Pass it on…

Fiscal pressures, the search for talent, international expansion… family companies need to deal with a wide array of challenges. Without doubt, however, the most critical challenge involves generational change. More specifically, what happens when the third generation – the grandchildren of the founders of the company – takes over.

“The most important temptation for today’s entrepreneur is not being infallible, but being immortal.” A seasoned entrepreneur

The role that family-owned businesses play in the economy should not be underestimated. For one, they are in fact the most common type of business organisations. Furthermore, they can be quite large, as exemplified by such global players as Walmart, Samsung and Ermenegildo Zegna, which are also major employers.

An impressive 88% of current family business owners believe the same family or families will control their business in five years, but succession statistics undermine this belief. Only about 30% of family and businesses survive into the second generation, 12% are still viable into the third generation, and only about 3% of all family businesses operate into the fourth generation or beyond. The statistics reveal a disconnect between the optimistic belief of today’s family business owners and the reality of the massive failure of family companies to survive through the generations. Research indicates that family business failures can essentially be traced to one factor: an unfortunate lack of family business succession planning.

Where should the apple fall?

Most family businesses struggle with succession as it is an extraordinary and rare event. However, it can and must certainly be planned for. In Switzerland, 216,000 out of 300,000 companies number less than ten employees, and only 1,000 have more than 250 employees. Small and medium- sized, mostly family owned, companies form the backbone of the Swiss economy. One out of four is confronted with having to find a replacement for their owner/founder/manager as he or she approaches retirement age. According to UBS, 45,000 to 60,000 enterprises will find themselves in such a predicament within five years.

Entrepreneurs generally put the lion’s share of their effort into building up their business, naturally, while a negligible amount goes into planning for succession, even though it can take up to seven years to successfully transfer a business. The complexity of the issues to be resolved and that the owner/founder is confronted with is both highly technical (taxes, retirement amount, inheritance taxes, succession rights of the family, qualifications and motivation of the successor(s), credit rating, etc.), and sometimes also very emotional (family involvement in the business, for example). That may explain why in a seemingly disproportionate 52% of cases the business is sold to its employees through a management buy-out.

In 2007 Credit Suisse and the University of St. Gallen published an extensive study on the subject. One of the sad consequences of the failure of entrepreneurs to proceed to an orderly and successful transfer of the business they created is a very important number of job losses because the businesses, without management, close down.

There are several solutions to replace the ageing owner:

  1. succession by family member(s)
  2. management by an outside person while the business remains in control by the family
  3. an IPO
  4. merger or participation by a financial investor (however, the latter does not provide for management)
  5. a MBO and/or a management buy-in
  6. the sale to a strategic partner.

Choice challenge

Even for the owner/founder of a family company, it can be a challenge to navigate not only the complexities of the business itself, but also of the family dynamics, let alone succession planning. The family and the business become so intertwined that it’s hard to tell where one ends and the other begins.

The nature of the beast often leads to the conclusion that the time is ripe to strip the family business of its “family member” status and treat it for what it is: a business and, accordingly, consider selling the company. Easier said than done – for many entrepreneurs, their company is their life’s work, and the sale of their business may have dramatic implications for both their own and their family’s financial and personal lives. But after the sale decision has been made, new issues emerge and another planning process begins:

Moving to the next gen

It is mandatory for the entrepreneur to put in writing the organisation of the enterprise when he is not longer the “captain of the ship,” get the adequate people to do the job – and stick to his decision to hand over the daily business as well as the strategy of the enterprise and implement the plan of succession. This process may take several years and must be taken seriously if the value and the future of the enterprise are to be preserved.

Pure figures

The enterprise should be priced at fair value. To be able to do that, any assets adding value to the balance sheet but not to the company, should be eliminated, and transferred to the owner. So, the buyer will pay only for what interests him.

Also, the balance sheet must be transparent. Undervalued assets may cause conflict in the points of view of the negotiating parties and also be a risk for the buyer in case they are re-evaluated and the difference in value taxed as a profit, even though no cash has been generated.

The seller will certainly hesitate because transferring assets from the commercial to the private fortune entails taxation of the price difference between value on the balance sheet and market value as partial liquidation of the business. Since tax rates are progressive, transforming business into private assets should be done gradually, over several tax periods (years), in order to be taxed at lower liquidation tax rates.

The business may also be divided into several separate entities, e.g. into production and real estate holding enterprises, of which the first will be sold and the second kept by the owner.

