BUSINESS
Succession
Clear vision and robust plan needed If you haven’t got a strong business when you are looking at succession, you are not going to have many options to make it work, Peter Flannery writes.
T
here are four pillars to building a successful succession plan. They are: 1. Build a strong business first. 2. Communication with family. 3. Fair comes before equal. 4. Transfer of ownership and control. The first of those pillars. If you haven’t got a strong business when you are looking at succession, you are not going to have many options to make it work. So what does a strong business look like? First, it has to have scale. A business generating $1.5 million of income is going to have more options than one half that size. Every business has fixed overheads, regardless of size. The biggest fixed cost is personal drawings. Your drawings are not a function of the size of your business. They are a function of your lifestyle and your own family’s size, stage and age.
Table 1: Costs Higher scale
Lower scale
Income
$1,500,000
$750,000
Farm working costs at 55% of income
$825,000
$412,500
Interest at 15% of Income
$225,000
$112,500
Tax assuming a partnership
$90,740
$29,690
Drawings
$95,000
$95,000
Plant and machinery replacement
$43,750
$31,250
Principal repayment
$112,500
$56,250
Surplus for reinvestment
$108,010
$12,810
Higher scale
Lower scale
Land Value (Income x 7.5)
$11,250,000
$5,625,000
Stock Value (Income/140*200)
$2,142,857
$1,071,429
Plant and Machinery
$350,000
$250,000
Total Assets
$13,742,857
$6,946,429
Debt (Debt servicing/5%)
$4,500,000
$2,250,000
Equity
$9,242,857
$4,696,429
Equity Ratio
67%
68%
Debt Ratio
33%
32%
Return on Equity (Before principal repayments)
2.4%
1.5%
Table 2 Assets and Liability
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Table 1 shows two businesses, one with twice the scale and both drawing $95,000 for personal expenditure. If we assume farm costs and debt servicing are in similar proportion to income, then after tax, plant and machinery replacement and principal repayments, there is a stark difference in the cash available for investment. In this simplistic example, the business with twice the scale generates $100,000 or nearly 10 times more available cash surplus for investment, thereby providing more options for succession. So the amount of free cash generated within the business is key, however we should also look at the balance sheet. This is also impacted by scale. The larger the scale, the more borrowing power a business will have. If we extrapolate out the above and make some assumptions, the respective balance sheets may look like Table 2. Not surprisingly in this example the equity is nearly double in the larger scale business, both with similar debt and equity ratios. However, the harsh reality is that the larger scale business has a lot more borrowing power. To be “bankable” a business needs to be strong enough to generate enough “free cash” to repay its debt over 20 years. At current interest rates, this equates to around 2.5% of total debt borrowed. Bear with me while I get a little bit technical. To be able to achieve this, the business needs to have a debt to EBIT ratio better than 11. This is a reasonably “modern” measure, and at least one bank uses this as their criteria to assess credit risk (Table 3). Given the profit and loss of the two businesses in this example the lower scale business is pretty much fully lent whilst the larger scale business can most likely increase its debt ratio to 43% meaning it could potentially borrow another $1.4m. The harsh reality therefore is in this example the lower scale business has very few options. With $4.7m of equity, at 68% of total assets, what would appear to be a bankable business in its current state has very few options to remove capital
Country-Wide
October 2021
