Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in
Chuck LeFebvre: This is Chuck.
Ed Sutkowski: This is Ed, and today’s topic is Sibling Rivalry in the Business Organization Setting.
Chuck: I was thinking, Ed it was probably a great idea to start a business with your siblings, so you’re saying maybe not.
Ed: Well, it isn’t, it’s the question of fear, greed, the government, and revenge. We think of revenge as divorce stuff, we don’t do that. That’s the greatest source of revenue. The government’s not too bad, but the sibling rivalry really attracts all sorts of emotions. Let’s pretend we’re walking through at least four of those examples that we’ve accumulated over five-plus decades of messing around in this area, so to speak. One is the business organization that owns, let’s say a restaurant. We have a son and we have four daughters. We have five siblings. It’s marginally profitable and the guy that runs it wants to own it. You’ve seen that.
Chuck: Oh yes, you’re talking about the son.
Ed: The son. A guy, so the son, yes. The owner, the man, the older guy, let’s call him Ed, has these kids. The business has been pretty profitable, it’s not a franchise. It’s a home cooking sort of a thing. I own the real estate. The business is owned by an S Corporations tax on their subchapter S. The issues that arise are the same as you’ve seen, I take it in other situations.
Chuck: Well, yes. First of all, it seems like this is an issue that comes up in estate planning all the time when you have somebody who’s a business owner, and is part of their succession plan or their estate plan. If they have multiple children, they’ll have somebody who they say, “Well, this person can run the business, but I want to give to all my kids equally.” You end up in this situation where you’ve got multiple owners, but one person who’s really involved in the business, and the others who are not as involved in the business. The question is, if the brother who’s running the business if that person’s name is John, or what’s John doing with this business after a few months or a few years? What’s going on with this business especially if there’s a bad year?
Ed: Yes, and what’s John’s compensation level? How do you measure that relative to a return on invested capital, and that’s not going to occur that John is a special or divine God, and he can do things no one else can do, so he’s entitled life-size compensation, plus a share of the business, or an option to buy it all at a reduced rate. We see this in the farm context also, but that’s a little easier to understand. We have four daughters and one son who’s on the farm. Let’s assume it’s 160 acres or 320 acres or whatever number, but the point is that that son seems to say that the son Charlie is entitled to buy the farm at a discounted rate. Have you seen that?
Chuck: Oh, yes. I’ve seen that and I’ve had those conversations in situations where we didn’t ultimately do that, but where that comes up. The issue there is take a step back, and psychologically what’s going on is a lot of times these entrepreneurs are married to their jobs, and then if there’s a child who’s deeply involved in the business there’s already perhaps a little jealousy there. Then you start giving that person special consideration in the estate planning, and the parents are no longer around to keep the peace, it’s a powder keg.
Ed: See in the farm context, which is a little easier to understand, the son that’s managing it wasn’t receiving ‘adequate consideration’ while farms don’t produce a lot of cash. Why should that son be entitled to a special discount when buying the farm? I don’t get it, but versus the widget situation where we have five siblings, one daughter, and four sons, and I’m sorry the opposite. One son who’s running it and four daughters– I’ll get it right before the end of the day. There’s always the tension. The son is entitled to not only compensation but excess compensation. I’m not quite sure why. Have you figured it out, Chuck?
Chuck: No. I understand what the thinking there is, which is that the person who’s the entrepreneur thinks of that as a care taking function in some cases. This is something that whoever that person is they’re taking on a burden, they’re taking care of a legacy. They should be compensated for that above and beyond the normal compensation. That’s an appreciation for what they’re doing to the prior generations legacy by maintaining this business, and by running it the way mom and dad would have run the business. At the end of the day, that is always ultimately some flawed thinking because you could say that about anybody running any business. Also, what I found is that once mom and dad are gone that person that you left in charge, they’re going to run it their way.
Ed: Perhaps to the economic detriment of the passive investor daughters.
Chuck: Yes. That’s the risk, is that they could run it either because of the way they run it or because of conditions that are outside of their control, that you could run into some times that are hard times. It becomes perfectly appropriate just from a pure business standpoint to question whether management is the correct management and to question whether compensation for management is the correct compensation. You cannot have those conversations in a– you just cannot separate those business conversations from the emotional overlay when you’re talking about families that have gotten into business by way of inheritance. Have gotten into business together by way of inheritance. I don’t see how you ever separate those emotional things out from the pure business questions that are there.
