Order of Succession: The Next Generation of the Family-Owned Company.

 Succession in companies has a high conflict potential. The reason is usually a conflict between generations resulting from a lack of willingness to let go.

Order of Succession: The Next Generation of the Family-Owned Company

There should always be an alternative plan for the future, as the current events around Covid-19 show. An unpredicted event can happen sooner than expected and ruin all planning. This is particularly true for family-owned companies. Experts agree that it takes around ten years between the senior's first thought of retirement and the final transfer of power to a successor.

A hasty transfer, however, often goes hand in hand with a generation conflict. In order to avoid this, it is not only necessary to settle the conflict early on, but also to provide thorough information and talk openly to all family members. In this context, the senior should ask himself the following questions in particular: 

  • When do I want to transfer? 
  • What do I want for my company? 
  • What does a successor have to bring along? 
  • And finally: How much is my company worth?

Depending on what the entrepreneur desires for his own future and for the future of his company, there are different orders of succession.

In this context, the following options are probably the most common for both a family internal and an external succession:

1. Business Succession by Way of Anticipated Succession

The entrepreneur can already transfer the company or his share in the company to the successor selected by him during his lifetime – by anticipating inheritance. This offers several advantages, one of which is that the designated successor can be better introduced to the company. It also gives him the opportunity to prove himself during the lifetime of the senior entrepreneur. In addition, this option also has advantages in terms of inheritance and gift tax. By transferring at an early stage, but at least ten years before the inheritance takes place, possible claims to a legal share or supplement to the legal share can be excluded. In contrast to that, the main disadvantage of anticipated succession is that the senior shareholder loses his or her complete power of disposition. It makes sense to take advantage of the statutory right of rescission in Articles 525 et seq. German Civil Code, for example in the event of the childless premature death of the successor or his – from the point of view of the senior entrepreneur – unacceptable personal or economic developments. In any case, it is necessary to take into account contractual and statutory formal requirements, consent requirements and any rights of preemption of other shareholders that may exist. 

2. Gradual Transfer by Setting Up a Partnership or a Corporation

The transfer of a sole proprietorship by setting up a partnership or a corporation brings the advantage that the transfer cannot take place all at once but in stages, i. e. by gradually increasing the participation of the successor as co-shareholder. 

Furthermore, unlike limited liability companies and stock corporations, partnerships offer the senior the possibility of having a certain heir succeed him in his partnership share by 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. According to the articles of association or the testator’s last will, however, the co-heirs may be obliged to transfer the share to one of them or to a third party.

The joint-stock company (Kommanditgesellschaft auf Aktie, KGaA) is a special type of organization. The joint-stock company is a stock corporation (Aktiengesellschaft, AG) that has personally liable partners (general partners) instead of an executive board. The KGaA is particularly attractive for family-owned companies that want to raise capital on the stock exchange. In contrast to the AG, the position of power in the KGaA is not linked to the amount of the contribution of capital. Depending on the provisions of the articles of association, the general partners of a KGaA can also have control in a company if they make only a small or even no contribution of capital. For this reason, the KGaA is considered particularly resistant to takeovers. Moreover, in addition to resistance to takeovers, there are other benefits for family-owned companies when it comes to the order of succession. In this context, the GmbH & Co. KGaA offers creative leeways in terms of inheritance tax arrangements (see also Insight dated October 31, 2019).

3. Company Sales 

As a rule, the company or shareholding constitutes a major source of income for the senior entrepreneur. From the senior entrepreneur’s point of view, it is therefore important to prevent the transfer from endangering their economic basis of existence and financial independence. This danger can be avoided by transferring the company in return for payment. This can be done in the following ways:

  • One-Time Payment
    If the company is sold at once, this has the advantage that the seller is not dependent on the entrepreneurial abilities of his successor. The buyer gains free power of disposition straight away.
  • Recurring Payments
    Another possibility is that the purchase price is not paid in a single payment, but over a longer period of time in the form of an income, installments or a permanent payment. For the buyer, this has the advantage of not having to rely on external financing. On the other hand, this model is disadvantageous for the seller, because in this way he becomes dependent on the entrepreneurial abilities of his successor.

