Deal a winning hand
By Shirley Roenfeldt  |  Sunday, June 01, 2003

Editor’s note: This is the third article in a multi-part series on how to successfully transfer the business from one generation to the next.

The series:

• Can your dairy support another family?
• Can you pass a partner compatibility test?
• Deal a winning hand
• Build a better dairy leader

Put all of your cards on the table. 

That’s the motto that potential business partners need to heed.

It’s only when the parties involved can openly address the issues and write a plan that you have a chance to successfully bring in a new partner and pass the business from one generation to the next.

Take for example, an Illinois father and son who have gone their separate ways. When the son returned home from college and went to work at the family farm, his dad said, “I’ll bring you in and make you a partner.” After six years of promises with no changes in management, responsibilities or asset transfer, the son filed suit. The verbal promises to make him a partner were, in fact, a binding contract. The court ruled in favor of the son, and the father had to pay a cash settlement.

If they would have tried to develop a written agreement that addressed the transfer of management and assets, a red flag would have gone up for the son, says Darrell Dunteman, accredited agricultural consultant and accountant in Bushnell, Ill. However, it wasn’t until they were in court that the son learned that his dad had no intention of bringing him into the business.  

Business succession planning should not be done at face value. One partner may simply be bluffing another, like he would in a poker game. That’s why a written agreement is so important — it forces each party to put all his cards on the table.

For business succession planning, you’ll actually use three written agreements — a pre-agreement, an operating agreement and a buy-sell agreement. Use the following guide to help you address the issues you need to include in each of these documents.

The pre-agreement

When a son or daughter first returns to the family farm,  you can use a pre-agreement to test the waters and determine if everyone can work well together. During this period — generally two to three years — both sides can walk away without any financial repercussions to the business.

This time is really like an engagement period, says Mike Salisbury, certified agricultural consultant and CEO of Salisbury Management, Inc., in Eaton Rapids, Mich. It gives the son or daughter a chance to demonstrate his or her skills, and even learn some new skills. And the parents will use this time to learn the coaching skills necessary to help develop the son or daughter to eventually run the business.

The pre-agreement should be a written document. It should include job descriptions, including responsibilities and performance expectations for all of the parties involved, compensation, hours, vacation, benefits and how you will evaluate success or failure. You also must spell out how compensation will be determined — hourly wages or a set salary with or without profit-sharing potential.

In addition, you’ll also want to develop a current organizational chart of the business that explains the management structure and identifies the strategic leadership team, stresses Bob Milligan, senior consultant with Dairy Strategies and former human resource management specialist at Cornell University. The strategic leadership team is comprised of the critical decision-makers for your business, and can include spouses who have a financial stake in the business. The point is, everyone needs to understand who is responsible for what aspects of the business and how decisions are made.

The operating agreement

It doesn’t matter what type of business structure you choose — partnership, S-corporation, or limited liability corporation, to name a few — all require a written operating agreement. It is the formal, legal document that establishes the structure for the business. Although the business structure will vary, the issues you must address remain the same.

Experts recommend that you include the following:

• Start by defining the initial ownership structure of the business. List out everything that will be included in the partnership — assets and liabilities. For example, you may only include machinery and cattle in the new partnership — the land will remain with dad until a later date. That will bring up the issue of renting or leasing the land from dad.
• Develop a timeline for making management changes.  The junior partner will be expanding his management role and the senior partner will be retracting his. Establish the criteria that must be met along the way. For example, for the junior partner to start managing employees, he must attend a seminar or workshop on how to manage employees, and also complete five years of service at the dairy. Detail the responsibilities and added salary that goes with each step of the management ladder. In addition, you’ll also want to address how to resolve the issue of the junior partner being ready to take on the next level of management when the senior partner isn’t ready to give it up.
• Develop a plan for asset transfer. When son or daughter first enters into the business, a 50-50 partnership will not be practical, because the junior partner will probably not have enough money.  A transfer of assets will need to occur over time. List the order in which the assets will be purchased, how the purchase price will be determined — fair market value or appraisal — interest rate, and terms of the payment, including the length of time for payment.
• Determine how profits will be split. Is the profit split tied to ownership stake or equity?
• Define who will manage each aspect of the business and what his responsibilities entail.
• Establish a path that others could use to buy into and join the business.
• Set a timeline that you will revisit and revise the agreement as needed. Generally, this occurs every three years.

The buy-sell agreement

Planning for contingencies is one area that many people fail to address adequately. No one likes talking about death, disability, divorce and disillusionment, but they can and do occur. Without proper planning, they can disrupt and sometimes even destroy the business.

The best time to talk about these issues is before they happen. That way, you can sort through all of the details without being blinded by anger, grief, and even denial when the situation occurs, explains Milligan. Take the time to run through several what-if scenarios.

A buy-sell agreement is a tool commonly used to address these contingencies. In the agreement, you must determine the valuation method for the business, terms of payment and a method of arbitration. Generally, in the case of death or disability, the buyout occurs at full value. However, for disillusionment — when a partner decides he doesn’t want to work at the dairy any more — or when a partner is forced to sell due to a divorce, the buyout is always discounted by at least 10 percent to 25 percent.

And if the change occurs during the first few years of the partnership, Salisbury uses a vesting schedule to determine the rate of the buyout. For example, if the buyout occurs within the first three years of the partnership, the person would only be vested by 10 percent — that means a 90 percent discount on his ownership stake. The vesting percent would increase to 33 percent during years 4 to 6, and to 67 percent during years 6 to 8 years, and so on until 100 percent vesting is reached. 

For more details on buy-sell agreements, please see “Covers your bases” from the July 1997 issue of Dairy Herd Management. You also can find the article the Internet at www.dairyherd.com Once there, click on “This month.”

Protect the farming heir

If some of the sons and daughters return to the farm, and others don’t, be sure to include a plan that will protect the interests of the farming heirs.    

For example, if dad still owns the land, and the business partnership rents the land, then you need to specify the terms of sale in the will, says Darrell Dunteman, certified agricultural consultant and accountant in Bushnell, Ill. For example, the son who helping to run the farm has first chance to buy the land for the appraised value at the minimum federal interest rate with annual payments over 20 years. Anything less would leave him in a precarious financial situation if siblings demand their inheritance from the sales of the land immediately.

“As a junior partner, I would not sign any partnership agreement unless dad can show me an estate plan that addresses these types of issues,” says Dunteman. Any assets needed to operate the business, but not owned by the partnership, must be protected through an estate plan.