Ed: You want to lose a client or a relationship suggest an objective set of criteria resulting in compensation to the person involved. Specifically, my world is cashflow, whatever else you want to talk about, Tesla, all fancy dot coms and whatever. Wait a minute, how much money am I receiving per month or per year from this organization? What is the return on invested capital? The sum of cumulated profits, original paid-in capital, and debt, that is not third-party debt, but family debt. What’s the return on that invested capital after paying some interest on that debt, and you get 5%, 10% of that amount in excess of a threshold, which I expect a 10% return. I’m going to give you 10% of the cash flow in excess of 10% on my investment. Does that sound fair, Chuck?
Chuck: Well, it does, but I bet you haven’t had too many people bite at that.
Ed: Too many, that’s an overstatement. I’ve never had one, I’m talking 50 plus years, not one instance will they buy into the clients, whether it’s farms, manufacturing, companies, bakeries, I don’t care what it is. If you say, well what’s the value of the apartment project? Well, it’s the cash flow. Capitalized at 5%, that’s the value of the apartment. It isn’t anything else and if you have some repairs and whatever, maybe you adjust the purchase price, but a very simple formula, what are you earning on my money, you lose control. Not control you lose credibility. Where are you coming from, Ed? Well, I’m just coming how I buy stocks. It’s a return on investment. Is there something magical about that? Well, we’ve got this valuation expert that says, I’m sorry, Chuck your experience?
Chuck: Oh, no, I’ve had the same thing. It seems to me like there’s only two ways out of this. One is that you either need to have everybody actually involved, and actually running the business and being part of it and cooperating, or you need to have the ownership consolidated in whoever’s running the business. I hate to be so simplistic about it but it just seems like, whenever you have passive investors in any business, there’s always an issue, there’s always the potential for an issue. If you’re going to have that occur for decades on end when you’re talking about a closely held business where they can’t just go out to the market and find a third-party buyer if they want to divest. The likelihood of that eventually causing some hard feelings is pretty high.
Ed: Yes. In defense of those that raise concerns about Ed’s simplistic approach return on invested capital, the converse is equally applicable I should mention that is, I don’t care how much you make. I care about what I make. That’s whether it’s a New York stock exchange company, or whether it’s a closeout business, that may be the better approach. Look, Charlie, you can make a gazillion dollars so long as I get a return on invested capital it exceeds market rates.
Chuck: That’s where you run into this issue when it’s an inherited business. What’s the invested capital in that context? It seems like a lot of times, people have maybe an inflated view of what their “invested capital” is on a business that they’ve inherited. You might be getting a pretty great return on your invested capital, it’s just that you think you invested twice as much as you actually did.
Ed: Yes, the value of your home and trying to list it is far in excess of what the market price or market value really is, you fall in love. Well, in this situation, I would challenge you and say, look, the net worth of the business, the cumulated profits in the original paid-in capital is a million dollars. If I’m getting a rate of return of 20% of them, I’m getting $200,000 a year in cash, do I care what you’re making? Let’s assume you’re making $800,000 but if the net gets me the $200,000 in cash, I can’t complain too much, can I?
Chuck: No. Well, you shouldn’t, let’s put it this way. You shouldn’t complain too much if that’s the case.
Ed: The passive investors will complain.
Chuck: Yes, they will.
Ed: The constant strain here is that money creates problems. An exit strategy would be to liquidate the company.
Chuck: Liquidate the company by finding a third party buyer who’s going to come in and just simply buy it out of the family, or have some buy-sell agreement in place so that there’s a buyout so that the person who’s running the business is gradually buying it from the other people at a price that’s according to a formula. It seems like those are your only two options.
Ed: My favorite story involves, say, Pete and Charlie. They each have a 50% ownership interest in this business organization. Pete wants to buy out Charlie and comes up with a number. Charlie’s response is “Here’s what we’re going to do. You’re going to put a number on the table, and I will either buy your interest for that amount or sell my interest for that amount.” Guess what happens? The issue is off the table because you’re putting a value on the table and you’re willing to buy the interest of the other owner or sell yours at that price. It’s the umpire, negotiation evaluation approach. Guess what? Over a long period of time, whenever that’s been put on the table, issues go away.
Chuck: The number– No one even comes up with a number in that situation.