4. Leasing or Renting

However, the senior entrepreneur can also ensure his “pension” by not selling the company but renting or leasing it out. 

By leasing out the company, the ownership of it does not yet pass on to the successor. In addition, the entrepreneur is guaranteed regular income. In contrast to leasing, only the operating premises are made available for use when renting. The successor usually buys the machinery and the furnishings directly.  From a tax point of view, this is the same as giving up the company and results in the disclosure of hidden reserves.

5. Management-Buy-Out (MBO) and Management-Buy-In (MBI)

If no suitable successor can be found within the family, there are the options of selling the company to its own management (so-called management buy-out) or having it taken over by external managers (so-called management buy-in), see Insight of November 21, 2017.

The advantage of an MBO is that the new owner already knows the company, which usually makes sales negotiations easier. The disadvantage is in many cases that the “operational blindness” of the new owners gets in the way of necessary innovations. 

The advantage of the MBI is that new owners typically bring new impulses with them. A disadvantage is that the takeover by external managers is often connected to a long settling-in period. 

6. Foundation 

The reason for considering the establishment of a foundation linked to a company is often the existence of a company for the continuation of which there is no suitable successor available after the death of the senior entrepreneur. In addition, there may be the altruistic intention to put the assets embodied in the company to charitable use on a permanent basis. But the entrepreneur’s wish to continue the company independently of his successors’ efforts can also be a reason for setting up a foundation.

From a legal point of view, a foundation is independent. It does not need an owner or a partner. The endowment fund of the foundation is strictly separated from the founder and his successor. Required is (1.) a certain purpose of the foundation. This can be both charitable or private, or it can only serve the needs of the family. (2.) In addition, it is necessary to have an endowment fund that is sufficient to achieve the purpose of the foundation. (3.) Moreover, a board of the foundation which implements the will of the founder in a fiduciary manner must be appointed. 

A major advantage of a foundation is that as a direct sponsor of a company or a shareholding, it protects against a division of company shares due to inheritance as well as against the associated shift in the power relationship and outflow of liquidity. However, it is important to consider the use of the foundation in the field of business succession carefully, not least because of the permanence of the earmarking of business assets for a specific purpose associated with it. Compared to other legal forms linked to partners, the foundation is best suited to enforce the will of the instituting entrepreneur permanently. While the partners in a partnership or corporation can generally amend the articles of association at any time by resolution, amending the articles of the foundation is only permissible if the articles themselves or the strict requirements of Article 87 of the German Civil Code allow it. Thus, an amendment to the articles must always be covered by the expressed or supposed intention of the founder. This can also be disadvantageous. The foundation’s legal institution is specifically designed for durability and consistency, but companies are typically dependent on reacting quickly and flexibly to changes in the market. 

7. Going Public – Stock Market Launch

When looking for a suitable successor, it may alternatively also make sense to break up the harmony between equity owner and management. This is possible, for example, by converting the company into a stock corporation. To do this, the company must meet certain minimum requirements:

  • annual sales in manufacturing companies of at least EUR 25 million,
  • good situation regarding revenues,
  • established market position as well as
  • good prospects for the company’s development.

Additionally, there is also the option of conversion into a so-called small stock corporation (“kleine Aktiengesellschaft”). It is defined by the lack of sharing in the capital market. Small stock corporations are subject to simplified provisions, such as

  • the exemption from worker participation in the board of directors,
  • facilitations of the conduct and documentation of general meetings, and
  • an increased discretionary power of the shareholders, especially with respect to the appropriation of earnings.

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

Practical Tip

On the one hand, succession in companies involves a great potential for disputes, but on the other hand, it also involves a large number of different options when it comes to structuring the succession. In each case, early planning and regulation are advisable. It is particularly important to schedule a longer lead time and to involve the family – if necessary also the management – at an early stage. Only in this way can generational conflicts be avoided.