July 6, 2022

Farm Succession: Financial Readiness for Succession

On this episode Purdue ag economists Brady Brewer and Michael Langemeier, along with extension educator Ed Farris discuss farm financial readiness and how it impacts succession planning.

A downloadable version of The Farm’s Legacy: A Guidebook for Intra-Family Succession is available here. An audio transcript is also available below.

Audio Transcript

Brady Brewer: Hi and welcome to Purdue Commercial AgCast, the Purdue University Center for Commercial Agriculture’s podcast featuring farm management news and information. On today’s episode I’m your host, Brady Brewer. And joining me today is Michael Langemeier, a professor in the Department of Agricultural Economics and associate director for the Center for Commercial Agriculture, and Ed Farris Extension Educator in Huntington County.

So, before we get started, this is part of the broader farm succession planning series. So, for other farm succession planning topics, please go to those podcasts here on the Center for Commercial Agriculture’s AgCast podcast. I also want to take a moment to highlight where this information is coming from. So, for more comprehensive succession planning materials, I advise all listeners to go to the Purdue Center for Commercial Agriculture website and the Purdue Institute for Family Businesses website for more materials on succession planning.

Specifically, I want to highlight the document that the bulk of the material we’ll be discussing here today comes from. And that document is called The Farm’s Legacy: A Guidebook for Intra-Family Succession. You can find that on the Purdue Education Store. It is free for download, and it will also be linked on the Purdue Center for Commercial Agriculture’s website as well, for download.

There is a number that goes along with that. If you can’t find this document, by the name of the document, the number is EC-817-W. So, for more information about the topics, we are discussing here today, that is the guidebook that has all the farm succession planning materials from the farm succession team. So, on today’s podcast, we are going to be discussing financial readiness for succession.

So, Michael, I’ll pitch this first question to you. What do we mean when we say financial readiness for succession?

2:19

Michael Langemeier: There’s a lot of different things we need to think about when someone is coming back to the farm or we’re looking at transitioning, transitioning part of the management and the farm to a younger generation. And one of those is related to the financial position of the farm. And so, when we talk about financial readiness, what we’re really talking about, is there enough liquidity, is there enough solvency? And probably most importantly, is the farm profitable enough to compensate someone that’s coming back to the farm?

And so let me talk a little bit more detail about some of the financials that that we really need to take a look at when someone’s coming back to the farm. Obviously, we’re going to talk more about the balance sheet a little bit later here.

But obviously the balance sheet and here specifically we’re talking about is liquidity. Is the liquidity of this farm solid? Because some of that liquidity is probably going to be drawn down when we when we start paying this person coming back to the farm. And so that’s a very important consideration. Another one, what is the debt structure on this farm?

3:21

If the farm needs to expand, do we have the ability to do that? Do we have the ability to borrow money on farmland that we own and so on? And so that’s also a very important consideration. And then and then looking at that farm income, it typically way I handle that is I look at the net farm income over a number of years, not just the last year. For example, ‘21 was a very good year. You can’t base decisions on a year like 21. And so, I’d like to look at a five, ten-year period in terms of profitability, and ask the basic question is that net farm income big enough support both the people that are currently on the farm and the people that are joining the operation?

And if it’s not, do we do, do we need to expand? Does this person coming back need it all farm job? And so, these are some of the questions that we’re trying to address before the person actually comes back to the farm. Another way to kind of analyze this is by looking at repayment capacity. We’ve talked about that in another podcast, Brady, and essentially what you’re doing there you’re saying that the farm has enough cash flow, if you will, to pay debt, and that would include any debt we might incur because we’re expanding in anticipation of coming back to the farm and pay the salaries of the people that are on the farm.

And so, there’s a number of different ways we can look at this profitability, the cash flow, liquidity, and solvency. But all of these are important to look at when someone’s coming back to the farm.

4:57

Brady Brewer: Yeah, you certainly don’t want to add a new member to the farm if financially you can’t afford it. Now, the financial is just one piece. Now, Ed, I want to ask you this next question. Thinking about, you know, the feasibility of adding a new member to the farm. Is there a feasibility test that we can go through or is there a checklist or what are the things we should be thinking about if we are planning to add someone to the farm here in the near future?