Ed: No, no, let’s get a third party and they say “Well, wait a minute here. I’m charging a lot of money here to resolve what is a psychological issue. It’s a sibling– I don’t understand what’s driving this, but I’m talking numbers.” Pete, you put on a million dollars and Charlie, you can buy Pete’s interest for a million, or you must sell your interest to Pete for a million dollars.
Chuck: You come up with a number that you are equally happy to either purchase the other half of the business for that number or sell your interest for that number?
Ed: That’s right.
Chuck: You come up with the number then the other person decides which way the transaction is going to go.
Ed: Payable in cash or payable in deferred amount. All the issues about financing are expressed on the table. You make the offer, and you either buy or sell at that. Guess what? Issue goes away.
Chuck: They start getting along?
Chuck: That’s great.
Ed: The psychiatrist in me which I am not qualified to be a psychiatrist, I think we’re qualified to come up with solutions to problems. That solution works. Now it’s more difficult when you have multiple parties.
Chuck: I was just about to ask when you have three people, it’s a little hard.
Ed: It’s a little hard, but you can orchestrate it by one party buys both out, you spend a lot of time talking about this thing, setting up the guidelines but by the time the guidelines are established, guess what happens?
Chuck: They’ve decided that they all want to stay in.
Ed: It goes away. Then they say to me, “Why in hell are you sending me a bill, you didn’t do anything?” That’s right, I didn’t do a thing.
Chuck: That does seem like a solution when you’re in a situation where multiple parties feel like they are competent and they are interested in running the business. It seems you have a different situation when you’re talking about a business where some of the parties are competent and interested in running it, and others really, there’s no set of circumstances where they want to be in charge of this thing. They just have strong opinions about how the people who are running it.
Ed: Yes, the less they know about the business, the more they think they know about the business. There’s a direct correlation. We see that in business organizations, manufacturing companies. In a solution, oftentimes you find someone in the family that’s not involved in the business, but possesses some very good analytical skills, and is a good communicator. If you can find that person and you can communicate with that person, and everyone has confidence in that person the problems go away. I’m not sure that’s not true, the problems don’t go away but a solution is implemented. Has that been your experience?
Chuck: Yes, I have seen that less often than the situation where you can’t find a person, the description you just gave, in which case something generally has to come to a head. Usually, it just means either someone just simply gets forced out, or sometimes years go by, or you just have this festering disagreement without any real legal action, or any transaction taking place, but someone is just constantly sitting on the sideline, upset about the way the business is being run. I’ve seen that many, many times, haven’t you?
Ed: Oh, unfortunately, yes. I could do a better job. Well, you lost four jobs, five jobs. Why do you think you can do a better job with this company’s family business than you couldn’t do with the other– well, each is a different situation as well. I have to tell you, you can come up with a solution so everyone gets cash. That seems to rectify the problem.
Chuck: Cash flow is king. When these things start turning around cash and they’re paying profit distributions to all the family members, everyone does seem to be happier, but–
Ed: It goes away.
Chuck: -the problem seems to arise when you have a business that is not cash flowing.
Ed: At an adequate level.
Chuck: At an adequate level, regardless of what the cause of that is. Sometimes the business is profitable, but the earnings are being retained for one reason or another.
Ed: Yes, and maybe for a punitive reason, I’m not sure. The issues that I can never understand how to resolve relate to how much more money do you want? The answer is just a little bit more. It’s more of an ego thing. Charlie makes more money than I do, and my sister-in-law’s husband, my son-in-law makes– The guidelines are crazy. The guy down the street makes more money than I do and I work harder than he does or she does. It isn’t confined to the male, female, it’s both sides of the fence, so to speak. Fear, greed it drives these transactions.
Chuck: It seems to me when you get into one of these situations where you’ve got a company that is not very profitable, and you’ve got this going on between, let’s say, a passive owner and an active owner, it’s hard to really extract yourself out of that situation, once it gets to that point, because A, if it’s not very profitable, you’re going to have a very hard time finding a third party to come in and buy it out. B, you have the same issue if you’re talking about someone in the family, purchasing someone else in the family. Typically, their only source of funds to be able to do that would be the business itself, or whatever cash flow the business is able to create. I’ve seen a few situations where it’s possible to spin out a component of the business, that seems to be a way of resolving these issues. Maybe you should comment a little bit about that because the circumstances where that’s really plausible are pretty narrow, aren’t they?
