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First Generation Solutions

Most entrepreneurs may not think of themselves as a family business, but it’s best to prepare as such as the business evolves

Story by Lee Marie Reinsch

You’ve hung out your shingle: Cupcakes by Cutie. Your website’s up, your commercial kitchen’s ready, your client list quivers with anticipation. You’re ready to start baking — just you, your massive Mixmaster and … your family?

Even if they’re nowhere to be found (or nonexistent) when it comes to dishwashing, they’re in it with you. A business is a family business from the start, said Dale Feinauer, business management professor at University of Wisconsin Oshkosh College of Business Administration and faculty liaison to the Wisconsin Family Business Forum.

“Immediately, Day One, your spouse is co-owner of the business, and he or she is engaged in that question of ownership if the person dies,” Feinauer said. “So what’s now occurring in the business, how it’s being managed and how it all plays out is influencing the spouse right away.”

Along with the late nights, cold dinners and scrapped weekend plans.

Any closely held business has the potential for undesirable turnover, Feinauer said. So it’s smart to have a plan in place, should a bus hit you or an epiphany spark a move to a yurt.

“We need to be thinking about all these transition issues from the very beginning,” Feinauer said.

Granted, new business owners’ heads buzz with myriad minutiae accompanying the survival and growth of their business.

Outreach to others

Based at UWOshkosh, the Wisconsin Family Business Forum leads workshops for family businesses, counsels and advises, and offers a family business education certification. Its small peer groups help those in similar stages of business evolution tackle issues they face.

“Running a business is complicated enough, and running a family is complicated enough with all the personalities and relationships and communication,” said Meridith Jaeger, executive director of the Forum. “You get even more interesting dynamics when you put the family in the business.”

Most businesses involve owners, managers and families – and they’re usually separate. “They fall into three different boxes – your family are not fellow employees, and employees aren’t typically owners, for most businesses,” Jaeger said.

All that’s out the window in family businesses. Prepare for communication glitches, petty jealousies, sibling rivalries, competition for a parent’s attention. Whose shoulder can you cry on?

“One of the downsides of being the owner of a family business is you don’t have anybody to talk to,” Feinauer said. Peer-group participants from the Forum are there to lend an ear.

Passing the torch

The founding generation may be used to governing autocratically.

“As that business moves into the hands of sons, daughters, executives and nonfamily members, decision-making becomes more collaborative, more like a partnership where we have consensus,” said Bob Mathers, partner, business law and estate planning attorney with Davis & Kuelthau, S.C. in Oshkosh. He’s also a CPA and certified financial planner. “A lot of times that drives the need to have policies in place.”

For example, consider the issue of wages: with autocratic decision making, if Mom says that’s what employees earn, that’s the final decision. “But when you get to brothers and sisters deciding on compensation, you need a compensation policy, and make sure you adhere to it so we don’t get people’s noses out of joint,” Mathers said.

Siblings working together usually know what to expect, said Jaeger. They usually grew up together in the same house, with the same parents and motivation. They know what trips each other’s trigger.

It’s the third generation – “the cousin consortium” – where all hell can break loose.

“They didn’t grow up in the same house with the same motivation,” Jaeger said. “With my brothers and I, we had the same parents, and we know what’s expected of us moving forward.”

The cousin consortium leans more like a formal business environment, where family and nonfamily are involved in decision-making.

“How the business makes decisions changes as the business evolves to the next generation,” Mathers said.

Shifting between generations

Transitioning a business is the No. 1 reason that brings most Forum members into the organization, Jaeger said. Where to begin?

“We look at their financial plan,” Mathers said. “Most don’t have a financial plan, but if they do, it goes a long way.”

Figure out a way to turn asset ownership and balance-sheet assets into income. “The next generation can manage the assets, but if you have that safe and secure income stream for that senior family member to live on, they can feel more comfortable to start giving up some of those reins,” Mathers said. “Look at the senior family member’s income needs, assess how realistic they are and get those as secure as possible so they’re independent from the family business.”

One example: When a separate entity, controlled by the parent, owns the business real estate. “It’s a technique most but not all family businesses have already engaged in, so you can give or sell that operating company to the next generation but that operating company is paying rent to the real estate company,” Mathers said. “So the senior family member may have given up the operating company off their balance sheet, but they still maintain an income stream from that operating company.”

Lately Mathers is seeing more companies doing the same thing with intellectual property instead of real estate. “So instead of a lease in the form of rent, I’ll pay a royalty in the form of a license on that intellectual property and use that as my income stream.”

Along with the retiree income stream: Income from an operating company is considered self-employment income and subject to higher tax rates, Mathers said.

“Rental income is considered passive income and not subject to self-employment taxes,” Mathers said. “Not only do we have a healthy income stream going to the senior family member, but it’s also taxed at a different rate.”

The operating company can deduct expenses, and the Mom and Dad’s income stays independent from their kids’ business decisions.

So how to move equity ownership from one generation to the next? One way is gradually, through gifting transactions: Mom and Dad can give away the business in smaller chunks using the $14,000 per year gift-tax exclusion.

“Often what I will do is make a gift in December and then again in January, so that’s $28,000 worth of gifting,” Mathers said. “For a married couple, that’s $56,000 in gifts that can be made within a couple days of each other.”

Upside: Recipients don’t pay tax on that income. Downside: Recipients inherit the donor’s tax basis, which is usually lower, which means higher capital gains taxes when the recipient sells the business.

Inheriting the business can remedy the capital gains problem – but it means someone had to die for that to happen. By that time, if heirs aren’t in the business, they may not have the needed experience.

