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Business expansion might mean transition of risk

Scott E. Plew Published on 29 October 2010

One thing I like about working with dairymen is they are not afraid of taking risks to be successful.

Initially, we were asked to talk about expansion opportunities for dairy operations. While that sounds great and full of risk, we’d like to expand your thinking by asking you to see risk transfer as the business expansion itself.

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Given today’s dairy environment, we believe it makes more sense to address expansion and planning from a different angle than what a traditional expansion looks like. Instead of expanding the dairy operation by adding more cows, land and facilities, let’s look at it from the individual owner’s perspective. For example, how does a son or daughter increase their ownership in the family dairy from 10 percent to say 25 percent or 30 percent?

Most dairies are family-owned and typically consist of more than one generation of family members. The current owner or majority owner may have inherited the operation from his father and now his children are involved in the operations and some of them, but most likely not all, want to become an owner or own more of it.

That means transitioning a dairy operation, which consists of financial, legal and tax issues along with personal and family dynamics. This takes an expansion of your current thinking because it requires planning and tough, honest discussions with key advisers.

Who should be taking the risk
Think of it like this. It’s a lot easier to rebuild your equity if you lose it at age 35 than age 60. As we all know, the dairy industry is full of peaks and valleys. As a dairyman reaches the later part of his life, he doesn’t typically have the desire or energy to work through the valleys. He’s been there and done that.

However, the younger generations have the time and energy, and more often than not, they are hungry to do so. With the assumption of greater risk, a greater reward typically follows. Meaning, the younger generation takes the risks associated with owning a dairy operation and have the opportunity to participate in the fruits of their labor.

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However, there sometimes exists a lack of understanding that each party has of the other in this transition process. As an overview, let’s take a look at an example and afterwards some of the issues that face each player as they transfer risk and expand their operational outlook.

Example: Father is a second-generation dairyman milking 1,500 cows with his three sons A, B and C. They have a partnership that owns all of the cows, land and facilities. Father owns 70 percent of the partnership and each of the sons own 10 percent. Father is looking to spend less time on the dairy and more time doing other things he enjoys. Also, Father does not want to have to risk all of his years of hard work and equity if the operation were to experience another year like 2009. What can be done?

One option is to move Father’s role from a dairy manager/operator to a landlord. This is done by separating the real estate from the operations. Father owns the majority of the real estate and rents it to the partnership. He sells his interest in the cows, feed, rolling stock and other operating assets to sons A, B and C and now collects a monthly rent check to do with as he pleases, as well as payments from the sons for his partnership interest.

[ NOTE : the above example is an illustration. It is admittedly simplistic and missing many of the necessary steps that need to be followed to make this type of structure work. There are many options and various structures to do this. Each situation and dairy operation has its own uniqueness; it is impossible to give a blanket answer to this scenario.]

At the end of the day, this example achieves the goal of expansion by balancing the need for security with the ability to shoulder risk. Father owns the majority of the real estate and the sons own the assets that possess more risk, but also can produce more rewards.

Top transfer-of-risk issues
1. Father’s personal guarantee on operating lines of credit and other debt

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Restructuring the operation as mentioned in the above example, with the intent of reducing the older generation’s risk and exposure to equity losses, is somewhat ineffective given the fact that if the operation were to experience another year like 2009 and become out of compliance with its loan agreement, Father’s personal guarantee may be called upon to make good on the loans.

This does not achieve what the operation has set out to do. In order to make this work, the dairy’s lender needs to be part of the process from the beginning. The lender needs to understand the reasons for the restructuring and the benefits to be derived from it. This can’t all happen overnight, so a negotiation with the lender to gradually reduce Father’s personal guarantee of the debt over a period of years is more realistic as long as sons A, B and C continue to strengthen their personal balance sheets to replace Father’s equity.

2. Sons – relationship and knowledge transfer

It is as critical that fathers have faith in their sons as sons have faith in their fathers. Transitioning from Father calling all the shots to sons A, B and C can be more of a challenge than changing the structure of the operation and negotiating with the bank. Father has a knowledge base developed over many years of experience that somehow needs to be transferred to the next generation. Again, this doesn’t happen overnight and needs to begin very early in the process. Aside from the knowledge and skills needed to manage a dairy operation, knowing the business side of agriculture is just as important.

Father has developed relationships over the years with his banker, CPA and attorney, and they have worked together to assist Father in getting to where he is today. These are important relationships that need to be transferred to the upcoming generation. Father should get the sons involved in the business side of the operation as soon as possible by having them participate in meetings with banker, accountant and attorney. You can learn quite a bit just by being a fly on the wall and watching how others interact.

Planning requires outside perspective
The above situation is ideal, with both parties willing and able to participate in this expansion of thought.

How many of us live in an ideal world? More than likely, the next generation consists of different personalities and different ways of doing things that need to be dealt with early on so the interfamily dynamics affect the operations positively and don’t hinder it. A sound succession plan is a must in this situation, and even those can go awry.

Keeping key individuals informed and part of the process also helps promote and support the rest of the transition. Those who should be involved include the successors, managers, family and key non-family employees, investors, professional advisers such as accountants, attorneys and consultants.

Having an outside perspective in this process is a good idea. Professional advisers are equipped with experience and skills necessary to shed an objective light on the situation – both parties could be too close to it, so judgment might be muddied by emotional bias or family conflicts.

Conclusion
As an accountant, I have to mention the tax consequences that come into play in this expansion of thinking. For Father, this triggers taxable gains on the sale of his interest in the cows, feed, rolling stock, etc. Also, since Father no longer owns a part of the dairy operation itself, he loses some of the tax advantages and strategies available to producers. However, with proactive planning, the income tax impact can be reduced.

If the younger generation does not already own an interest in the operation, the tax consequences and benefits vary greatly from those of an employee earning a wage. The tax advantages and strategies Father is losing out on are now available to them.

As a business adviser, I have to say there’s so much more than that. The new “risk takers” need to have clearly defined roles in the operation that capitalize on each of their individual strengths. I cannot stress enough that there are consultants that can assist in identifying each individual’s strengths and weaknesses and structuring the internal workings of the operation so that the operation gets the best from everyone and has the greatest opportunity to succeed. The new “landlord” needs to continue to nurture relationships and transfer his knowledge.

Don’t be taken off guard if this expansion and transfer of risk and power doesn’t go smoothly. It’s a risk. But as hockey player Wayne Gretzky once said, “We always miss 100 percent of the shots we don’t take.” PD

Scott E. Plew

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