Ed: Yes. If you have some real estate, you can orchestrate some favorable lease terms. They should step up cash flow, deductible expense of the corporation, the owners of the real estate are involved in the business. You want to somehow divorce the operation business from the passive owner, so are just receiving a check. Now, that’s fine with first-generation, but then in-laws come up with issues. I must tell you over the period, I don’t recall very many gifts to daughters-in-law and son-in-law, but they seem to get their oar in the water and it creates a little bit of furor. That’s the child’s generation, you go down to the grandchild’s generation, it is a real good source of fees. It is a barnburner. Let’s talk about some resolutions aside from fragmenting the business organization of real estate and leases and W2, and how you can do that. My favorite far and away, was one of some years ago, involving a restaurant. The owner of the restaurant is an older guy. He had five kids, and they’re fighting, two of them are in the business, three are not. I sat down with the older gentleman, the owner of the controlling interests, and I said, “Pete, here’s what we’re going to do. Here’s my recommendation. Here’s what we’re going to do it’s your business. Here’s what, give all the shares to the kids, equal. Five kids, they each get 20% of the shares. Take into account with the owner already, but when a day is done, each own 20% and you resign all offices, give them the checkbook and you go and enjoy yourself. You own the real estate and so you may do what you like to do with the real estate.” Guess what happened?
Chuck: Well, they started fighting like cats, right?
Ed: Yes, but the owner is happy as a clam. He’s not involved. If the kids want to fight, that’s their problem. If they want to get lawyers, want to get five lawyers– too many cooks in the kitchen. The point is your job as the lawyer is to come up with a solution.
Chuck: For your client which in this case, was the person who stepped out?
Ed: Yes. He came in the office only because I’d had lunch there a couple of times. You never know where the law business is coming in, but it was really funny. You can be dealing with a multi-million-dollar transaction. There may be no solution to those things, just too much money involved, too many cooks in the kitchen. Our little situation with the restaurant, the family restaurant, that solution, it cost nothing and it went away.
Chuck: That’s a great story.
Ed: I just couldn’t– I still can’t believe that. I go by that restaurant every day thinking, “What’s going to happen next?” I’m sure they’re fighting now but guess what, they’re going to understand that they better get along.
Chuck: They need to.
Ed: Yes, they have to.
Chuck: That’s a tough business to make work under the best of circumstances.
Ed: Your experiences with any, Chuck?
Chuck: Oh, yes. It’s interesting because I’ve been both in the situation of let’s call it the sibling who has control of a business. Then there’s others on the outside that are questioning and believing that that person is managing the business incorrectly. I’ve also been assisting the sibling who’s on the outside who’s upset about the way someone on the inside is running things. Tell me if you disagree with this, but I think that if you are the person who’s running the business, and you’re in this situation, let’s say there really isn’t a solution for someone to buy the other person out, you’re stuck with each other. My solution on this has been that as much transparency as you can possibly provide is probably a good thing. You may not be able to satisfy the other person that you’re doing everything correctly, but you certainly can at least satisfy them that you’re not hiding anything from them.
Ed: That’s right. We see that as carrying the day. It results in resolutions that you can live with. We don’t see that in the large corporate setting. If you try to read a proxy statement with all the disclosures, not going to happen, you’re not going to understand restricted stock-stock. It goes on and on and on. You have to have– I don’t know what it will be a wall street financier who understands these proxy statements because there’s too much disclosure. That is what is really relevant, but too much disclosure. How much are you making? How much am I making, how you’ve done with it? Make it simple, keep it simple, as people have said, me, “Ed, keep it simple, stupid.” I’m not suggesting that in an artful way but the point is, the function of the lawyer, the counselor is to get it down to an understandable level that you should be able to explain it to an eighth-grade student. If you can’t, you’re wrong.
Chuck: No, I agree with that because most of our clients have gone beyond eighth-grade but generally speaking, you can’t really expect them to have more than an eighth-grade understanding of a topic they’ve never had to deal with.
Ed: That goes for estate planning. I don’t care what it is. The only value I’m overstating it that a lawyer confers is simplifying what can always be an inordinately complex transaction plan. What’s really going on here? What are your fears? What are your concerns? Does this solve it? You’ve got to have value created and if you don’t, it’s going nowhere.
