Case study: treating your heirs fairly

Nation's Business, Sept, 1997 by Donald C. Reinardly, Jeffrey M. Davidson

Sandy is up-to-date on the latest in family-business literature, but nothing he has seen seems to talk about calculating financial value based on future opportunities.

His daughter, Cindy, is 25, has three years of experience in real-estate development, and is about to join Essex Quarry, which Sandy acquired five years ago.

Although the business is struggling as a quarry and has a negative book value, the discovery of a new vein and some pending zoning variances to allow for commercial development are making the future look bright.

Having read too many articles about the differing interests and resulting battles of stockholding family members who work in the business and those who don't, Sandy is convinced that ownership of a family business must be in the hands of those who work in it. He wants to give his daughter 40 percent equity in Essex Quarry while its value is still low.

However, he doesn't know how to deal fairly with his son, Lewis, who has a thriving career in journalism and has made it clear that he has no interest in joining the business.

"If I sold stock with a book value to Cindy at a discount," Sandy remarks, "I could calculate what I `gave' her and make it up to Lewis with other assets. But I'm dealinng with `potential.'

"How do I calculate that and be fair to both my kids?'

Response 1

Keep Issues Separate

Sandy needs to address each of the issues separately. Giving stock to Cindy is appropriate, and the need to be fair to both children doesn't change that.

Sandy should make the gift to Cindy and determine the gift-tax value of the stock using his best estimate of the value of known mineral reserves. Allowances can be made to compensate for estimates, extraction costs, minority interest, and lack of liquidity. But that value might not be the best measure of what Sandy can or should do for Lewis.

Because the stock value estimated future income, actual results will be different, and the future stock value will be compared with what Sandy gives Lewis today. Some ways to deal with this situation are:

1. Delay any gift to Lewis until the stock value is more certain.

2. Give Lewis an equal amount of "phantom stock" now, with its change in value to be cashed in five years hence. Under this plan, no real stock is transferred but Lewis is given appreciation lights to his shares.

3. Give Lewis the equivalent in nonvoting stock. He would have no voting rights, but his stock value would follow Cindy's.

4. Make a gift to Lewis equal to the best estimate of present value of Cindy's stock and make up the difference to one of them later. Don't ignore the risk that Cindy has in realizing the future value of her stock.

Sandy must make sure that his son and daughter understand his concept of fairness so they won't resent each other. Finally, Cindy should be compensated at market value for her work in the business.

Response 2

Involve All In The Process

Sandy should recognize that fairness and equality are seldom compatible goals.

Fairness revolves around the issue of equity, which often addresses differences on a logical basis.

Equality, on the other hand, implies that everything has to be the same. Aiming for equality is often impractical and can lead to bad decisions.

First, it's important for Sandy to articulate and analyze his goals. He should clearly determine what he wants to accomplish and why.

The next step would be a meeting with his children, Cindy and Lewis. At this meeting, Sandy would articulate to them his desire for fairness and his belief in providing ownership in a family business only to those who work in the business.

Cindy and Lewis would have a forum in which to let Sandy know how they feel about the situation. A second three-way meeting may be neccessary for a full Wiring of ideas.

Because of the cloudiness around the current worth of Essex Quarry, the family members might agree to have a valuation made at a given date, perhaps two years hence. At that time, the fairness-versus-equality issue could be revisited.

Or, rather than wait, the family might agree to find a valuation expert who might be able to anticipate the significance of the discovery of the new vein and the pending zoning variances.

Whichever approach is taken, all affected parties will be involved in the decision-making process and will have resolved in advance the fairness-versus-equality balancing act.