Tips for Tough Transitions

When the older generation steps down, family members are faced with difficult decisions about the future of their business. Here's some expert advice

The building stands out majestically in downtown Chicago. A gigantic black neon sign informs patrons they're about to enter The Berghoff Restaurant. The sign and the restaurant are as much a part of the city's tapestry as the Picasso sculpture in Daley Plaza or the department stores that line State Street.

But it's all about to end. After a 108-year run, the 48,000 square-foot restaurant renowned for its German food will serve its final round of Wiener schnitzel on Feb. 28.

The end is forthcoming because the third-generation Berghoffs who run the restaurant -- Herman, 70, and Jan, 68 -- are ready to halt their 65-hour working weeks and retire. Their four children, ranging in age from 35 to 44, have decided not to take on the responsibilities of running the restaurant.


  And so, the Berghoff as it is now known will soon close. However, daughter Carlyn, 44, will be operating a scaled down version of the Berghoff cafe and bar in the same space through her catering company, Artistic Events. She hopes part of the family legacy is preserved that way.

The decision facing the Berghoffs is one many family businesses encounter when the older generation decides to step down. Whether it's a mom-and-pop dry cleaners or a multimillion-dollar enterprise, a successful continuity plan needs to be in place for a business to survive.

But it takes more than just planning ahead. "It has been widely assumed that the failure of family businesses to survive was due to a lack of planning. In actuality, more recent research reveals three factors that correlate with failed survival," says Paul Karofsky, a family-business consultant and principal of Transition Consulting Group. "These are failed leadership; the inability to agree on personal, family, or business goals; and unresolved conflict."


  Similarly, there are three factors that are associated with effective continuity, according to Karofsky. "One is family meetings, another is strategic planning, and the third is having a board of advisers and a board of directors."

If the time has come for a family business to make a transition of power, whether inside the family or out, there are several options available:

Selling the Business to Keep It Intact

While the Berghoffs have decided to retire and close their principal business, there are several other options that a family can take to keep the business going, albeit with a new generation of leadership.

"Many firms would want to buy the business and have the family go their separate way," says Brian Colton, partner with Generation Equity Investors, a private-equity firm that's focused on investing in the family-business market. "That's a great strategic buyer."

For example, in 1952 James Beck founded the Precision Twist Drill Company, based in Crystal Lake, Ill. The company grew and grew throughout the second half of the 20th century, becoming the leading drill-bit manufacturer in the U.S. In 1997, they recorded sales of $124 million, with approximately 1,300 employees manufacturing 500,000 drill bits a day.


  That year, after years of inquiries from outside sources, Beck decided it was time to consider a sale. "My grandfather thought he had taken it as far as he could as a privately held company, and in order to benefit the entire family, who were the primary shareholders, he decided to listen a little closer to people who had inquired about buying the company," says Randy Beck. "We narrowed it down to five companies, and the company that bought it said they could take it farther as a public company in five years than we could over 30 years."

James Beck had distributed privately held stock to his children, grandchildren, great grandchildren, and the officers and directors of the company. He finally sold the company for $135 million to Sandvik, a Swedish corporation. "My grandfather made a lot of people millionaires," Randy Beck says. We got the maximum amount of money for the company, that's for sure."

Keeping the Business in the Family

For family members who don't want to sell, other options are available.

1) Bring in non-family management. In past generations, it was thought that if family members owned a business, they had to work in it. That's not necessarily the case today. Many family members inherit, purchase, or are gifted family businesses in which they don't wish to work on a day-to-day basis. Professional non-family managers can allow family owners that luxury.

2) Sell the business to the children who wish to run it. Karofsky believes this option gives the children a sense of self-worth and authenticates that they have earned their newfound status. Moreover, that same message is also sent to the employees, vendors, and customers. Also, purchasing the business themselves, reduces the children's sense of entitlement.

3) Gift the business directly to the children who will run it. According to Karofsky, this may be a more tax-efficient option (depending on the value of the business), but the members of the older generation need to be certain it's financially viable for them, as they most likely don't want to become dependent on their children.

Families might also consider some combination of the above options.

Working with an Investment Firm

An investment firm can help with issues such as "How do I get money for mom and dad, but still keep the company within the family's hands?" says Samir Desai, a vice-president for Key Principal Partners, which specializes in these types of transaction.

Key Principal typically works with businesses that have annual sales figures ranging from $20 million to $200 million, and usually invests through subordinated debt or preferred stock. "In our situation, we provide a capital infusion into the company and the company then provides a dividend to the family shareholders. We end up taking a minority position in the company and serve on the board of directors and help the company grow the business," Desai says.

While Colton agrees that there are advantages to working with an investor group, he warns, "Any time you bring an outside partner you're giving up some control, whether it's expressly written or not. Some family businesses are run like an ATM. They take a lot of cash for non-business reasons. When you bring in an outside investor, they're going to want to run the business for increasing value for the shareholders."


  If the family decides to bring in outside investment, two options are non-control recapitalizations or mezzanine funding. These are alternatives to selling the company outright.

"Sometimes we do a recapitalization where we buy 51% to 80% of the company," Desai said. "It depends on the needs of the family. If there's a second or third generation of the family that wants to stay involved, we do a non-control recapitalization, but if it's the final generation, then we come in with a controlled recap."

Another possibility is mezzanine funding, which is a type of financing that lies between debt (both secured and non-secured) and equity. While riskier than financing with pure debt, it also generally provides a higher rate of return. At the same time, it isn't as risky as equity financing, but conversely usually provides a lower rate of return.


  Desai cautions that there's a "get-to-know-you" phase at the start of a partnership. "People have to understand, you have to keep one another informed. And in the first year with a family that has never had an outside partner, you have to see how the other party works," he says.

Even though lack of planning may not be the major cause of a family business' mortality, exploring all the options can surely go a long way to sustaining the legacy and providing an opportunity for subsequent generations to preserve the wealth.

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