Chuck: When you have someone come in, and they, let’s say you have someone come in and their family is great– by the way, I have five kids, and my son is running this business with me, and the other four don’t have anything to do with this business. Don’t worry, Ed, everyone’s going to get along just fine. The family is very close. What’s your advice to them?
Ed: Well, I start with saying, “Tomorrow morning, I’ll have a full head of hair.” Starting out with that, we understand and I’m not saying you don’t know what you’re talking about, but you’re here to buy experience and experience is wisdom that you’re able to endure because wisdom is enduring after you’ve made all kinds of mistakes. The wisdom is, I hear what you’re saying, but trust me, that’s not going to work. What you do is you have a one on one meeting with each child alone. What’s really going on here, and then you listen, you never say any comments. As they’re ready to leave they will say, “By the way, what I really meant was, I don’t like this guy’s wife.” Well, okay, fine. After you’ve met with everyone one on one, you listen, and then you come up with a solution. Maybe there is no solution. The solution is liquidating the company.
Chuck: I think far too few people think of that as an option, but really when you’re talking about a closely held family business, if there isn’t really a natural fit for the next generation, then why force it on them?
Ed: Exactly. Are you going to live with someone that you don’t like to live with? You’re living with this person, so to speak, eight hours a day with your asset, maybe that’s your only inheritance. It gets very complicated when you pass the entrepreneur’s generation to the child, and then the grandchild, the great-grandchild Oh, man.
Chuck: Maybe everyone should think about this the way licensed professionals have to think of– doctors and lawyers don’t have the option of just passing their businesses on to their children, because the child would have to agree to become licensed. They’d want to be operating in that same area of specialty. Guess what, we don’t have this issue do we?
Ed: Not at all. The bigger issue is, you never own a relationship you control. Physically control. I do not want any of the children involved in the business, to say the least. I don’t know the solution, but there is no single solution, Chuck. The solution pops up after you’ve listened to everyone independently. Where are you going with this? Get the other lawyers out of the picture because they’re representing the best interests of their client? You’re seeking a solution. By the way, the solution oftentimes is there is no solution.
Chuck: Well, takeaway for the listeners of this podcast is, if you’re an entrepreneur and you have a business, don’t assume you’ve already fixed this or solved this problem, right? Don’t assume there is no problem.
Ed: Once you assume there is no problem, you’re being you’re going to be blind-sighted. We always want to create, want to live forever. We want our name on a building. Well, that’s great. Name and a scholarship you want this business to endure. That is interesting but folks, don’t rely on it.
Chuck: When I think about the most successful entrepreneurs that we’ve dealt with very few of them have passed the businesses on for their children to run. Most of them have found management who’s come in, and they’ve come up with some other succession plan.
Ed: The only yes, right on. The only solution or the exception of that is the use of an Esop employee stock ownership plan and trust, a form of tax-qualified, deferred compensation. There are some special provisions of the Internal Revenue Code that permit transactions that result in no taxable gain, but you got to be careful because then everyone who has an ownership interest, “wants to run the business.” If properly orchestrated proper values of the Aesop tends to be the best solution. You’re getting all the employees with skin in the game so they’ve got to work together, but the families usually cashed out.
Chuck: Which is a good thing.
Ed: Which is a good thing, because the founders’ children may not be equipped to go from B, the million dollars a year to C, a million dollars a month to D, $10 million a month. Don’t assume that your progeny possess the integrity, the intellectual capability, and the passion that you have.
Chuck: Especially the passion for your business seems like that’s always a stretch to assume that that’s the case.
Ed: That it seems the main challenger it always is the case. Well, our next podcast will be multiple marriages.
Chuck: Oh, it’s great. You’re talking about in sequence? Not all at the same time?
Ed: No, no. Although I’ve seen some of those where I won’t comment on, and I’ve seen the situations where not all the descendants are disclosed. To say it’s a fun exercise is understating it, but it is a specie of sibling rivalry and only in spades with quadratic number of problems. It’s an informative and given today’s world, half marriages are dissolved, you better be prepared for it, whether you’re a female or a male, I think it warrants an analysis of how this could or should be handled. Bottom line is the case with sibling rivalry.
It’s better to get along and not have the lawyers become very, very wealthy than it is not to get along and it’s just it– Well, revenge is something that’s hard to deal with, but boy the revenue, the gross margins on revenge are just absolutely terrific. Talk to you next time, Chuck.
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