Family Buyouts – The Challenges of Cashing Out Family Members

By Generational Equity

08/28/2015

In the course of my daily readings I came across a tremendous article covering the downside and risks associated with intra-family buyouts and succession. Penned by John A. Davis, senior lecturer in the Entrepreneurial Management unit at Harvard Business School, the piece examined one tragic story of family transition gone bad, using it to point out some of the pitfalls of family succession and how NOT to manage it.

I am sure many of you have read about the Market Basket story in the past. I remember following it several years ago as it worked its way through the legal system. In his article entitled “Managing the Family Business: Market Basket’s Lessons About Buyouts,” this is how Mr. Davis introduces us to the sad story:

Buyouts of family owners rarely happen—even when it is clearly a good option.

Market Basket, a highly respected supermarket family business in New England, learned this lesson the hard way last summer [summer of 2014]. In this real Greek American tragedy, two branches of the Demoulas family warred for 30 years, in and out of court, over legitimate grievances involving a lot of money and, of course, over control of the company …

The founder, Arthur Demoulas, had two capable sons, Mike and George, who joined him in his little store, took it over, and then built a great supermarket business. The founder died, then George unexpectedly died, and Mike took over.

I highlight the tragedy above because it points out the first mistake many business owners make; having no clear, written succession plan. When tragedy occurs without a plan, the consequences can be devastating to not only the family but sadly also even more so to the business, its customers, employees, and suppliers.

The ramifications of an unexpected turn can be far reaching. That is why it is vital for business owners to have a clear succession plan in place long before something unplanned occurs. No one likes to face issues like this, but if you do, you prepare your family and company in advance in case one of the big D’s – Death, Disability, Divorce, Disinterest, and Disagreement – occurs. I have highlighted this last big D because the story of the Market Basket transition now takes a disagreeable turn for the worse:

The brothers had an agreement that the surviving brother would take care of the other brother's family, but instead, George's branch accused Mike's branch of defrauding them out of their shares in the company. The two branches went to war.

A buyout was proposed, but the two sides were far apart on price. In 1990, they went to court. After a few years of expensive, embarrassing, and exhausting battling in court, a judge awarded George's branch with 50.5 percent of the company's shares. Problem resolved?

No. Another buyout was proposed but couldn't be agreed on. The battle moved to the board.

A key point that we often make to business owners we meet with is this: Selling your business with your relatives in the best case scenario can be extremely emotional, even more so if you are expecting your relative(s) to buy you out at a fair market value.

We meet with business owners regularly who tell us horror stories about the “buyout” they had in place (usually based on nothing more than a handshake around the family dining table during Christmas dinner) that never came to pass because the agreement with the cousin, nephew, brother, sister, aunt, uncle, etc., failed to materialize because of valuation differences. This is why we advise folks that it is far better to find a third party to acquire the majority of the business, cash out any owners that need or want to exit, and retain current owners that wish to stay. This is far cleaner and allows the family to avoid nasty trials over internal valuations.

The Heartbreaking Situation Deteriorates

Sadly the Market Basket story gets even worse. According to Mr. Davis:

Mike's branch wanted to invest aggressively in the business; George's branch wanted more dividends. Mike's branch kept a slim majority on the board until 2014, when George's branch obtained control and fired the CEO—who happened to be a cousin, Arthur T. Demoulas. Management was outraged, and the employees walked out in support of their CEO.

The company lost tens of millions of dollars as shoppers largely honored the wishes of workers. Eventually, the Mike-Arthur T. Demoulas branch bought out their cousins with the help of outside investors.

The good news is, as I discussed above, outside investors stepped in and bought out half the family and the issue of ownership was alleviated. However, this didn’t happen before the business was severely impacted by the loss of customers, goodwill, employees and ultimately millions of dollars in income. Do you think that affected the ultimate price the investors were willing to put into the business to buy half the family out? You can bet it did. Keep in mind that the original litigation started in 1990, but half the family was cashed out in 2014. In the intervening 24+ years, you can imagine the impact this horrid situation had on sales and income.

Mr. Davis goes on in his fine article to outline key reasons why intra-family buyouts are generally not successful. One of his points we encounter all too often: Expecting family members to have the financial wherewithal to be able to actually afford to cash you out. Even if you can come to some agreement on valuation, the reality is if your business is worth $10 million, and your half is then worth $5 million, odds are high that your partner family members will not have that much cash laying around to buy you out.

So what happens? You agree to a long, long, long earn-out – in some cases for years – in the HOPEthat your family members will be able to grow the business so that throughout the next 5-10 years they can eventually pay you the $5 million they owe. Look closely at your next of kin that are running the business with you. Do you really think that cousin Larry has the DNA to become a great CEO? It matters not that he has been working in the mailroom for 30 years; he may not (and most likely will never) have the skill set necessary to run a multi-million-dollar business.

Avoid the Intra-Family Buyout Tragedy

I use Mr. Davis’s article and the Market Basket story to illustrate one key point: In most cases, it is far better to look for outside investors/buyers from the start rather than waiting until the business is tanking due to a family disagreement.

At our M&A seminars we spend a great deal of time discussing the various methods of creating working succession plans including ESOPs, family member buyers, outside investors, high net worth individuals, corporate strategics, etc. The point being – not every solution fits every business. However, to avoid situations like Market Basket’s, we strongly recommend looking at outside folks for help.

Most family business owners are concerned about two issues simultaneously and they sometimes see them as being polar opposites:

1. Maintaining the family legacy in the business AND
2. Becoming financially solvent.

The great news is that both can be accomplished even in an outright 100% sale of the family company.

In most cases, because of brand recognition, buyers will retain the original company name and often will take great pride in recounting the 100-year history of the business going all the way back to the founder. And, just as importantly, key long-term employees are usually retained in order to maintain business continuity. So in most cases, the legacy of your firm in the industry and local community will continue on for years.

But most importantly, you and your partners will be relieved of the financial burden of running a company and the risk associated with that, and you will be able to maintain good familial relations throughout the process, which is perhaps ultimately the greatest benefit of all. Just take a look at what happened to the Demoulas family!

If you find yourself in a position where a succession plan is needed to ensure the longevity of your family business, I suggest that you and your partners attend an educational Generational Equity exit planning workshop. As I mentioned, these are designed to help your family see the benefits/risks of all methods of succession. While there you and your partners will be able to meet one-on-one with our exit planning team and confidentially investigate if our services might be a good fit for your family’s situation. 

And above all else, as you and your family look for transition methods that make sense, remember to realize that at the end of the day, all you have is family. If you destroy those relationships bickering over valuations and buyouts, you have more at risk than just money; you have family ties that go back generations that could be destroyed.

Carl Doerksen is the Director of Corporate Development at Generational Equity.

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