Succession planning: The next generation of the family business

Succession in companies hold a high potential for dispute. The reason is that there usually is a generational conflict resulting from the older generation's unwillingness to hand over the company.

As the completely unexpected Covid 19 pandemic has shown, there should always be an alternative plan for the future. An unforeseen event can happen sooner than expected and wipe out all planning. This is especially true for family businesses. Experts can confirm that it takes around ten years on average from the senior's first thought about retirement to the final handover of power to a successor. However, a hasty change is not infrequently accompanied by generational conflict. In order to avoid this, it is not only necessary to make arrangements at an early stage, but also to provide thorough information and to talk openly with all family members. The senior should ask himself the following questions in particular:

• When do I want to hand over?
• What do I want for my company?
• What does a successor need to provide?
• And finally: What is my company’s value?

Depending on what the entrepreneur wants for his own future and that of his company, there are different possible succession arrangements.

The following variants are probably the most common, both for an internal family succession and for an external succession:

1. Company succession by way of anticipated succession

The entrepreneur can transfer the company or his shareholding to his chosen successor during his lifetime - in anticipation of the succession. This has several advantages, including that the designated successor can be introduced to the company in a much better way. At the same time, he has the opportunity to prove himself during the lifetime of the former entrepreneur. In addition, this option has advantages above all in terms of inheritance and gift tax. By transferring the business at an early stage, but at least ten years before the inheritance takes place, possible claims to compulsory portions or compulsory portion supplements can be excluded. On the other hand, the main disadvantage of anticipated succession is that the former shareholder loses his complete power of disposal. It makes sense to define the statutory right of revocation under Sections 525 et seq. German Civil Code (BGB), for example, in the event of the predecease of the successor without children or in the event of personal or economic developments which are unacceptable from the point of view of the former entrepreneur. In any case, contractual and statutory formal requirements, consent requirements and, if applicable, existing pre-emptive rights of other shareholders must be observed.

2. Step-by-step transfer by establishing a partnership or corporation

The transfer of a sole proprietorship through the foundation of a partnership or corporation has the advantage that the transfer can be made in stages rather than all at once, namely through a gradual increase in the successor's shareholding as a co-partner.

In addition, unlike limited liability companies and stock corporations, partnerships offer the senior the option of having a specific heir succeed to his or her shareholding by operation of law (so-called qualified succession). In the case of corporations, on the other hand, the community of heirs as a whole takes over the position of the deceased partner. However, the co-heirs may be obliged by the articles of association or by the testator's last will and testament to transfer their share to one of them or to a third party.

The partnership limited by shares (KGaA) is a special type of partnership. The KGaA is a stock corporation that has personally liable partners (general partners) instead of a management board. The KGaA is particularly attractive for family businesses that want to raise capital on the stock exchange. Unlike in the AG, the power position in the KGaA is not linked to the amount of the held capital. Depending on the structure of the articles of association, the general partners of a KGaA can control their company even if they only hold a small capital contribution or even none at all. The KGaA is therefore considered to be particularly resistant to takeovers. In addition, there are further advantages for family businesses in terms of succession planning besides resistance to takeovers. The GmbH & Co. KGaA opens up scope for structuring inheritance tax in this context (cf. here).

3. Sale of the company

The company or the shareholding usually represent the main source of income for the former entrepreneur. From his point of view it is therefore important to prevent a jeopardizing his economic livelihood and financial independence by the transfer. This danger can be avoided by transferring the company against payment. The following options are available for this purpose:

a) One-time payment

If the company is sold all at once, this has the advantage that the seller is not dependent on the entrepreneurial skills of his successor. The buyer, for his part, immediately gets free power of disposal.

b) Recurring payments

Another possibility is that the purchase price is not paid all at once, but over a longer period of time in the form of an annuity, instalments or a permanent charge. This has the advantage for the buyer of not having to rely on external financing. However, this model has disadvantages for the seller because in this way he becomes dependent on the entrepreneurial skills of his successor.

