemented to deal with family-related matters that affect the smooth running of the business.

It includes criteria for joining the business, definition of the roles and responsibilities of active and passive family members, and mechanisms to be adopted for the transfer of ownership and leadership.

"If you don't deal with the emotional family side, it has spill over effects and reverberations throughout that organisation," he says, particularly in the transition from founder to second generation.

Professor Ken Moores, the director of the Australian Centre for Family Business at Bond University, says the process of writing a family constitution also helps to professionalise the company as it focuses attention on the business and its needs.

He says any rules should preserve the unique features of the family business while recognising that it is a professional company. This, in turn, will allow it to be more easily valued (see box, right).

Sale ready

Given that there will be a flood of small businesses on the market over the next 10 years, the experts say owners should always be ready to jump at a good offer should it come along unexpectedly.

This also applies for those who want to sell to their children, as no one knows if and when the proverbial bus will come along.

"It is a good idea to always be prepared because you don't know when the opportunities will come up, like a supply chain operator in your industry with an aggressive acquisition strategy," says Judy Hartcher, CPA Australia's business policy adviser.

The checklist for sale-ready businesses include ensuring that you have a family constitution, the company has been realistically valued (even if it is just a rough figure), and senior management and key staff are in place.

Options

Harry Kras, from the Family Business Resource Centre, says businesses have five basic options when the owner wants to retire: hand it on to the next generation, sell to a third party, arrange a management buyout, liquidation or list on the stock exchange. The last option, he says, is not open to most small businesses due to the sheer size necessary for it to work.

Tim Gullifer, a partner at Deloitte Growth Solutions, offers one more option. He says family business should at least contemplate making use of the hundreds of millions of dollars now in private equity funds and looking for a home.

Within the family

Whether the owner is first, second or third generation, it is highly likely that they have poured their heart and soul into building up the business. In most cases this means that the owner's "retirement savings" are also locked away in the company.

Deloitte's Gullifer says no matter who buys the business, the owners must establish an agreed value. This will protect the parents financially and help instil the child with a sense of the business's intrinsic value.

It will also prevent a feud between siblings who are concerned about their perceived share of the pie.

"If you are selling to family members it is important to get an independent valuation, because if you overvalue it the family member who acquires it pays more than they should," Gullifer says. "Conversely, if you go down the emotional route and undervalue it, it will be to the detriment of the owner and other family members. If you put a figure on the table, a family member can come in and buy it."

The owners will already know if any of their children want to take over the business, thanks to the family conference/constitution.

Once the "new" generation agrees on the price, parents have a number of payments options, Kras says.

The price can be written off in the will, paid out of future profits, or the child(ren) can simply take out a bank loan.

Dominic Pelligana, a partner at KPMG, says if owners opt for future profits, they must have cash reserves to pay the capital tax liability once the sale is made, not when the purchase price is paid.

The Australian Tax Office also says that in any business sale it requires a letter confirming that the company is an ongoing one.

Trade sale

One of the worst exit strategies is simply putting an ad in the paper. Deloitte's Gullifer says this is generally seen as "desperate" and could seriously dilute the firm's goodwill.

A large part of the goodwill that jacks up the final sale price is the company's relationships with its suppliers and customers. Gullifer says if they are not sure if the business will be an ongoing concern, they could look elsewhere - creating risk and uncertainty for any new buyer. A bit of homework could add thousands of dollars, if not hundreds of thousands to the price, he says.

Sellers should quietly compare themselves with others in the sector, value the business, and then compile a list of potential buyers.

"Once they have identified likely acquirers, prepare an information memorandum. This is when the public become aware, so you have to inform your employees," Gullifer says. "The acquirer will also want to talk to your customers and suppliers, so they must be brought in."

But be warned, he says - although suitors may agree to sign a confidentiality agreement, "[these] are not worth the paper they are written on". Connolly says the information memorandum should contain the sale procedure, executive summary of the sale, history of the business, products/services overview, details of the market, distribution and supply arrangement, names of key customers, financial projections and future potential.

Management buyout

This is an increasingly popular method of sale as it allows managers and staff to pool their resources to buy the business.

For larger companies, the employees may have to get the backing of the bank and use the business as collateral.

Connolly says as management usually comprises younger people who already have mortgages and insufficient equity, the majority of buyouts do not add up and often fail to attract even the more expensive senior debt and mezzanine funding.

"However, for those who can achieve funding this choice is highly desirable," he says.

Some owners who want a staged retirement may loan the managers money or pay future salaries as equity in the business.

Liquidation

Hopefully a business will never get itself into the situation where they have no option other than to liquidate the company. However, if this is their only choice, they should consult a compliance accountant, Connolly says.

Private equity

Every month about $3 million pours into investment houses through super funds. Yet the sharemarket is at a high and other investment classes are at best mediocre.

The extra funds still need to go somewhere, and at the moment they are being held by the likes of Deutsche Bank Private Equity, Investco, and many others.

"It's not a difficult process selling to a private equity player," Gulliver says. "Last year I sold a $35 million business in the rag trade to Deutsche Bank. It was funded by two super funds. It [the bank] was looking to cobble three similar businesses together, then exit [through an ASX listing] and make some money on the way" for the super funds.

