When retirement planning becomes a family affair, it’s difficult to sort out how a win-win situation could exist—with all the baggage, emotion and control issues familiar to every family. It’s not always easy or even clear-cut, but business owners can create favorable conditions now to finance retirement, while implementing a transition satisfactory to everyone when the time comes.
All in the Family
A few years ago, I worked with two clients, John and Mary (not their real names) who ran a business that consistently ranked in the top 15% in their industry. They had been in business about twenty years, but still had a limited retirement savings from the business. Even so, they continued to count on financing their retirement from the business.
John was 55 and Mary was 61 at the time I worked with them. Mary had two children from her previous marriage, Jerry and Mimi. Jerry had been the general manager of the business since its inception. Mimi was a family physician and had no interest in the business.
The objective was for the proceeds of the transfer to fund John and Mary’s retirement. However, Jerry had demonstrated limited capabilities in running this business (or any business). John expressed faith that Jerry would be able to handle the business in time, with proper training, while Mary continued to be concerned that Jerry would fail, without any future job prospects. Her worries were rooted in the fact that Jerry had emotional issues and was a recreational drug user. Mary’s concerns, both as a business owner and mother, were valid.
In addition, Jerry had made many mistakes in the past by acting on poor advice or information on investing in real estate and businesses. But while Jerry did not have sharp business acumen, he had no debt due to a recent inheritance from his biological father.
Who’s the Boss?
According to O’Donoghue & Rabin (1999), there are two personality approaches to finances:
1) Sophisticated tends to mitigate procrastination.
2) Naïve tends to enjoy the rewards now.
Both John and Mary could be classified as sophisticated because they proactively planned their retirement and how to reach their goals through succession planning. Jerry could be classified as naïve because of his propensity to enjoy rewards available to him in the immediate without thinking about tomorrow.
In hopes of optimizing the outcome scenario of Jerry of not meeting expectations, with my team’s help, they put in place a properly managed implementation of a succession plan to help all parties stay on course.
Let’s look at the obstacles this family succession plan had to address:
• John’s overconfidence regarding Jerry’s capabilities. Barber & Odean (2000) found overconfidence in frequent trading resulted in underperformance compared to the benchmark.
• Jerry had historically underperformed compared to his peers in the business.
• Jerry’s underperformance in work potentially could have deviated John and Mary’s plan.
• The plan required a long-term correction in not overreacting with each bias to help in achieving the goal. Daniel, Hirshleifer & Subrahmanyam (1998).
• The plan required John to put a training plan in place to ensure Jerry’s success in the business transition.
With a succession plan in place, John and Mary were set to leverage an annual gift exemption of 40% of the business to Jerry over a 7 to 10 year period, motivating Jerry to ensure the business continued successfully. Upon buy out, Jerry would obtain a business loan to buy out the remaining 60% of the business from John and Mary.
Prevent a Family Feud
To address Jerry’s naïve propensity, a revised operation agreement was put in place based on O’Donoghue & Rabin (1999). The operating agreement stipulated the following:
1. In case of Jerry’s bankruptcy or any wrong doing that potentially might impact the business as a liability or use of the business as a collateral, the operating agreement excluded certain rights to prevent Jerry from putting the business in financial danger.
2. If Jerry no longer had any desire to take over the business at the designated time, John and Mary would buy back Jerry’s share at a set price agreed upon at the time of the agreement.
3. The underlying business real estate property would not be a part of the transition plan. Upon transition, Jerry would lease and pay the market rent.
One Day at a Time
Over the years, John’s training plan addressed some of the overconfidence he had in Jerry’s capability issues. However, we recommended that seeking a third party buyer or employee(s) buyout might be more viable. John insisted on going forward with the initial plan that included Jerry, despite the fact that Mary was opposed to moving forward in that direction. The stipulations above in their operating agreement provided some level of comfort for both, as well as addressing loss aversion concerns.
I strongly believe you can reduce the risk and enhance your odds of meeting your retirement goals when you transition out of your business, by using the right planner who will help you implement the right plan. Just as John and Mary proactively implemented timely succession strategies, so can you.