Why Gifting Stock to Your Children May Be Poor Stewardship

**Note: This story is a composite derived from five different real-life situations.  The names are fictitious and are changed to protect the identities of those involved.**

Tom and Jenny own an eight million dollar manufacturing and retail business. They manufacture decorative fascia products for homes and then sell them through their own showrooms as well as selected partners around the country. They have one son and two daughters.

Ever since the kids were young, Tom told them that they would own his business. It has been his life-long dream to pass along his business to his children. And they have been raised to believe – right or wrong – that they will inherit the business and “be the boss”. Tom never said anything to them about buying the business – just that they would one day own it.

Tom’s son – the eldest of the three – worked in the family business in high school and college. After graduation, he worked full-time in the business but grew tired of his ideas to improve sales and get new customers in the door being discounted and often outright rejected by Tom. As part of trying to keep his son in the family business, Tom gifted 10% of the shares of the company to him. His son worked another couple of years, but was still unfulfilled, so he left the business. He went back to school, earned another degree and pursued a career in a different field. After 3 years, he also tired of that career. Tom wanted him to come back, so Tom offered his son another 10% of stock to come back and also offered 10% of stock to his son’s wife as part of a “signing bonus”. They both felt this was an opportunity too good to pass up, so Tom’ son came back into the business, this time as (pragmatically) 30% owner. Still, Tom was not open to new ideas from his son. When Eric returned to the business, he realized that nothing had changed. But he had a choice to make – get back out or dig-in and see what he could do to improve the business. He chose the latter.

Tom didn’t discuss with his son or Jenny much of anything about a succession plan. In fact, he didn’t plan at all. He just kept working in the business until, one day, at the age of 63, he realized he was tired, burned out and ready to sell. He decided he wanted to get it sold in 30 days (which, for those of you who don’t work in the sale of businesses, is a completely unrealistic time frame. Most businesses take 9-12 months, minimum, to sell).

So he calls his accountant and asks for a valuation of his business. The accountant told him that it was worth $1.2 – $1.5M. Tom heard the accountant clearly say it was worth $3M while Eric heard him say it was worth $400K. Nothing was written down – the accountant only gave a verbal, back-of-the-envelope valuation – so Tom and Eric started pointing fingers at each other. Finally, Tom asked his son to take a seller note for $3M so that his son could own the business.

Naturally, his son, Eric, refused to pay $3M for the business. Sales had been declining the last two years due to customers wanting a new type of product that they didn’t supply. Tom refused to spend $500K on a new machine to manufacture the new product and pointed to the decline in sales as a reason he couldn’t afford to spend that type of money. Tom blamed Eric for the drop in sales. Eric blamed his dad for not investing “in the future” of their company and that was the reason for the drop in sales.

Jenny is most upset about the deterioration of their family relationships. She is scared that there may come a day when she can’t see her grandkids because of the building animosity between Tom and Eric. Eric’s wife doesn’t want to be around either Tom or Jenny because Eric gets so made so easily with them. She values the peace and tranquility of being a family, but doesn’t want the fireworks of Tom and Jenny’s presence in her home.

So, what has gone wrong? A number of things – and if you own a business and want to pass it on to your children – then you should pay attention to the rest of this blog post.

Tom’s Mistakes

Tom’s first mistake was in promising the business to his children. While a romantic idea, he should have never made such blatant promises over and over again when his children were growing up. It significantly contributed to Eric’s sense of entitlement and caused a temporary rift between Eric and his two sisters as portions of their natural inheritance from the business was being gifted to Tom.

Secondly, he should have never gifted stock to Eric or his wife. Eric was right to refuse to pay full price for the business – after all, he already owned 30% of it. What Tom and Jenny didn’t realize was that by gifting the stock to their son and daughter-in-law, they would never be paid for that stock. They gave it away. Foolishly, they thought their son would pay them anyways out of the goodness of his own heart. They were wrong. This further contributed to a growing rift between them.

Thirdly, after gifting the stock to his son, they never held Shareholder meetings to elect corporate officers, hold board meetings and so forth. They never acted like a corporation. So Eric felt more and more “used” and didn’t feel like an owner. His dad made all the important decisions without consulting him. So Eric saw his future being squandered away by (what he perceived to be) his father’s poor choices and he felt discounted by his own father. Eric was never given the respect he was due as a legal stockholder in the company.

Fourthly, Tom offered to sell the business using a Seller Note – meaning that Eric could pay Tom for the business over time. Fortunately for both, Eric turned down the offer and didn’t sign the note. Had he signed it and then ran the business into the ground, not only would Eric be bankrupt, but Tom would have nothing to live on during his later years in life. The value of the business could have been destroyed had Eric made some blunders. I always recommend that the younger generation pay cash for the business so that they have to get some real skin in the game.

Lastly, Tom didn’t get objective values on his company by taking it to market and finding out what others would pay for it. So their life-long accountant got put in the middle between Tom and Eric by having him value the business. In the end, neither side wanted to use the accountant because both wrongly felt he “took sides” because he didn’t always agree with either Tom or Eric. So, without a neutral third party, Tom and Eric haggled back and forth over the price of the business for close to six months. Tom wanted $3M+ on $250K/EBITDA and Eric didn’t want to pay beyond $500K for 70% of the business. At the time of this writing, they are deadlocked, angry, tired, frustrated and unsure of what their next moves are.

What Can be Done to Fix the Problem?

The first thing Tom should do is focus on building sales back up in the business. He should stop blaming his son and take the responsibility for the state of the business. After all, he is the majority owner and the buck stops with him. Tom needs to stop whining and get going in building his business. He should work *with* his son, not against him and learn to value other opinions.

After getting sales back up, he should let Eric run an increasingly large segment of the business. This will give Eric needed experience in case he does find himself the owner of the business someday. Just because Tom is the majority owner in the family business doesn’t mean that he should run the business. Eric is fully capable of running the business, if Tom would just coach him.

Thirdly, he should realize he has given away 30% of the business and as a consequence, adjust his expectations for how much cash he is going to get from the sale of his part of the business. It’s sad, but true, Tom and Jenny will need to downsize their retirement because of unwise choices they made earlier on in their professional lives.

Lastly, Tom should take his business to market and find out how much it really is worth. Accountants can give you figures all day long, but until you’ve taken it to market to find out what real buyers think, you really don’t know what its worth. Tom should consider selling all the shares to a third party and letting his son walk away with a wad of cash so that both of them can focus on having a family, father/son relationship. Jenny needs this too. She needs assurance that she will be able to see her grandchildren. The entire family really needs to learn to be a family without a business. It will be difficult for them – but a good transition.

Summary

Good stewardship of a business which God has given to you means stewarding well your exit from the business. Simply giving stock to your children can cause unwanted and unforeseen consequences. Your exit can be thwarted and muddied by how you manage the sale process. Finding competent consultants who do this for a living is one of the best things you can do to ensure that you’re exiting your business well, realizing as much value as possible and then putting that cash to work as God directs in His kingdom.

Bill English

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