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It is widely acknowledged that family businesses are important to Canada, given that they are the dominant form of business, accounting for a significant portion of our wealth and employment. According to one study, "family-owned firms ... constitute 80% of all Canadian businesses and generate $150 billion in sales." In this article, authors Tami and Glenn Feltham and James Barnett assess of the level of family, legal and financial readiness for succession planning.
Table of Contents
It is widely acknowledged that family businesses are important to Canada. Their importance follows from two characteristics. First, they are the dominant form of business in Canada, accounting for a significant portion of our wealth and employment. According to one study, "family-owned firms ... constitute 80% of all Canadian businesses and generate $150 billion in sales." These firms account for about one-half of Canada's gross domestic product and employment.
Second, it may be argued that family businesses have particular attributes that make them more valuable to the nation - that family businesses enjoy a competitive advantage by being a family business. These attributes include higher levels of trust, greater focus on building customer loyalty, more active role in the community, a culture of shared values, and a more long-term perspective.
Family businesses may also be more nimble, more customer oriented and more quality focused - perfectly suited for the global competition. Porter argues that family businesses provide a competitive advantage to a nation, through sustained commitment to the firm and industry, and greater flexibility.
It has been repeatedly argued that the greatest risk to the continued success of family business is succession - the passing of the business from one generation to the next. Succession planning in a family business can be far more difficult and important than in non-family corporations since the planning must include far more than a determination of the successor. Family dynamics are critical. If the family has not "bought into" the succession plan, the firm may not survive.
Financial and legal issues are also more likely to be important to a family business than to a non-family business. Often, if financial and legal considerations are not planned, the firm will need to be sold or divided to pay a tax liability on the parent's death, or to satisfy the inheritance claims of the children or spouse.
Given the importance of succession readiness, one would expect that family businesses would be well-prepared for succession. However, several factors may work against preparedness:
To determine if family businesses are prepared for succession, it is necessary to first define what we mean by succession readiness. Succession readiness is a construct. There is no single element that can, in itself, define whether a family firm is prepared for succession. However, it is possible to look for themes or dimensions of readiness. We classify succession readiness along three themes or dimensions:
In this study we expected to find the following. Anecdotal evidence suggests that family businesses are not prepared for succession. Our first belief, therefore, was that a significant proportion of family-owned businesses are not prepared for succession. A second belief was that, the closer in time a parent is to retirement, the higher the level of succession readiness. The rationale for this is that, as a parent approaches retirement, the importance of succession planning should be more evident - in effect, the parent can no longer put-off tough decisions. We would expect that this would hold across our three measures of succession readiness. However, anecdotal evidence suggests that the effect may be most pronounced on family readiness since some claim that certain decisions, such as choosing a successor, should not be made prematurely. Further, and perhaps more important, family readiness for succession may be delayed as parents may not want to discuss issues that will create significant family conflict until they feel it is absolutely necessary.
A survey questionnaire was developed to examine the level of succession readiness in Canadian family businesses. In the summer of 1998, 7,500 questionnaires were mailed to a nationally representative sample of Canadian family-owned businesses obtained from Dun & Bradstreet. To qualify for the survey, the businesses had to meet the following criteria:
A total of 765 surveys were returned, representing a 10.2% response rate. The regional distribution of returned surveys closely matched the distribution of the mail-out.
The respondent profiles from the survey were as expected. Nationally, the age distribution of respondents was similar to the age distribution of the population in general. The survey showed that 95% of the respondents were shareholders, 90% were the top decision makers, and 90% indicated that their family controlled the business we believe we were successful in surveying individuals who understood the level of succession readiness in the family business. When asked about their family circumstances, 93% indicated that they were married and the majority had two children.
The responding businesses tended to be larger than the average family firm this is a result of requiring annual revenues of at least $1 million. The most frequently reported sales revenue figure was $2 million. One-half of these family businesses employed 18 or more full-time people. Note that the $1 million revenue threshold created a bias in favour of succession readiness. If the firms we surveyed are not prepared for succession, smaller firms are even less likely to be prepared.
Results will be presented for each of our three measures of succession readiness.
