Making It a Win-Win Situation
A few years ago, I worked with two clients, John and Mary (not their real names), a married couple who ran a business that consistently ranked in the top 15% of their industry. 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.
They had been in business about twenty years but still had only limited retirement savings from the business. Even so, they continued to count on financing their retirement from the business.
When retirement planning becomes a family affair, it’s difficult to sort out how a win-win situation could exist—with all the baggage, emotional and control issues that occur within 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 that will be satisfactory to everyone.
The Goals and the Plan
Their objective was for the proceeds of a transfer within the family 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.
In hopes of optimizing the possible outcome scenario of Jerry 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:
- The plan required a long-term correction to avoid overreacting to each bias and to help in achieving business goals. (Daniel, Hirshleifer & Subrahmanyam 1998).
- John’s overconfidence regarding Jerry’s capabilities. Barber & Odean (2000) found overconfidence in frequent trading resulted in underperformance compared to the typical benchmark.
- The plan required John to put a training plan in place to ensure Jerry’s success in the business transition.
- Jerry had historically underperformed compared to his peers in the business.
- Jerry’s underperformance in work potentially could have undermined John and Mary’s plan.
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.
According to O’Donoghue & Rabin (1999) there are two personality approaches to finances:
- Sophisticated tends to mitigate procrastination
- Naïve tends to enjoy the rewards now
Both John and Mary could be classified as sophisticated, because they proactively planned for their retirement and determined how to reach their goals through succession planning. Jerry could be classified as naïve, because of his propensity to enjoy rewards available to him immediately without thinking about tomorrow.
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:
- 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.
- The underlying business real estate property would not be part of the transition plan. Upon transition, Jerry would lease and pay the market rent.
- 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 collateral, the operating agreement excluded certain rights to prevent Jerry from putting the business in financial danger.
Working It Out Over a Period of Time
Over the years, John’s training plan addressed some of the overconfidence he had in Jerry’s capability as a business owner. 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 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 a timely succession strategy, so can you.
Barber, B. M., & Odean, T. (2000). “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors.” Journal of Finance, 55(2), 773-806.
Daniel, K., Hirshleifer, D., & Subrahmanyam, A. (1998). “Investor Psychology and Security Market Under- and Overreactions.” Journal of Finance, 53(6), 1839–1885. doi: 10.1111/0022-1082.0007
DellaVigna, S., & Malmendier, U. (2006). “Paying Not to Go to the Gym.” American Economic Review, 96(3), 694-719.
Kahneman, D., & Tversky, A. (1979). “Prospect Theory: An Analysis of Decision Under Risk.” Econometrica, 47(2), 263-292.
O’Donoghue, T., & Rabin, M. (1999). “Doing It Now or Later.” American Economic Review, 89(1), 103-124.
Post, T., Van den Assem, M. J., Baltussen, G., & Thaler, R. H. (2008). “Deal or No Deal? Decision Making Under Risk in a Large-Payoff Game Show.” American Economic Review, 98(1), 38-71.
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