The author, from Orefield, Pa., is a veterinarian with a master of business administration degree (MBA). He serves as dairy transitions coordinator for Pennsylvania's Center for Dairy Excellence.
Sooner or later, most farm families reach a point where they must consider transferring assets and responsibility to the next generation. Many discover this is not an easy task. The value of the assets is often far larger than the younger people can afford. Other children who have no interest in the farm business may also complicate matters. Where do you begin?
Many times the best first step is to separate the farm business from the land. This usually reduces the value of the assets being transferred and makes the process more feasible. Often two business entities are established, with the farm business owning cows and replacement animals, and perhaps equipment. A separate business owns the tillable land and buildings. The farm business rents these assets from the land business. Sometimes these arrangements vary, with the farm business entity owning the buildings and the tillable ground being owned by the land business.
The next step is to determine the value of the farm business. It is difficult to devise a fair plan to transfer assets unless the value of the assets is known. This should be done using two methods. One is to simply add up the market value of the tangible assets owned by the farm business. For what dollar amount could the cows, calves, heifers and perhaps equipment be sold? This step makes sense to most people. The second method is less obvious. Based on the profitability of the farm business, what is it worth as an ongoing operation, retaining all of the assets?
To get this figure, the net farm profit (after deducting a fair value for family labor) is determined for the past three to five years and then averaged. That profit is then "capitalized."
The easiest way to understand this concept is to ask, "What return on investment is required to justify purchasing the farm business?" A minimum value is probably 10 percent, and some would suggest as high as 20 percent due to the risk involved with dairy farming. Using this concept, if the average net profit for a farm operation is $30,000, then the maximum value is obtained by dividing $30,000 by 0.10 (10 percent return on investment) yielding $300,000. The minimum would be using the 20 percent required return and would generate a value of $150,000.
The reality is that many dairy farms do not generate this high of a return on the actual tangible assets. Thus, if the younger generation buys the assets of the farm business at full market value, they cannot pay for them out of farm profits. They must either have outside income or work for very low compensation. So how do farms actually do it?
Three approaches to consider
There are at least three approaches to transferring assets at less than the market value.
1. Sweat equity - This is a term applied to the younger generation working ("sweating") for cash compensation below the going rate for the job they do. For example, assume a son performs the job of herdsman on a 200-cow farm. That role might command a compensation package worth $45,000 if an outside person were hired by the farm. If the son is paid only $25,000, then the $20,000 difference can be used to transfer that amount of farm assets to him. This could be in stock, in cows, or some other tangible asset that the farm business owns.
2. Gifting - The older generation can simply gift some percentage, or some tangible assets, to the next generation. This is often done, and it works if the parents can afford to do so and if it is possible to treat other children fairly as well.
3. Added responsibility - Besides fulfilling the role of herdsman, the son in the example above might also do the homework and planning of some farm project designed to improve the profit of the farm. This could be improving cow comfort, moving to custom harvesting, or instituting an improved reproduction protocol. The son would receive additional farm assets to compensate him for this added effort.
Profits improve transfers
This last point is worthy of further discussion. The simple truth is that the more profitable a farm business is, the easier it becomes to transfer assets. That is because if the next generation acquires ownership in the business, they can pay the parents for those assets if the farm generates adequate profit.
Sounds simple, but obviously it is not easy, especially when dealing with low milk prices. Yet, the truth is, some farms are drastically more profitable than others. And some farms are able to keep their investments in tangible assets relatively low on a per cow or per cwt. (hundredweight) of milk sold basis, which also eases the process.
Many dairy farmers become frustrated when they begin considering bringing in the next generation. There seems to be no way for the next generation to acquire equity without the parents "giving away the farm." The first step is to determine the value of what is being transferred, and then work to make the farm business as profitable as possible.
I urge you to start the process early, giving yourself and your family several years to carry out the process. Get professional advisers involved. Doing so will greatly increase your odds of seeing the farm continue under family ownership and management.