Family Readiness
In determining the level of family readiness, we measure choice of successor, communications with children and contingency planning. The survey results for family readiness are presented in Table 1 below.
Table 1 - Family Readiness for Succession
|
|
When will parent retire? |
| |||||||||||
|
0-5 years |
6-10 years |
11-15 years |
> 15 years |
Average | |||||||||
|
Successor: A successor has been selected |
44% |
33% |
16% |
4% |
30.5% | ||||||||
|
Process is established for selecting successor |
51% |
34% |
20% |
11% |
34.4% | ||||||||
|
Communication: Have discussed division of estate with children |
36% |
28% |
18% |
8% |
26.2% | ||||||||
|
Contingency plans: Have contingency plans on death |
46% |
38% |
31% |
28% |
36.9% | ||||||||
|
Have contingency plans on disability |
38% |
33% |
30% |
24% |
31.0% | ||||||||
From Table 1, one can see that only 30.5% of the family business sample had chosen a successor. More important, for those who will retire in the next five years, only 44% have chosen a successor. In other words, of Canadian family businesses that will be passed on in the next five years, less than 50% have chosen a successor. Further, among those that have not chosen a successor, few have a process for selection in place. Only 34.4% of respondents indicated that they had established a process for selecting a successor. This is approximately the same percentage as firms that have chosen a successor, 30.5%. An implication is that very few firms that have not already chosen a successor have put in place a process for that selection.
Effective communications within one´s family is generally considered to be very important to effective succession. At a bare minimum, it is believed that the children should understand their future role in the firm. From Table 1, we see that only 26% of parents have discussed the division of their estate with their children - even more surprising, among parents that will retire in the following five years only 36% have had this discussion. It appears that parents do not discuss succession with their children, even when succession is imminent.
To offset the difficulties facing the executor, it is argued that contingency plans should be established. While a written contingency plan will not have legal authority, it can provide solid advice for dealing with business matters that will be faced until the assets can be turned over to the beneficiaries. The survey indicated that most family businesses do not have written contingency plans - only 37% have contingency plans in case of the parent´s death, and even fewer, 31%, have plans in case of disability.
Consistent with our second belief, family readiness increases on each item as the parent approaches retirement - that is, family readiness increases as the parent approaches retirement.
To summarize, the overall level of family readiness for succession in Canada is very low. As expected, this level of readiness does increase as the parent approaches retirement, but continues to be at a surprisingly low level. Most Canadian family businesses are not prepared on the family readiness dimension for succession - even where succession is imminent.
Financial Readiness
Financial readiness is measured through examining the parent´s use of insurance, business and strategic plans, and tax readiness. Results are presented in Table 2.
Table 2 - Financial readiness for succession
|
|
When will parent retire? |
||||
|
0-5 years |
6-10 years |
11-15 years |
>15 years |
Average | |
| Have key person insurance: On parent´s life | 70% | 78% | 77% | 69% | 72.4% |
| Have key person insurance: On parent´s disability | 50% | 59% | 60% | 46% | 52.1% |
| Have other insurance: Personal life insurance | 87% | 90% | 90% | 87% | 87.7% |
|
Have plans: |
43% |
41% |
36% |
42% |
40.2% |
|
Tax knowledge: Have knowledge of estimated tax liability Know if tax liability would be funded |
45% 72% |
43% 70% |
28% 62% |
16% 65% |
36.6% 67.3% |
Key person insurance is important as it allows the business to continue to function if the parent dies or is disabled. Most firms had key person insurance on the parent´s life (72%) and a slight majority had key person disability insurance (52%). Personal life insurance is an indicator of financial readiness in that it allows the family, on the death of the spouse, to pay taxes, provide for survivors, and take other actions with respect to the firm. Almost nine of every 10 respondents held personal life insurance (87.7%).
Similar to previous research, written business plans were not as common as one might expect; only 40% of the family businesses had one. A business plan, as defined in the survey, is an annual written document dealing with such aspects as marketing, capital expenditures, cash flow, research and development, income and expenses, and financing requirements. Businesses often compare actual results to this plan on a regular basis (weekly, monthly, quarterly, annually).