Ed Farris: Yes, there is a feasibility test that is recommended to think about these key proficiency areas, and that would include management, policies for the operation, and family structure, critical agreements in farm financials. So, each of these areas, its way a checklist would help would be just thinking about you know, is there something in place? Or is it in process?

Or maybe you don’t even need it. Maybe it’s so. So, this checklist is really something that is going to be unique to each family that is going to be changing as time moves forward. When you think about, you know, what stage you’re at with this, you know, transitioning it for management. So, you know, thinking about management, and looking at the strategy for the farm operation and considering a cash flow projection, you know, what are your routine tasks that are done in the operation, decisions that that daily have to be made?

You know, who is responsible for making those decisions? Do you have that those governance agreements in place and then thinking about that goes hand in hand with the policies that you have. You know, what kind of things are critical to the farm operation? You know, if it’s a multi which many farm operations are, you got different people involved.

You may have Uncle Joe that that always takes a fishing trip in the in the certain time of the year. And, you know, so if you don’t go into this realizing that he’s going to be away from the operation at that certain time and you know who’s going to cover those things and thinking about you know just the compensation levels and are you know what’s your classification.

7:38

So that covers the policies and the critical agreements that would cover things like, you know, your buy sell agreements that you have for people that want to buy into the farm operation. Who is involved with family members? Is there outside people that that may want to eventually become involved? And then, you know, your lease and rental arrangements, there’s insurance liability, health and disability, revenue sharing agreements, you know, how that is structure formed.

And then just looking at the farm financials, thinking about things like your cash flow, we mentioned already your balance sheet, income statements, depreciation schedules, production records, you know, some budgeting. You know, this is a critical time right now to be you know, ever thinking about budgeting with where we’re at with commodity prices and in input costs, is getting that cost price squeeze.

You know, looking at those. And whenever somebody is looking at, you know, making a major change, coming back to the operation, perhaps that has been away for a while or, you know, is slowly scaling more into that business, these things are critical.

9:09 

Brady Brewer: So, Ed that’s a pretty extensive list that you just mentioned.

Ed Farris:  Yes, it is.

Brady Brewer: Stuff that they need to be thinking about. Does the farm need to have every one of those boxes checked now or how do they need to think about filling out this entire checklist or, you know, the next couple of years?

Ed Farris: So really, that’s important to identify, you know, what are the most critical items that need to be in place because, you know, obviously if something you know, you have a potential health issue or, you know, somebody could not be available to run the operation, making sure you have those contingency plans and is, you know, some things that are maybe the most critical. But something things could be identified as, you know, you’re going to be working on that or, you know, for perhaps in the next five to ten years because, you know, it’s a retirement thing that you have goals set where a certain family member does want to eventually retire in ten years. So, that’s those are those are going to be different for each farming operation.

10:39

Brady Brewer: Yeah. And a lot of those things that you mentioned, I you know, I can say from personal experience, you don’t necessarily think of vacation days being a farmer or having, you know, planning that out with your colleagues. But that is a reality when you add new members into it that you want to have those come at opportune times or not all at the same time.

So, you know, some of these is just planning and getting ahead of the curve on the wants and needs of additional people that you’re adding to the farm. So, speaking of the wants and needs. Ed, I want to turn to the next topic, which I think is a pretty tricky topic for a lot of farm families. And that’s living expenses and income needs why and how do we need to estimate, you know, our living expenses? And how does that factor into succession planning?

Ed Farris: Well, I think back to when I started as a lender and working with some of these dairy operations. And the mindset was, well, we provide milk, meat and that truck for you, you know, you really don’t have a lot of living needs. You know, we’ve maybe got housing for this person.  So sometimes I think they just assume that there’s so many advantages because you’re part of the farming operation, you now, the farm pays for certain things.

And I think that’s the mindset that people often go into this. But really what is important is in thinking about the living needs is really identifying what all is involved there. You’ve got, you know, annual expenses with insurance that you’ve got, you know, debt on perhaps maybe the residential for a person.