This kind of scenario will have to be dealt with according to the Law on Fusions (which also rules scissions of enterprises). It is crucial to know that this law also defines the conditions at which this kind of operation will be fiscally neutral – i.e. a period of five years without changes or transfers in order to avoid tax reprisals.

Influence of the juridical status of the enterprise

A business in Switzerland may be founded without creating a company. Registered partnerships, limited partnerships and individual enterprises may be registered with the company register to do business. Creating and registering the enterprise as a joint stock company or a limited liability company has the advantage of separating the business from the private assets of the entrepreneur, but entails a 35% withholding tax on dividends, a final tax on dividends, plus the annual taxes on the net assets and the benefits of the company. This system is considered a double taxation of company profits.

Fiscal factors

Fiscal aspects may sometimes hamper the transfer of a small to medium-sized business in Switzerland. This is why tax planning is crucial to a successful succession. Tax authorities make a distinction between the commercial and private assets of a natural person, and the passing of any assets from one to the other category entails tax consequences which may be quite expensive.

Sale of a non-incorporated business

The sale of the business or parts of it is subject to the liquidation tax on capital gains. This tax is levied on the difference of the value of the enterprise’s assets in the books and the price received from the buyer/successor, at the rate of the personal income tax on independent professionals. The maximum tax rate is 40%, to which 9.5% AVS (social security) on professional income must be added.

Sale of a joint stock company

If the owner has incorporated his enterprise as a joint stock company, the sale of the shares and any gains on their value may be regarded as private capital gains, which are generally not subject to income tax in Switzerland. The reason is that the shares are regarded as being a part of the private assets of the seller.

Hence, advisors usually recommend that the owner convert the enterprise into a joint-stock company before selling the business. The company must keep its productive assets for at least five years; if they are sold in order to finance the acquisition, the operations will be deemed to be a partial liquidation and the seller will be taxed as if the had liquidated the company. Therefore, he must provide in the sales contract that the buyer may not, for a period of five years, proceed to what the tax authorities may consider as a partial liquidation of the company.

Financial factors

An enterprise being put up for sale should be able to generate enough cash to liquidate present indebtedness in a period of five years. The buyer should be able to raise at least 20% of the sale price of the enterprise. The banks are generally well equipped to counsel and work out financial plans to facilitate a handover. Many entrepreneurs help the buyer by conceding payment conditions such as payment by tranches, granting a loan, granting a guarantee to the bank financing the deal, or a reduction of the price of sale.

Family inheritance rights

One important factor often neglected is communication within the family of the founder/owner of the company. Family enterprises are frequently structured by hierarchy and power of predominant members, with little or no communication with members of the family such as children of even the spouse. Decisions taken by the owner, if he or she wants to keep an adequate relationship with his or her family, need to be shared with other family members in order to avoid conflict that may hamper the functioning of the enterprise and even the transfer to one family member or employees or even third parties. Highly emotional issues may end up in court proceedings, stopping or slowing down the evaluation process of the company and any negotiations to hand it over. If one child is to take over the enterprise, the spouse and other children have to be thought of and paid off in cash or other assets in order to respect at least obligatory succession provisions of Swiss law.

As a guideline, the following parts of the heirloom are protected:

For the spouse: 1/2 of the value of all assets accumulated by the couple during the marriage, as entitlement to the liquidation value of the marital union; the only way to avoid this is for the entrepreneur to enter a formal separation of assets agreement at the onset of the marriage

For the spouse as heir:

  • 100% of all assets, of which 50% are protected, if there are no children
  • 50% of all assets, of which 50% are protected, if the heirloom is to be shared with children
  • 75% of all assets, of which 50% are protected, if the heirloom is to be shared with the company owner’s parents For the children as heirs:
  • 100% of all assets, of which 3/4 are protected, if there is no surviving spouse
  • 50% of all assets, of which 3/4 are protected, in case of a surviving spouse
  • If there are children of the deceased, his parents inherit nothing.

These inheritance rules must be followed if the succession is to be effective within the family. Neither the spouse nor other children will accept to be despoiled of their part of the value created and held within the company in favour of the chosen successor within the family circle (one of the children, cousin, nephew, etc.). They will have to be paid off in cash amounting to the value of their protected part of the heirloom, so arrangements will have to be made to generate enough liquid assets to pay off their claims.

If the enterprise has been incorporated into a joint stock company, the product of the sale of the shares will be divided among the heirs in the same proportions as cited above. Such are some of the points which have to be envisaged for a successful transfer of a family business.

About the author: Geneva-based Isabel von Fliedner is an international lawyer and litigator with extensive experience in Swiss Corporate Law.