Even less common were written strategic plans - only 21% of firms had written strategic plans. A strategic plan was defined in the survey to be a longer term written plan covering three or more years. Given the significance of the business to most parent´s estates (52% of respondents reported the business is greater than 50% of their estate, 16% reported it is greater than 75% of their estate), it was surprising that only 37% knew what the tax liability to the estate would be if they were to die today. While very few parents knew their tax liability, most (67%) felt their estate would have the resources to fund the liability. However, 28% of parents that were going to retire in the next five years did not know how their tax liability would be funded.
Somewhat surprising, financial preparedness does not appear to increase as the parent approaches retirement. Our second belief, therefore, is not supported - financial readiness does not increase as the parent approaches retirement.
To summarize, except for the existence of personal life insurance, family businesses generally seem financially unprepared for succession. Somewhat surprisingly, the level of preparedness is independent of the timing of retirement by the parent - that is, whether a parent will be retiring in two years or in 16 years seems to have little effect on their financial preparedness. An exception is that the parent is more likely to know their tax liability the closer they are to retirement.
Legal Readiness
The overall level of legal readiness for family businesses, as presented in Table 3, appears surprisingly low.
Table 3 - Legal Readiness for Succession
|
|
When will parent retire? |
| |||
|
Existence of a: |
0-5 years |
6-10 years |
11-15 years |
> 15 years |
Average |
|
Will |
77% |
74% |
70% |
59% |
71.0% |
|
Power of Attorney |
52% |
41% |
42% |
34% |
43.7% |
|
Letter of instructions |
17% |
15% |
13% |
7% |
13.6% |
|
Shareholder´s agreement |
44% |
45% |
46% |
50% |
45.1% |
Less than half of respondents have a power of attorney, a shareholder´s agreement, or have provided a letter of instructions. It is even more surprising that only 71% of respondents have wills - note that this percentage is not much higher (77%) where the parent is approaching retirement. In the case of unexpected death, the effect of not having a will can be devastating on the business.
While it is apparent that the health of family-owned businesses is strategically important to Canada, the overall level of succession readiness is surprisingly low - this is true for family readiness, financial readiness, and legal readiness. Prior studies have shown that only about one-third of companies survive to a second generation. The results of this study are consistent with this reality - it is difficult to successfully pass a family business from one generation to the next if there is not family, financial and legal preparedness.
It is also clear that Canadian family-owned businesses are not becoming sufficiently prepared even when the current decision-maker approaches retirement. We found that as the parent approaches retirement, there was a large increase in level of family readiness, a smaller increase in legal readiness, and no increase in financial readiness. However, even where the level of readiness increases as the parent approaches retirement, absolute levels of preparedness remain very low.
Canada has attempted to provide support for family business succession (largely through the income tax system). In particular, the federal government has enacted measures that reduce or delay tax consequences on succession. For example, Canada´s income tax structure allows a parent to take a $500,000 lifetime capital gains exemption on qualified small business corporate shares, and to transfer the future growth in the corporation to the child on a tax-deferred basis (an estate freeze). However, for a family to take advantage of these provisions (especially an estate freeze) it is crucial that there is succession readiness.
There does not appear to be appropriate policy in place to help increase readiness. The results of this article appear to imply that merely creating appropriate economic incentives may not be effective in ensuring that family businesses will survive succession. If through a lack of succession readiness businesses are not surviving the succession process, this may have a profound effect on employment, dislocation, and the competitiveness of Canada as a nation.
Tammi S. Feltham is an Associate Professor in the Department of Management & Marketing, and Glenn Feltham is a Professor and Department Head of Accounting, both at the University of Saskatchewan. James J. Barnett is the Director of the Deloitte & Touche Centre for Tax Education and Research, and the Director of the Master of Taxation Program, School of Accountancy, University of Waterloo. The authors would like to thank colleagues at the University of Saskatchewan and the University of Waterloo for helpful comments and suggestions. They would also like to thank the Deloitte & Touche Centre for Tax Education and Research at the University of Waterloo for providing funding for this project.
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