You’ve got other things like family expenses. Maybe there’s children that are going into college and you know just your typical things that you have to come up with for a person that’s maybe making a big switch to become a part of the farm operation and just, you know, realizing that there are critical areas that you know, if there’s not enough producing from the farm, that’s going to cause future communication issues.

12:58

Ed Farris: So really identify and sitting down, you know, each family to make sure that, you know, you understand what your living costs truly are, and you know, in some cases, you do have at least one person working outside the farming operation that may be able to obtain, you know, some insurance coverage. So that that is less of an outflow for the farm itself.

But, you know, if you really look ahead for retirement, you know, is there a plan to put away money away from the farm, you know, in a 401K, something investment that it’s not just particularly tied to the farm. That’s you know, what I think is important as well is if there is some longevity for some people that are joining the operation.

14:01

Brady Brewer: Yeah, and this can be you know, forecasting your needs in retirement is always something that’s going to be difficult. I know here at our job at the university, you know, we have retirement plans. And part of that is there’s a financial calculator that I can get on and say, here’s how much I think I’ll spend in retirement. Here’s the age I think I will retire at, you know, so, you know, you can give me a rough estimate of what I will need in 30 years to retire.

And sometimes that can be daunting. But it also just gives me an idea of, you know, I did that a year or two ago and I realized, well, I may need to be putting 100 or so more away a month to reach my financial goals here in 30 years. And I know that’s a long way away, but small changes now can really help when you do need to do the transfer of succession when the time comes.

So, we’ve talked a lot about financials. Michael, I want to turn next to you and think specifically about the balance sheet. You know, we’ve talked about cash flow, but let’s think about the assets of a farm. Farms are typically pretty asset heavy. So, do we need an accurate assessment of the farm’s balance sheet, particularly on the asset side for this financial readiness roadmap that we’re that we’re doing here?

15:21

Michael Langemeier: Obviously, we need a balance sheet if we’re going to borrow money. And so, a lot of farms will have a balance sheet. But it’s so important that this balance sheet is accurate, and it’s done at the same time every year. And so, if we’re a calendar year, doing that balance sheet as close as possible to January one is always a good idea.

Let’s talk a little bit about some of the items on a balance sheet. This is not a podcast to just focus on the balance sheet, but let’s talk about some of the assets that are on the balance sheet. Obviously, the liquidity situation is defined by the current assets. Those are the largest current assets on farms, in crops and in storage.

But also, there could be some market livestock on a farm. Those are those are key current assets that are really sometimes quite large on most farms. Some of the most important current assets. But there also would be cash, for example, as a current asset, as it’s always a good current asset to pay bills. And then you have the current liabilities, the operating debt that you need to pay sometime during the year, but also the current portion of term debt you’re going to have some principal payments due on the machinery or land loans that you have.

And so, the current portion is a current liability. And so, taking a look at that, liquidity is always a good idea. Looking at the longer-term assets, we have machinery, equipment, grain bins, shop in other buildings that we need to make sure is on the balance sheet. Any debts associated with those assets also would be on the balance sheet.

And then we get to the most important assets on most farms, land. And so obviously we want to we want to value land at its market value on most balance sheets, but also clearly record the debt that’s associated with each track of land. And so, it’s really easy to figure out where that which tracts of land that debt is assigned to.

17:17

And so sometimes we’ll just see a number on the balance sheet that says real estate debt. 505,000 at least have a footnote or auxiliary statement that that indicates, what is that 505,000 represent is that is that one piece of land? Is that two pieces of land? Where are the mortgages? You know, what mortgages are represented by that 505,000.

So, detailing that is very important and the reason why that’s so important is one of the decisions that a farm is going to make when someone’s coming back to the operation typically is should we expand and just as importantly, should we expand by leasing land or should we expand by buying land, or both? And really to make that buying decision in particular, it is going to be very critical to assess how many assets, how much land we have in terms of value and how much debt we have on that land.