This article appears on page 594 of the September 25, 2015 issue of Hoard's Dairyman.
Return to the Hoard's Dairyman feature page.
Sooner or later, most farm families reach a point where they must consider transferring assets and responsibility to the next generation. Many discover this is not an easy task. The value of the assets is often far larger than the younger people can afford. Other children who have no interest in the farm business may also complicate matters. Where do you begin?
Many times the best first step is to separate the farm business from the land. This usually reduces the value of the assets being transferred and makes the process more feasible. Often two business entities are established, with the farm business owning cows and replacement animals, and perhaps equipment. A separate business owns the tillable land and buildings. The farm business rents these assets from the land business. Sometimes these arrangements vary, with the farm business entity owning the buildings and the tillable ground being owned by the land business.
The next step is to determine the value of the farm business. It is difficult to devise a fair plan to transfer assets unless the value of the assets is known. This should be done using two methods. One is to simply add up the market value of the tangible assets owned by the farm business. For what dollar amount could the cows, calves, heifers and perhaps equipment be sold? This step makes sense to most people. The second method is less obvious. Based on the profitability of the farm business, what is it worth as an ongoing operation, retaining all of the assets?
To get this figure, the net farm profit (after deducting a fair value for family labor) is determined for the past three to five years and then averaged. That profit is then "capitalized."
The easiest way to understand this concept is to ask, "What return on investment is required to justify purchasing the farm business?" A minimum value is probably 10 percent, and some would suggest as high as 20 percent due to the risk involved with dairy farming. Using this concept, if the average net profit for a farm operation is $30,000, then the maximum value is obtained by dividing $30,000 by 0.10 (10 percent return on investment) yielding $300,000. The minimum would be using the 20 percent required return and would generate a value of $150,000.
The reality is that many dairy farms do not generate this high of a return on the actual tangible assets. Thus, if the younger generation buys the assets of the farm business at full market value, they cannot pay for them out of farm profits. They must either have outside income or work for very low compensation. So how do farms actually do it?
Three approaches to consider
There are at least three approaches to transferring assets at less than the market value.
1. Sweat equity - This is a term applied to the younger generation working ("sweating") for cash compensation below the going rate for the job they do. For example, assume a son performs the job of herdsman on a 200-cow farm. That role might command a compensation package worth $45,000 if an outside person were hired by the farm. If the son is paid only $25,000, then the $20,000 difference can be used to transfer that amount of farm assets to him. This could be in stock, in cows, or some other tangible asset that the farm business owns.
2. Gifting - The older generation can simply gift some percentage, or some tangible assets, to the next generation. This is often done, and it works if the parents can afford to do so and if it is possible to treat other children fairly as well.
3. Added responsibility - Besides fulfilling the role of herdsman, the son in the example above might also do the homework and planning of some farm project designed to improve the profit of the farm. This could be improving cow comfort, moving to custom harvesting, or instituting an improved reproduction protocol. The son would receive additional farm assets to compensate him for this added effort.
Profits improve transfers
This last point is worthy of further discussion. The simple truth is that the more profitable a farm business is, the easier it becomes to transfer assets. That is because if the next generation acquires ownership in the business, they can pay the parents for those assets if the farm generates adequate profit.
Sounds simple, but obviously it is not easy, especially when dealing with low milk prices. Yet, the truth is, some farms are drastically more profitable than others. And some farms are able to keep their investments in tangible assets relatively low on a per cow or per cwt. (hundredweight) of milk sold basis, which also eases the process.
Many dairy farmers become frustrated when they begin considering bringing in the next generation. There seems to be no way for the next generation to acquire equity without the parents "giving away the farm." The first step is to determine the value of what is being transferred, and then work to make the farm business as profitable as possible.
I urge you to start the process early, giving yourself and your family several years to carry out the process. Get professional advisers involved. Doing so will greatly increase your odds of seeing the farm continue under family ownership and management.