“Oftentimes because of the governance of the family business, the senior family member wants the junior family member to start making decisions and taking ownership before they die,” Mathers said.

That’s actually where Oshkosh-based Aegis Financial president Bill Bowman starts when a transitioning family business comes in for financial advice: By asking if the next generation is ready to take over the business.

“We ask the questions that are on everybody’s mind, but they don’t know how to ask them,” Bowman said. “If a son and father come in, we can easily discuss those things … We’ve had clients that are multigenerational businesses and, although the founder loved it, for the second generation, it may not be their thing. The first generation has to really be sure the next generation is passionate about the business just as much as them.”

No cookie cutter approach

Transition deals can be structured many different ways, depending on the assets of the business, the cash flow it provides, and goals of all those involved, Bowman said.

“The more assets and the more cash flow the business is generating, the more available lending will be,” Bowman said.

Selling the business to the next generation for less than its value is one way to keep the business operating or give it some flexibility during the transition.

“If the payments are less (or stretched out into the future), it helps the next generation with cash flow so they can keep it operational,” Bowman said. “It depends on what they’re trying to accomplish and how can we structure this deal so that, one, the second generation has the best possibility of continuing on and, two, the individual retiring has enough income to provide for his retirement years.”

Aegis’ team of accountants and attorneys strives to develop a deal that minimizes taxes while helping each party succeed.

“Everybody needs to win in this circumstance,” Bowman said. “For the person who’s retiring, his future is based on the business being able to maintain itself or grow, so you don’t want to put too much burden on that second generation. If they’re not able to maintain that business, the first generation won’t get their money out of it.”

Entrepreneurial families

It’s commonplace that only a small percentage of family businesses make it to the second and third generation. Mathers’ experience leads him to posit that the truth may be more positive than the data illustrates.

“For the entrepreneurial family, it’s not about this one company – they’re buying and selling businesses, not just holding onto them generation after generation,” Mathers said. “Successful family businesses, that’s what they do: Just because we sell the widget company doesn’t mean it’s a capitulation, because more often than not, the entrepreneurial family is taking the proceeds … and reinvesting into another family-owned business.”

In the last decade, low interest rates have heated up the private-equity market. In his own practice, Mathers sees families selling off parts of the business so they can focus on the core that really represents it.

“Family-owned businesses on average drive a 6 percent higher return on assets than their nonfamily-owned counterparts, so private equity firms are very interested in getting that financial success into their portfolio,” Mathers said. “Low interest rates have made money more available for them to come to family businesses and say, ‘We’ll buy you out.’”

All in the family

Brothers Joe and Charlie Luedtke of SPC, Inc. in Hortonville – producer of skids, pallets and crates – have always known they were going into the company their dad, Bob, started.

“Dad wanted to start it so he’d have something to pass on to us – a secure job, a future, something we’d like to do and would enjoy doing,” said co-owner Joe Luedtke. “It was always drilled in from early on that ‘I’m starting this for you guys’ and we would carry it on after he retired.”

Although now retired, Bob remains majority owner of the company, with the brothers as minority owners. They haven’t consummated the formal stock transfer yet. “I think Dad plans to hold onto that for several more years just, still being CEO on paper,” Luedtke said. “He still wants to have some involvement in the business, still wants to be informed of what’s going on, but as far as what really happens and the decisions that get made on a daily basis, we’re doing that. But he still wants to hold onto the baby that he started to make sure it’s successful and stays on the path he started for us.”

The brothers complement each other. Joe handles sales, buying and customer support, and Charlie handles payroll, receivables and payables.

“We have a great relationship while we’re here and outside of work as well,” Luedtke said of he and his brother.

When a business needs professional help

Steve Utech’s father, Ken, never intended to create a family business. Yet decades later, his wife, son and daughter are key principles of Utech Consulting, Inc. of De Pere.

Utech began as a family therapy office, but found itself dealing with many business owners. As the consulting firm evolved, it now helps companies thrive by improving relationships and communication. Steve Utech said 20 to 40 percent of his family’s business comes from other family businesses seeking help with transitions and uncomfortable family dynamics.

“For example, one of the kids or siblings is underperforming and it’s difficult for parents to address that because of the emotional ties that come along with that (situation),” Utech said. “We facilitate conversations. Sometimes we’ll do a little bit of family therapy at the front end to get the emotional baggage out so people can clear the conversation and get through some of the transition planning and have effective communication with their lawyers or accountants so it doesn’t have to be this painful process where families are torn apart during the transition.”

Utech said family businesses come with pros and cons. “Being a son or daughter (of the owners), you’re going to get opportunities to move ahead quicker than someone who doesn’t have that opportunity,” he said. Two years after graduate school, Utech said he had projects that otherwise would require a decade of experience.

“That itself was a gift and allowed me to fast track my career,” he said.

But those not in business with their families may have more freedom to be the adults they’ve grown up to be, rather than the kids their family members see.

“The emotional dynamic of the family can be somewhat confining,” he said. “In some family businesses, it might be you don’t want to disrespect your parents or maybe the founder doesn’t want to give up control, and that puts a constraint on the kids.

“Or maybe there’s competition between the kids and how they receive love or affirmation from the parents: It’s not spoken, but you’re performing for that love and appreciation.”

And feedback: From your boss, it’s just feedback. But when Mom’s your boss, it can seem like approval or love.

“It’s this weird thing that develops with family business dynamics.”

Lee Reinsch of Green Bay worked 18 years at daily newspapers before launching her freelance business, edgewise, in 2007.