4. Leasing or renting out

However, the former entrepreneur can also secure his "pension" by not selling the business but by leasing or renting it out. By leasing the business, its ownership is not yet transferred to the successor. In addition, the entrepreneur has a safe ongoing income. In contrast to leasing, only the business premises are provided for use in the case of renting. The successor usually buys the machinery and equipment directly. From a tax point of view, this means giving up the business and consequently disclosing hidden reserves.

5. Management buy-out (MBO) and management buy-in (MBI)

If there cannot be found a suitable successor within the family, it is possible to sell the company to the company's own management (so-called management buy-out) or to have it taken over by external managers (so-called management buy-in), cf. here.

The advantage of the MBO is that the new owner already knows the company, which regularly facilitates sales negotiations. The disadvantage is often that the "operational blindness" of the new owners prevents necessary innovations.

The advantage of the MBI is that the new owners typically also provide new impetus. A disadvantage is that the takeover by external managers is often associated with a long period of induction.

6. Foundation

The reason for considering the establishment of a company-related foundation is often the existence of a company for which no suitable descendant is available to continue the business after the death of the former entrepreneur. In addition, there may be the altruistic will to permanently donate the assets embodied in the company to a charitable cause. Nevertheless, the will of the entrepreneur to maintain the company independent of his descendants’ commitment can be the reason for the establishment of a foundation, too.

A foundation is legally independent. It does not require an owner or shareholder. The foundation's assets are strictly separated from the founder and his descendants. (1.) A certain foundation purpose is required. This can be both public and private benefit, or only serve to provide the family’s alimentation. (2.) In addition, foundation assets sufficient to achieve the foundation purpose are required. (3.) Furthermore, a foundation board must be appointed, which implements the will of the founder in a fiduciary capacity.

A major advantage of a foundation is that is the direct owner of a company or shareholding. Through this, it is protected against the division of company shares due to inheritance and the associated shift in the balance of power and outflow of liquidity. However, the use of the foundation in the field of corporate succession needs to be considered carefully, not least because of the permanence of the associated earmarking of corporate assets. Compared to other legal forms tied to shareholders, the foundation is best suited to permanently enforce the will of the founding entrepreneur. Whereas the shareholders of a partnership or corporation can, in principle, amend the articles of association at any time by resolution, an amendment to the foundation's articles of association is only permissible if it is permitted under the articles themselves or under the narrow conditions set out in Section 87 BGB. Accordingly, an amendment to the articles of association must always be covered by the declared or presumed will of the founder. This can also include disadvantages. The legal institution of the foundation is designed precisely for durability and permanence, but companies are typically dependent on being able to react quickly and flexibly to changes in the market.

7. Going public - initial public offering

In connection with the search for a suitable successor, it may alternatively also make sense to break up the alignment of capital owner and management. This is possible, among other things, by converting the company into a stock corporation. In Order to do this, the company must meet certain minimum requirements:

• annual sales of at least EUR 25 million for manufacturing companies,
• good earnings situation,
• an established market position, and
• good prospects for the company's development.

In addition, there is also the possibility of conversion into a so-called small stock corporation. This is defined by the lack of participation in the capital market. Small stock corporations are subject to simplified regulations, such as

• the exemption from employee participation on the Supervisory Board,
• facilitation of the holding and documentation of annual stockholders' meetings, and
• an increased power of disposition for shareholders, especially with regard to the appropriation of profits.

However, for small stock corporations it is also possible to cover their equity capital requirements by issuing shares on certain stock exchanges, such as the "Neuer Markt" in Frankfurt/M. or the "Start up Markt" at the Hanseatische Wertpapierbörse Hamburg.

On the one hand, succession in companies holds manifold potential for disputes, on the other hand, however, it also offers a multitude of structuring options. In any case, early planning and regulation are advisable. Above all, it is important to plan for a longer lead-time and to involve the family - and if necessary also the management - at an early stage. This is the only way to avoid generational conflicts.

Dr. Thomas Hausbeck, LL.M. will be happy to answer any questions you may have in connection with a company succession.