If we have quite a bit of land with very little real estate debt, the farm is at a pretty good position to purchase land if land is available. If that’s not the case, then probably leasing land is going to be a better option. And so that’s why that balance sheet is so important. To have an accurate balance sheet, clearly indicating what assets the debt is associated with, so we can make these very important decisions about whether we should buy additional machinery to accommodate expansion of the farm, or whether we need to lease land or purchase land.

18:58

Brady Brewer: So, Michael, I want to ask a follow up question. You talked about valuing the land at market value. Obviously, when you go to the bank and your lender, you want it to be at market value. So, you get the full value of that collateral, which allows you to maximize, you know, what you’re able to borrow against it.

But when we think about the financial readiness and the succession plan and retirement, should there be a sensitivity analysis done to take a conservative number? So, to say if the land is only going to be at 85% of what I think it may be valued at or 80%. Would this still work? Should you do a worst case scenario here to add in a little bit of contingency.

19:42 

Michael Langemeier: Definitely and definitely doing something like that would be very prudent. Again, you can have multiple balance sheets. You can have the base balance sheet where the land is as valued at market. But then you take a look at that what if land was 10% lower what it is 20% lower. Could I still purchase additional ground and be able to repay the debt?

And so yes, that’s an excellent idea to look at sensitivity analysis, particularly with respect to land values. I don’t think that’s quite as critical many times with respect to some of the other assets on the balance sheet. But we have to we have to remember that on average, we look at the U.S. farm, a balance sheet 82% of all the assets are land, and so that’s why we want to kind of focus that sensitivity analysis on land values. And when we’re purchasing land, but also leasing land, because many times we’re leasing land, we’re going to incur quite a bit of debt doing that too. And we always want to ask that question, if we’re expanding, are we going to generate enough cash flow to pay for the debt associated with that expansion?

20:53 

Brady Brewer: So, I want to move now to the next topic, and that is the division of income or the allocation of sweat equity in the business. Obviously, on the financial readiness side, we’re going to divide the income as we think about bringing new business partners into the farm. So, Michael, I want to ask you how should we divide or what are the ways we can think about dividing the income or the sweat equity in the farm?

Michael Langemeier: Yeah, before we get into dividing our business income, one of the things I think farms need to think about is when this new person comes back to the farm, should they be paid a salary for the first two to three years? Rather than becoming a full partner in the business? And the reason why I say this is important is, first of all, that that person coming back to the farm they may have a family that they’re bringing with them, and they may want some stability in that income for that first three years.

You can do that by paying them a salary, rather than making them a partner from day one, because that that family coming back to the farm probably doesn’t have a real strong balance sheet compared to the family that’s already there. And so, they really don’t have a cushion to fall back on. And another reason for paying a salary for the first two to three years, it’s usually not any longer than that.

But for the first two to three years is we want to see if this is going to work out. We think it’s going to work out, but maybe there’s going to be conflict. Maybe this is not really what this person really wants to do for the rest of their life. It’s different growing up on a farm and seeing the farm from that angle to being a partner in the business, you’re treated differently.

22:36

And sometimes it’s hard for families to adjust to that transition from just being a worker on the farm, growing up in the farm as a teenager to becoming a full partner on the farm. And so, this transition period two to three years paying someone a salary is a good idea. Now, once we get past that stage where we’re paying a salary, then we need to start thinking about how should we compensate say, the younger generation in the older generation?  I’m a strong believer in what I call the contribution model and what that what that model essentially does is it looks at the effort in terms of work that goes into the business or accounts for that as a contribution for each party, but also looks at the assets of both parties.

And so, the older generation has quite a bit of land that they own personally. They own a vast majority of the machinery, they should be compensated for the fact that they own that machinery, that they own that land. And so as overall contribution standpoint, they should get a larger share of that net farm income than the younger generation.

It could be because we need to pay for those assets that that older generation owns, this is particularly important for land because for most farms, land is owned outside of the entity. It’s usually owned by the farm family. But its owned personally. And so, we want to make sure that we’re paying cash rent and I would recommend paying market cash rent to the people that own that land and make sure that they’re getting compensation for the fact that they all know those assets.

