Valuing Sweat for Equity

 

In last month’s article we highlighted that the desire for equality can cause stress and difficulty when dealing with the complex arrangements that apply to the transfer of a family farm. We raised the issue of “sweat for equity” and received a number of questions regarding how a family can estimate the succession value of the past efforts of children who are still working on the farm and playing an important role in its development.

So how is this contribution by the on farm children recognised and how do the off farm children get compensated for forgoing property ownership? It is important that “fairness” prevails.

Let’s assume that the on farm child reached a level of involvement on the farm where they were actively contributing to decisions that led to the growth and development of the business. Their energy, drive and commitment may have meant that investment decisions were made, that would not have otherwise have occurred.

As an example, let’s say that the parents are able to pinpoint this time to approximately, 10 years ago and the then, fair market value net worth of the business was, say, $2,000,000. Today, the business has grown by an additional $1,000,000. If divided equally between say, three children $1,000,000 would be left to each. The contributions from the three children toward the success of the farm business over the last 10 years may have definitely not been equal.

There are two dilemmas present in this example. The first arises because most of us want to treat our children fairly. Many of us think that the only way to treat each child fairly is to treat them equally and we certainly don’t want to be the cause of any hard feelings. We don’t want our non-farm kids to feel that they have been mistreated or slighted, but if the farm business was divided into equal pieces would that equal slice be of adequate size to create a viable business and would it represent a fair outcome?

The second dilemma occurs because the asset value of the farm may have increased over the last 10 years and in part this may be due to the efforts of the on farm child to the success and growth of the business? Also, they may have been paid less than commercial wages over a long period.

Let’s look at how the family can recognise the contribution of their on farm child by putting a value on their “sweat equity.” Once completed, they can use this to explain to the non-farm children how they reached their estate planning decisions.

Part of this process includes placing an arbitrary value on the contribution that the on farm children have made to the value of the farm assets. An additional element is placing a value on foregone wages of the on farm children.

The allocation of value to be distributed to on farm children could be calculated along the following lines:

ILLUSTRATION MISSING

In the illustration above, the contribution of 50 percent is simply an example. Every operation will have different factors and likely arrive at a different percentage for the value of the successor’s contribution. In the above case, the on farm child will receive substantially more than the off farm child. However, it is important they all understand the basic process.

Contributions equal compensation. The family business may look very different today because of the contribution of the on farm child. Each family situation will be different. The next family may have decided that their successor had contributed to only ten percent or maybe 80 or 90 percent of the growth. The question is how much has the “sweat equity” contributed to the growth of the farm?

There is also the issue of compensation to the off farm children. Often, a cash value is determined and this amount may be payable at some future time event. Say, after the death of the last surviving parent – e.g. 2 years. This enables the on farm children time to arrange financial facilities or dispense with part of their assets to meet this funding obligation.

Because there are fundamental differences in the nature of a cash asset as compared to farming assets, the cash obligation to the off farm children should less than the proportionate value of the farming assets.

If the farm is to be ultimately transferred to the on farm child then the compensation to be provided to the off farm child cannot impose such a financial burden that would make the business unviable

The term and nature of any payments will need to be agreed but will include:

  • Date of commencement of payments
  • Term of Payments
  • Level of payments
  • Will interest be payable?
  • Is there a lump sum payment at the end?(balloon payment)

Illustrated as follows:

 
2039_NEX_Next-Rural-Blog-info-graphic-nature-of-payments.jpg
 

Finally it is the current business owners that are in the best position to evaluate the contribution of the on and off farm children and adjust the compensation accordingly. As long as both the on farm and off farm children understand the method and calculations used and how the estate is to be distributed, then hopefully family harmony will prevail. 

James Benson is an executive director of Next Rural.

Next Rural specialises in business transition and succession planning.

Next Rural have put together a simple yet comprehensive guide to business transition and succession planning.

To obtain a copy of the guide for free and with no obligation, email Next Rural on info@ nextrural.com.au or call 1800 708 495.