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With a business entity that has a strong governance document, retiring farmers have a choice. Do they want to gift their share of the business to someone just as they would if they were to leave it to a successor in a will or trust? Or does the retiring farmer want to sell the business to the successor? There is some middle ground, as well– maybe the retiring farmer would like to gift ownership in the business to the incoming, aspiring farmer but wants the reliability of continuing to receive income from the business during retirement.
With a correctly structured governance document, all of these things are possible. In this way, building a succession plan into a governance document gives retiring farmers more flexibility than building it into their estate plan through a trust or will.
Before we get into some essential strategies for using a business entity for succession, let’s talk about some basic business valuation and transfer concepts. Using a governance document in farm succession means that there is a built-in internal system for incremental transfer of ownership and decision-making authority to a chosen successor farmer. Remember that the governance document lays out a plan for who owns how much of the business and how others buy-in or are bought-out. See Essential Strategy # 3 The Buy Sell Agreement, below for more details! For now, we can say that a good governance document with a buy-sell plan creates a contained ‘marketplace’ that only business owners can access. A farmer can use this private marketplace creatively to achieve a generational transfer.
What is being bought and sold in this marketplace? Small portions of the total value of the business are the goods sold in this internal marketplace. What we call portions here are formally called ‘shares’ of a corporation or usually ‘membership interests’ in an LLC. Sometimes, they are just spoken about as percentage ownership—owner number one owns 51% of the business and the second owner 49%, for example. All of these refer to the same concept—portions of ownership that can be traded, bought, or sold back to the business.
In their governance document, a business can simply decide that there are a set number of these portions. To illustrate this, we are going to use an example. Let’s say we have a business contemplating a gradual transfer to another farmer. This business has 100 portions of ownership. This is a manageable number to do quick calculations, and it is compatible with the percentage system so it will work well for our purposes.
This fictitious farm business that is contemplating succession has 100 portions of ownership. They are divided between a farmer and their spouse with a 51/49 split.
At the beginning of their farming career, this couple rented land at an incubator farm for years. This allowed them to save money until they could buy their small farm. Once they owned property, they wanted to formalize their business structure. Part of that process was capitalizing the business or transferring all the farm equipment, farm vehicles, and cash they had saved into their business name. The land wasn’t transferred into the farm’s name; the couple leased the farmland to the business. Therefore, the business was initially capitalized as follows:
At the establishment of the business, these transfers into the business name meant that the business had $188,590.00 of value. The owners divided this value by 100 to determine how much each portion of a business was worth.
One portion of this business = $1,885.90.
Of course, the value of the business will change over time. The goodwill (the value of the brand represented by the customer/buyer relationships it has) of the business will grow and establish its own monetary value that will eventually need to be calculated as part of the business assets. Maybe the owners bring someone else into the business who doesn’t have cash but gives $5,000.00 in sweat equity to buy into the business. Each year, the equipment listed here will depreciate, and the lease will decrease in value as the end of the lease term approaches. But those decreases will happen as other parts of the business assets grow—so this profile changes over time, going up and down. Hopefully, the net value of the business will increase over time. However, there will certainly be lean years, too, especially when debt is taken on to build new infrastructure or equipment.
As this profile of assets changes, so will the value of each portion of the business. What remains constant is the number of portions. About ten years prior to wanting to retire, the couple decides it is time to start thinking about succession and trying to find a farmer to take over their enterprise.
What strategies might be helpful to them in creating a succession plan via their business entity?
After consulting their attorney and tax professionals, this retiring farming couple decides to deed a portion of their land to the LLC. Now, their LLC holds the farm’s operations, equipment, land, and infrastructure. Their ideal aspiring farmer or farmers will buy the business over time, providing plenty of time for the transfer of management control and providing the retiring couple with some funds as they ease out of the business.
Once they’ve completed that process, they need a new business valuation. This couple we’ve been discussing has been successful; their business enjoys wide recognition, a strong customer base, and a functional infrastructure. Some of their equipment, though, is quite old and has depreciated greatly. Here’s the profile of their business value at the point when they want to start the farm succession process.
At this point, there are still 100 ‘portions,’ but they are now worth $2750 each because the value of the business has increased. The total value is $275,000.00.
Say this couple does find new, aspiring farmers that they get along with and who want to take over the business. However, the problem is that the new incoming farmers can’t afford to purchase the business and its assets outright. The valuation at $275,000 is a hefty price tag! However, the incoming farmers can initially afford $5,500.00 a year after a deposit of $5,500.00. After their first payment, the incoming farmers own 4% of the business. This is small but will continue to grow over the years.
The incoming farmers are allowed to start farming a portion of the land to continue to build their skills and to allow the outgoing farmers to introduce the new farmers to their customer base. Each year, the incoming farmers put as much toward purchasing the business as they are able (in the form of cash, other assets, or sweat equity per the agreement), and after five years, they own 25% of the business.