You were asking earlier about retirement, for many farms this is their retirement. This savings of this rent over time. You know, that represents their retirement. And when someone completely phases out of the business, that might be their primary source of retirement income. And so, it’s very important to make sure that those assets that are owned, particularly land, are paid for in addition to the labor.

And so that’s why I don’t like things like, well, we’re going to split net farm income 50/50. Well, the younger generation doesn’t own 50% of the assets. That doesn’t make any sense to me. And now, over time the younger generation’s is going to be a more critical part in buying machinery, perhaps even buying land.

25:04

And so, their contribution will grow over time. And so, they’ll get a larger proportion of the net farm income. But that’s how I kind of think about it. You asked another question. This is a whole other can of worms related to sweat equity. What sweat equity really means is we’re not able to pay this person coming back to the farm their full opportunity cost.

Let’s say that this person could get a job someplace in Indianapolis or someplace like that and earn $60,000 in that job. When they come back to the farm, we may not be able to afford to give them a $60,000 salary, maybe their salary is $40,000. And what we need to do is we need to keep track of that in some way and realize that that part of the income that they’re not earning of, part of their opportunity cost or we’re going to compensate for later on.

Maybe they’re going to inherit a larger portion of the land, for example, and that’s what that’s what we mean by sweat equity is they did not earn their full opportunity cost over time. And so and so when those assets are divided in the estate, perhaps that person can come back, the farm should get a higher percent reflect the fact that they were not paid their full opportunity cost, and this is something that would not happen if we were able to pay somebody their full opportunity cost. But in most family businesses, that’s just not the way it works. And so, we need to keep track of this sweat equity.

26:41

Brady Brewer: Yeah. And these are not easy conversations to have, especially when it comes to the compensation of individuals. I do want to just take a quick moment to say for information on conflict management within the families on this farm succession planning and road mapping, because this is one small piece of the broader farm succession puzzle, please check out the other resources we have on those very related topics and in some cases topics that allow for an easier implementation of some of these pieces to the puzzle.

Michael Langemeier: And a related point here, Brady, that I run across all the time is, is it’s so important for the older generation to be very transparent with the person coming back to the farm, and also the off farm heirs. And say, for example, we were not able to compensate this person coming back to the farm, we were not able to pay $60,000 salary. Because of that, we’re going to account for that fact in the estate. And so be very transparent with the person coming back to the farm, but also with the off farm heirs. And say this is why the person coming back to the farm is going to get a larger percentage of that land, to account for the sweat equity.

28:11 

Ed Farris: And I think going back to the contributions that Michael talked about, sometimes what we see is families have started having communication problems simply because they don’t take the time to think about what all the costs are associated with owning those assets. And, you know, it really comes down to something that I learned back in high school ag economics classes, which was the dirty five costs, you know, depreciation, interest, taxes, repairs and insurance. You know, those dirty five costs don’t always get all accounted for.

And that can cause some communication problems as you set up these different arrangements between family members that are, you know, somebody coming back. Or just adding somebody new to the business.

Brady Brewer: Yeah. And getting your financial readiness and making sure you are financially ready to take on this family business or take on a new family member, is in my mind kind of the first step to initiating this the succession plan. Well, first step of many to be perfectly honest, to make sure that you have this smooth transition.

So, with that today, we are out of time. I just want to remind our listeners for more economic information and farm management information, please visit the Purdue Center for Commercial Ag’s website purdue.edu/commercialag, or the Purdue Institute for Family Business website at purdue.edu/department/agecon/fambiz/. Again, the information that we mainly referenced on today’s episode is from the document that is titled The Farm’s Legacy: A Guidebook for Intra-Family Succession, and the information today came from chapter three of that guidebook. And that is on the Purdue Extension Education Store, as well will be linked on the Purdue Center for Commercial Agriculture’s website.

Please follow the Purdue Center for Commercial Agriculture on Twitter. Their handle is at @PUCommercialAg. And the Purdue Institute for Family Business’s twitter is @PurdueFamBiz.

On behalf of the Center for Commercial Agriculture and the Purdue Institute for Family Business and the Farm Transition Team. We thank you for listening to today’s episode.

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