Business Sage has Answers to Tough Family Business Queries

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Business Sage has Answers to Tough Family Business Queries

March, 2009

When he's not teaching at the University of North Carolina at Chapel Hill, James Lea is a nationally-known family business speaker, author and advisor.

When I encounter an especially thorny business topic, I often pick up the phone or the keyboard and contact Dick Levin. He's a former business professor and associate dean at the University of North Carolina at Chapel Hill and a noted expert and author on strategy and other business tools. He also has a magic touch when it comes to helping people make money.

When family companies began getting frantic about staying solvent in the midst of a general business meltdown, I called Dick. "Family businesses want help with financial decision making, managing assets, reducing taxes, sustaining profits," I told him. "They see large public corporations going down the pipe, and they don't want to follow them."

"The first thing privately owned companies have to realize," Dick said, "is that their financial decisions are distinctly different from those of large public corporations."

I grabbed my pencil and yellow pad. "Tell me about it," I said.

"Well, take ownership of assets. Family corporations shouldn't own real estate or, for that matter, any fixed assets. It's generally much better to set up a family-owned leasing company which purchases all required equipment and leases it to the primary family corporation. Similarly, business real estate should be held in a family partnership and rented to the primary company, so that increases in the value of the real estate are preserved for the family outside of the primary corporation. Earnings are taken out of the corporation by the family pre-tax in the form of rent paid to the real estate partnership. When family members own a real estate partnership or leasing company, they get the best possible tax advantage and accumulate the most after-tax cash."

"What about ownership of equity?"

"In family corporations, the line between debt and equity can be blurred," he said. "In many cases, it's better for the family to lend the corporation money instead of buying stock, because it's so much easier to get the money out again by just liquidating the debt.

"If the family holds stock, a bank can restrict the re-purchase of shares by the company as a loan condition, but getting money back to family members who loaned it is a simple matter of management paying off the debt.

"Retained earnings is a related issue. Retained earnings rarely reflect the future internal financing required to support the business. Instead, they're usually an accounting repository of funds left in the corporation to avoid paying double taxes."

"Anyone who knows how to read an income statement and a balance sheet should be able to follow that."

"Not necessarily," Dick said. "The income statements and balance sheets of family corporations are too often distorted by good intentions and tax laws. In some cases, balance-sheet assets are inflated by beach cottages, mountain chalets, automobiles and even airplanes - and, of course, assets that the family holds separately in supporting organizations but which it uses to support operations of the primary company. The income statement is similarly affected by employing relatives with salaries and benefits above market rates, making rent and lease payments to the family, and spending for recreation. In moderation, this is good tax strategy, but it makes it impossible to tell what's going on by a traditional examination of the company's books."

"OK," I said, "what about profit?"

"Reported profit is what drives the stock price of a public corporation," Dick explained, "so executives have to pay attention to it. But privately owned family companies that worry exclusively about profit are hung up on the wrong thing. They should focus on the cash they take home at the end of the day. They have to report profit to keep their lenders happy but not to boost stock value.

"If the company isn't publicly traded, it's less important to maximize profit than to maximize the amount of after-tax cash generated by the business."

"So how can a family owned business keep score?"

"The accounting system should track the after-tax cash that goes into the family's pocket as well as the money that stays in the company," he said. "All assets employed by the company, whether generated by the business or supplied by the family, should be taken into account in each financial decision. In fact, the company should keep two sets of books, one for the bankers and others with a profit fascination and one for management decision makers. It's a legitimate accounting practice, and it keeps the family's business focus right where it should be."

"Thanks, Dick. A lot more family companies will be sleeping well tonight."

James Lea is a professor at the University of North Carolina at Chapel Hill and a nationally known family business speaker, author, and advisor. You can send comments or questions to him at james.lea@yourfamilybusiness.net.

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