When the outgoing farmers are ready to retire, they still might be majority owners of the business. The incoming farmers will continue to put money towards purchasing the business incrementally. The retiring farmers might be counting on this money annually for part of their retirement income. As the business earns profit, the retiring and aspiring owners generally continue to split the profits in proportion to their percentage of ownership. This also provides the retiring farmers with additional income in retirement, although it declines as the aspiring farmers acquire more percentage ownership.
Eventually, the incoming farmers will have purchased all ‘portions’ of the business and be the full owners. The retiring farmers will no longer receive any income from the business, having been fully bought out.
Another common strategy is similar to the above example but involves multiple business entities. This is helpful in many situations, including where large assets (i.e., land) make it difficult for incoming farmers to purchase the business for its full value.
Rather than deeding land to the farm’s business entity, the land can be held in a separate land-holding LLC (for example) or can continue to be owned by the retiring farmers as a personal asset. In either case, an aspiring farmer taking over the farm, either incrementally as described in Essential Strategy #1 or by buying it outright as described elsewhere, could simply lease the farmland from the owners as individuals (or, if a land-holding business entity owns the land, the farmer would rent from the land-holding entity). This wouldn’t keep the aspiring farmers from purchasing the land at some point in the future. Leasing over a long time period might be the best solution for all the parties involved.
This strategy is not limited to separating the operation from the land. It is possible to place farming equipment into its own business entity, too. This means there could be an operations entity, an equipment entity, and a landholding entity. Multiple entities will require more paperwork, fees, and tax filings, but the benefits could be worth it. The operations entity would likely be the most affordable, allowing aspiring farmers to gain equity more quickly.
Of course, the aspiring farmers could eventually begin to buy into the other business entities or might eventually qualify for financing to purchase the land. This strategy provides stepping-stones for incoming farmers to achieve ownership more quickly and build savings and their businesses to make larger purchases down the road.
For businesses with more than one owner, creating a buy-sell agreement that every owner agrees to is essential for successful business succession. As discussed earlier in this guide, the buy-sell agreement will dictate when a portion or all of the business can be sold, how it can be sold (price, under what conditions), and to whom. Any business entity other than a sole proprietorship (or a single-member LLC) can and should have a buy-sell agreement. Let’s look at some sample clauses from a typical LLC Buy-Sell Agreement.
A retiring farmer’s co-owners might want the first chance to buy the retiring member’s portion of the business over and above any successor chosen by the retiring farmer. Suppose all owners agree they’d rather buy out a retiring farmer than risk a successor chosen by the retiring farmer not sharing their business goals and vision. In that case, a Right of First Refusal clause should be added to the buy-sell agreement. This clause protects co-owners by making it mandatory that co-owners must have an opportunity to purchase the retiring farmer’s ownership share before that retiring farmer could sell it to a third party. The co-owners, though, would need to pay the fair market value and be able to do so within an agreed-upon timeframe. See below for an example Right of First Refusal clause from an LLC Operating Agreement.
These clauses help protect business owners who are not retiring from unknown third parties buying into the business without them having an opportunity to purchase that share first.
If the business agreement doesn’t need to consider a Right of First Refusal, there are other restrictions on transfers that don’t require co-owners to find a way to fund a buyout of the retiring farmer’s share. A common way to restrict who can buy into a business is to limit the powers of an incoming partner/member/owner by refusing to extend voting rights to the incoming member. See the example clause for an LLC Operating Agreement below:
An Operating Agreement styled in this way doesn’t allow an LLC member to sell or give away their ownership interest in the LLC without the approval of the other owners and following other requirements set forth in the agreement. The ‘ownership rights’ referenced above are voting rights. Therefore, if an unapproved incoming owner is sold a share in the business, that owner would have no voting rights. With no power to vote, any incoming member would have no power to help influence the business’ direction and strategy, making the purchase of ownership almost invaluable.
Of course, this might feel like a harsh stance, and there are other options. As business owners, you all could agree that any incoming aspiring farmer who wants to buy into the business must simply be approved by the other members, whether unanimously or by majority vote. Or, the business could go to the other extreme and openly allow any transfers without consulting other members (this is likely ill-advised).
A common exception to unapproved transfers is transfers made between family members. An LLC Operating Agreement could address a familial exception to ‘improper’ transfers by adding a clause similar to what is below:
For the full context of a buy-sell agreement in an Operating Agreement, see Farm Commons’ Farmer’s Guide to Business Structures. There, you’ll find a fully annotated LLC Operating Agreement with even more detail and example buy-sell agreement clauses. And remember, when planning to sell or give (via a will or trust) the entirety or portions of a business, always check to ensure the governance document allows the transfer!