He says businesses should not be seen desperately knocking on the banks' doors. Instead, the introductions should be made through a corporate finance company, that has a relationship with the private equity fund.

Tax and discounts

For those businesses where the sale and asset mix is below $5 million, there are a number of discounts available.

These include the small business 15-year exception offering a total write-off of CGT liabilities; the small business 50 per cent active asset reduction; the small business retirement exception that provides owners with exceptions if they put the money into superannuation; and the small business rollover. For more information go to http://www.ato.gov.au.

Useful websites

Family Business Australia: http://www.fambiz.com.au

Family Business Resource Centre: http://www.fbrc.com.au

Family and Private Business Adviser Group:

http://www.succession.com.au, http://www.businessmentoring

.com.au.

The final cut

Leo Lucas hates paperwork and book-keeping, so, after more than 40 years of running the family butchers, he decided it was time to get out when the Government introduced yet another piece of regulation.

"I would have been happy to keep on going, but there is so much regulation these days that I just thought it was time to get out," Lucas says.

He founded the family business when he opened a small butcher shop in the Sydney eastern suburb of Randwick in the 1960s. In 1978 he moved the shop to the nearby beachside suburb of Bronte, also buying the large block of land on which it sat.

Over the years Lucas built a ham and bacon factory behind the butchers that during the peak Christmas period would employ about 12 staff.

When Lucas's second-eldest child, David, approached him about taking over the business, Lucas couldn't have been happier. He had been contemplating knocking down the factory and building apartments.

Lucas contacted a succession accountant through the Family and Private Business Advisory Group. He interviewed Lucas, his wife Ruth and David about the planned

sale. He also spoke with the couple's other five children and spouses to gauge their feelings about the purchase.

Lucas says the sale price was negotiated with David as there is no market demand for butchers and, as a wholesaler, there was very little goodwill in the business.

David has since spent about $100,000 updating the factory, and, although he had asked his father to help to train him, Lucas has found he is spending much more time on the golf course.

When the price is right

When even the experts say there is "a lot of art in the science of valuations", you know it's not going to be easy to put a price tag on a business.

The first rule, says KPMG partner Dominic Pelligana, is that it has to be a true valuation. Many businesses may pay private expenses such as, say, school fees out of cash flow. It must be accounted for in the calculation.

After that, the rules become blurry. CPA Australia's business policy adviser, Judy Hartcher, says there is no one method that is used, and which largely depends on the industry.

Differing methods, which can be employed on their own or in a combination, include the capitalised earnings approach, excess earnings method, cash flow method, asset valuation, and rule of thumb method.

Hartcher says due to the complexity, owners should seek professional assistance to determine the price.

One method is to value the business based on two assets: net (physical) assets, which are easy to determine; and goodwill, which is more troublesome to measure.

Net assets are what they seem. Simply take the book value of all assets, remembering to subtract debt.

Goodwill is more fluid and, Hartcher says, in many cases is simply determined by what the purchaser is willing to pay for what they consider the goodwill is worth.

Hartcher warns that owners may confuse their love of the business with its real value.

"A lot of people put their whole life into their business," she says. "It's like having a child, so they can overvalue it, particularly if they don't have an objective look at

what they are actually selling. They should be getting advice about the real value and how they can improve it in the lead-up to the sale."

Professor Ken Moores, the director of the Australian Centre for Family Business at Bond University, says goodwill is the premium that the business commands over and above the fixed assets and is based on the strength of its relationships with suppliers and customers, its market share, and the risks associated with operating in that sector.

Pelligana says for businesses to get an idea of the value of their own goodwill, owners should look at what comparable businesses have been sold for in the market.

Another common method is taking earnings before interest, tax, depreciation and amortisation, then multiplying it to generate an economic value, says Deloitte Growth Solutions partner Tim Gullifer.

The snapshot should be of the past three years and the expected outlook for the next year or two.

The multiplication factor, also called a risk factor, which generates an enterprise value, is industry specific. He says to ascertain what your company's factor is, examine sales of similar business in your sector.

Time to go

Kevin Chambers was returning to his usual trans-Pacific plane seat - upper deck, exit row 16K - when he asked himself why he was spending up to 10 weeks every year hocking his company's plastic tags around the world.

Soon after touching down in Melbourne, he spoke to his business partner and younger brother, Ron. They decided it was time to plan for a carefully executed retirement, and quietly put the feelers out for a buyer.

Kevin, 57, and Ron, 52, inherited the plastic tag manufacturing business, Kevron Plastics, in 1975 from their father, who founded it in 1952. Determined to make a go of their chance, the brothers transformed the suburban Brunswick operation into an internationally competitive company. It exports more than 30 per cent of production, topping 35,000 tonnes in the last year the brothers owned it.

"These plastic tags have fed three generations of my family and provided me and Ron with a very comfortable retirement," Kevin says. As with most of the family businesses of his father's era, it was expected that the children would end up running the company. "These days people emphasise developing succession plans, and they are right."

When Kevin told Ron of his desire to retire and work on his golf, the brothers already knew that none of their children wanted to take the business over.

Kevin says it took about two years to find the right buyer, Phil Parton, who runs the company with Paul Metz, who remained as general manager after the sale.

"I'm a great believer in networking, in building the brand - 50 per cent of the price was goodwill and that is very high for a small business," he says.