A strong business is needed

Transferring ownership of the farm to your successors is – relatively – the easy part, Peter Flannery writes.

do you transfer ownership of the family farm to the next generation? It’s actually quite easy. Lock yourself in a room with your lawyer and accountant for a few hours, sign a couple of legal documents, and you will have transferred some or all of the farm to your successor.

The problem is, we have just answered the wrong question.

The real question is not “how do you do it”, but more importantly, how do you make it work for the whole family once it is done. That question is a lot more complex.

The success or otherwise of your succession plan will depend on what has happened before and after ownership transition. I will discuss what should happen before succession in this column, options that may exist in a second column and will discuss what needs to happen after succession in a third and final column.

The first thing that needs to happen before you can implement a successful succession plan is to build a strong business. If you don’t have a strong business and you are thinking about impending succession, your options will be very limited.

What is the definition of a strong business? As a minimum it must have scale, profitability, and a balance sheet with an easily sustainable level of debt. It doesn’t have to be debt free, but that would certainly help.

Let’s look at the example in Table 1. A 6000-stock unit property with 10% debt and producing a Return on Equity (ROE) of 2.5% after “wages of management” (drawings) and tax.

In its current state this is a strong, well-performing business. But is it strong enough? Using a land value of $1000/su and $200/su for stock and some plant and machinery we have total assets of about $7.5 million and with 10% debt, ($750,000) this business has equity of $6.75m. Therefore with a 2.5% ROE, it is dropping out cash of $150,000 after principal repayments.

This is a strong business, and the owners have the option of using the “free cash” to invest outside the business and/or repay debt. With a strong balance sheet, there is also potential to take on more debt. But can it meet the needs of the family?

Let’s assume the successor has been home working on the farm for the last five years, and has three other siblings, one of which also has farming ambitions. Another sibling is a nurse, married to a highly regarded brain surgeon and they are doing very well thank you very much and the fourth is single, overseas and living the dream.

Mum and Dad are in their mid-sixties, and over the next five years hope to move off the farm to their yet-to-be-purchased dream retirement home, overlooking the lake or beach.

What are the considerations? Mum and Dad will need to take some capital out over the next five years to buy their retirement home and will also need to have an income sufficient to comfortably meet their needs.

Does the successor who has been home for five years deserve to be treated differently to the others? If so, what about the other sibling that would desperately love to go farming but hasn’t had the opportunity to come home and work on the farm?

Who is going to replace Mum and Dad within the business when they retire? There may then be room for the other farming sibling to come home or is that just a recipe for disaster?

In summary, do you treat everyone the same or do you treat them based on their own individual needs.

The key is to treat them fairly which may or may not be equally.

Who decides what is fair? The family does, and defining what is fair is the second thing that needs to be done before any transfer of ownership happens. Also, you need to start with the end in mind.

Don’t start transferring anything before you have defined fairness for your family, and you know how you are going to achieve it. Also, don’t make loose promises you can’t keep… “Come home, work for below market wages and one day it will all be yours”.

Back to our example. Let’s say Mum and Dad decide their successor has done enough to warrant an early inheritance of 25% of the business, and at the same time the successor borrows enough from the bank to buy another 25% which brings the successor up to 50% ownership.

The money borrowed allows Mum and Dad to buy their dream home and on that basis the amount of free cash, after principal repayments looks like in Table 2.

A 25% share of the business requires increased borrowing of $1.687m, bringing total debt to $2.437m, being 36% of total assets. Assuming an interest rate of 5% and a requirement to repay principal of about 2.5% of the total debt, there is only $23,000 of free cash dropping out the bottom after principal repayments. So while it is most probably a bankable deal, $23,000 is not a lot to come and go on to support Mum and Dad in their retirement and still provide something for the other siblings.

So what have we learnt?

It is easy enough to transfer ownership to a successor, but even a seemingly strong business will struggle to support Mum and Dad, allow a successor to get a foot in the door and still treat the remaining siblings equally.

In this family, what does fair look like? Did the successor return home with the expectation of being treated favorably, and what about the other farmer in the family? Is it fair they don’t get a crack at farming just because they were born two years after the successor?

What about the nurse and the surgeon? They are financially secure with a high income. Just because they don’t need financial help, does that mean they “get nothing from the farm”. Then there is the young gadabout, travelling the world, living the dream. What help do they deserve? If there were only two children in the family and one was financially secure and had the view that they would prefer to see the farm stay in the family, and genuinely expected nothing, then happy families. That can happen, but is a rarity.

One thing this does highlight though, is the successor and/or other family members need to bring something to the table. It shouldn’t just be up to Mum and Dad to create opportunities. Certainly, they can help, but the next generation needs to do their bit as well. Having said that, it is difficult for the next generation to create their own wealth, at home working on the farm. So it is not easy.

The third thing that needs to be done is, all of this needs to be discussed, sorted out and agreed to, probably five years ago before the successor came home, but most definitely before any ownership changes hands.

To go halfway down a succession path, only to realise too late that you can’t treat everyone fairly will most probably end in a fractured family. But on the bright side, you will save money on Christmas and birthday cards.

So even a seemingly strong business will have financial constraints. It is imperative everyone understands these constraints.

As I have said in previous columns, you should only treat your children equally if it is fair to do so. Only the family can work out what is fair in their situation, and that can only be achieved by talking, listening, and understanding. These conversations can be difficult, and it is the fear of these conversations that frighten some families, and it is this point that prevents some families from implementing a successful plan. It’s not easy but it can be done.

One thing I have learnt is that if you ignore the problem long enough, it will not go away. It is not easy, but if it is done well, family relationships can be strengthened. It is amazing what can be achieved once everyone sits around the table with full knowledge, understanding and empathy for each other.

• Peter Flannery is a director of Farm Plan Ltd, a company that specialises in facilitating families through succession planning.