Many aspiring farmers cannot secure traditional financing to purchase farmland or a farming operation. In these cases, developing alternative strategies for farm succession can be necessary.
If an aspiring farmer only has enough funds to pay monthly rental payments but still wants to work towards business and land ownership, willing parties can agree to a rent-to-own path to ownership. In this case, monthly rental payments could do double duty. Say an aspiring farmer wants to use one acre of the retiring farmer’s land to begin a market farm. The aspiring farmer doesn’t have enough savings for a downpayment on the business and land but is interested in eventually purchasing the farm if a suitable agreement can be reached.
Let’s say a farmer is paying $400/month for a one-acre parcel. This rental rate includes the use of a packhouse, van, and cooler. After working together for a year, both parties agree that they’d like to find a path to ownership for the aspiring farmer as part of the retiring farmer’s succession plan. They decide that the rent will increase to $650/month, but that $250 of the rental price will go towards the purchase of the business and land. At the end of the second year, the aspiring farmer would have accrued $3,000 towards the purchase price for the farm. In this way, a fraction of the rental rate could accrue to help purchase the business. The only limits to agreements like this one are what can be agreed upon by the retiring and aspiring farmer!
Seller financing is relatively common as far as alternative financing strategies go. Instead of a bank or other financial institution handling the mortgage process, the sale is a private affair between the seller and the buyer. The two parties would draft a contract governing the payment and other terms of the agreement. The aspiring farmer would typically pay the retiring farmer a down payment and monthly installments. Interest will still be applied, as the seller is acting as the lender in this scenario, but usually, these contracts provide more favorable interest rates than a traditional mortgage.
The parties can agree to any contract length, but most often, seller financing is a stopgap measure, not a 30-year agreement. Most often, what’s called a ‘balloon payment’ is due after some number of years. This larger, one-time payment will end the seller financing contract. Buyers usually acquire traditional financing to make the ‘balloon payment’ to the seller who originally financed the purchase, and then the aspiring farmer/buyer would begin making payments to the new, traditional lender.
This seller-financing strategy can work well for retiring farmers who do not need the cash from a farm and/or operations sale immediately. A seller financing agreement could be the only way some aspiring farmers could purchase land. It is highly beneficial to aspiring farmers as it gives them time to establish credit to acquire traditional financing while building their farm business.
If retiring farmers find ambitious aspiring farmers who don’t own many assets but are willing to work hard to add value to the business, another type of agreement might work. The retiring and aspiring farmer could agree that the ‘sweat equity’ or work that the aspiring farmer puts into the business could translate to a contribution akin to a cash contribution. Usually, an aspiring farmer would need to contribute cash in exchange for ownership shares, but there are a few other options for willing parties.
The first is simple–labor. Can the aspiring farmer work a certain number of hours a week for the retiring farmers doing work of high value? If so, these hours can be valued at a dollar amount, accounted for in the business ledger, and contribute to the aspiring farmer’s capital contribution to the business.
Another way that hard work and innovation can be rewarded in the business world is by allowing an employee (who is still paid for their labor) to take on management responsibilities that can potentially increase the value of the business. The retiring and aspiring farmer could, for example, agree that the aspiring farmer will take over the management of the farm for five years. At the beginning and end of this five-year period, the business value will be assessed (by a method clearly spelled out in the agreement). Any increase in the business value over the five years of the aspiring farmer’s management could accrue to the aspiring farmer. If, at the end of the five years, the aspiring farmer wanted to continue to take over the business, the increase in the valuation could be used as a down payment into the business ownership.
These options are more limited than cash-based options but might be helpful for specific situations. If you consider any alternative financing options, consult a tax professional and attorney. Make sure you fully understand any tax consequences of your plan. And, as always, write strong agreements that capture authentic agreements between the two parties!
If you want to use a business entity in your succession plan, you’ll need to know the answer to a few questions. To answer most of these, you’ll need a successor in mind already. It will also be helpful to understand their finances and what they are willing to commit to!
Are you wanting to sell your entire business at once, or would it be preferable to sell it slowly over time? If you hope to mentor and/or have a strong relationship with your successor, selling it slowly over time might make the most sense. If you need cash more than a mentee, then selling the business all at once might be best.
Which of the options below did you lean toward more? |
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What is the successor you’ve chosen capable of? Is there money for a downpayment? Can they make monthly installment payments? Can they afford the entire business or only a portion of it?
Which of the options below did you lean toward more? |
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Are you willing to lease the land to the aspiring farmer rather than include it in the business purchase?
Which of the options below did you lean toward more? |
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And, most importantly–if relevant, have you consulted your governance document’s buy-sell agreement to see what transfers are possible? Have you spoken to any co-owners about your plans?
What next steps do you need to take?
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