When you assist a family business owner with their estate planning, you should review with them the various potential provisions that they could include in governing documents and owners' agreements to protect the interests of minority owners in the next generation. Co-ownership of a family business by siblings, cousins, and other relations can benefit both the family and the business, but those benefits might not be realized if the rights of the minority owners are not specified in thoughtful and well-drafted governing documents and owners' agreements. In particular, such documents should address how minority owners might be represented in business governance and how they might realize the value of their ownership interest. This article presents a checklist of provisions that can protect the interests of minority owners.
THE PROBLEM AND THE OPPORTUNITY
Co-ownership of a successful family business can provide the context and the means to maintain family relationships and family culture as the family grows and changes over time. The family business can provide family members with a source of income, wealth creation, employment experience or an occupation, and financial education. Co-ownership can spread these benefits among a broader number of family members. Co-ownership can also be good for the business because it allows the business to focus on performance and long-term growth without expending resources on large-scale redemptions in every generation. In theory, co-ownership can provide the business with low-cost capital for periods that may span decades at a time.
Co-ownership may be a detriment instead of a benefit, however, if minority owners begin to feel that they are being treated unfairly by the owner (or owners) who control the business's governance and management. Under the default provisions of most business entity statutes, minority owners have few protections. In contrast, majority owners have broad direct and indirect control over the allocation of the economic rewards of business success. In many instances, under the default rules that govern business entities, a minority owner's only means of influencing the business's directors, officers, or managers is to threaten or commence litigation against them based on an alleged breach of fiduciary duties or to seek judicial dissolution of the business entity.
Therefore, when you are helping a senior family business owner plan for ownership succession that will leave some of the next-generation owners in a minority, you should suggest updating the business's governing documents (e.g., articles of incorporation or organization, bylaws) and owners' agreements (e.g., shareholders' agreements, limited liability company (LLC) agreements) to add provisions that will better define and protect the minority owners' economic rights in the family business.
For example, if a family business owner wants to leave the business to three children, it may be impossible to accomplish the business owner's objectives using only traditional estate planning instruments (i.e., a will and living trust). Under statutory defaults, if the estate plan leaves majority ownership to one of the children—perhaps the one most likely to succeed to the role of president—that child might have unilateral authority to elect, remove, and replace every member of the governing board, a power that they could wield to the detriment of the other children's interests. In the alternative, under statutory defaults, if the estate plan passes business ownership to the three children in equal shares, two of the children might unite against the third, or all three might fall into deadlock. Inequities arising out of governance flaws could affect a child's income, livelihood, and most valuable investment. You can imagine why they might be tempted to seek a remedy through litigation. To avoid these negative outcomes, and similar problems in other scenarios, you will probably need to update the business's governing documents and owners' agreements to better accommodate co-ownership in the next generation.
CORPORATE STRUCTURE
For planning purposes, it may be helpful to start by considering the default corporate model of business organization. This analysis can be useful even if the business is organized as an LLC. The default corporate model divides governance and ownership into the following four distinct levels:
- Shareholder voting. Shareholders meet once a year to elect individuals to serve on the governing board (i.e., the board of directors). Board members are elected by a plurality of the vote, which (in most states) means that a shareholder or a faction of shareholders who hold a majority of the votes can control who occupies every seat on the board.
- Governing board. The governing board appoints the officers and key executives and empowers them to manage the day-to-day affairs of the business. The governing board meets four to six times a year to oversee business operations, approve budgets and business plans, and vote on transactions that are outside the ordinary scope of business operations. There are almost no qualifications required for board service except adulthood.
- Officers and executives. The officers and executives manage the day-to-day affairs of the business and carry out other transactions that are approved by the board.
- Shareholder economic rights. Shareholders own 100 percent of the equity of the business. Shareholders may receive dividends (or distribution of profits) at the discretion of the governing board. If the business is sold, the shareholders receive a pro rata share of the net sales proceeds. Shareholders are free to sell their shares to anyone, but they cannot require the business to redeem their interests.
By explaining these separate roles, powers, and rights to the client, you can help them better understand and evaluate the provisions that could be added to the business's governing documents and owners' agreements to protect the minority owners.
THE CHECKLIST
The rest of this article is a checklist of provisions to protect minority owners that the client should consider. Not every provision is suitable for every client's family or business, but by reviewing all of the options, the client can make informed decisions about which provisions might establish healthy protections for minority owners without impairing responsible leadership or imposing economic hardships on the business.
Board Composition
Changing the default rules about governing board members' qualifications and elections can help ensure that the governing board is not entirely controlled by the majority owner or faction but also takes into account the minority owners' rights and interests.
Independent Board Members
Independent board members are individuals who have no connection to the family or the business other than board service. Qualified independent board members can bring many benefits to any business, including a diversity of skills, knowledge, experience, perspectives, and networks. They can also help provide a check on the absolute power of the majority owner in a family business. Governing board members owe fiduciary duties to the business and all of its owners. When the interests of owners diverge, the independent board members can objectively consider the matter.
Cumulative Voting
Cumulative voting for board members permits minority owners to aggregate their votes and allocate them in a way that ensures that they can choose a minority of board members.
Classified Board Seats
Board seats can be classified so that particular owners, or classes of owners (such as particular branches of a family), may decide who occupies particular seats on the governing board.
Voting Agreement
Under a voting agreement, owners can agree how to use their votes. For example, under a voting agreement in a corporation, the voting shareholders could agree to appoint a director selected by nonvoting shareholders.
Voting Trust
Under a voting trust, a fiduciary (or group of fiduciaries) is appointed to exercise the voting rights of all of the ownership interests that are assigned to the voting trust. A voting trust is especially useful when ownership interests are divided among a large number of family members. In such cases, a voting trust can lead to more stability and predictability in board composition and other matters put to a vote of shareholders.
Approval Rights
The business's governing documents can increase or otherwise change the number of owner votes needed to approve particular actions of the board or the business. The governing documents could require some actions to be approved by a supermajority of ownership interests or by a majority of the interests in each class of owners. For example, each branch of the family could be treated as a separate voting class, or the governing documents could designate owners who work for the business as one voting class and owners who do not work for the business as a separate voting class.
Conflict of Interest Policy
An enforceable written policy governing the substance of, and the procedures for, conflict-of-interest transactions can help avoid controversy over transactions between the majority owner and the business, including compensation decisions. It also can set standards for (i) noncompetition, (ii) nonsolicitation of employees or customers, and (iii) restrictions on appropriation of business opportunities. For example, if the family business owns a portfolio of hotels and the majority owner identifies an opportunity to build a new hotel, the conflict-of-interest rules might require the majority owner to include the rest of the owners in the new project. Conversely, if the other owners decide not to participate, the conflict-of-interest rules might prevent the majority owner from proceeding with the project if the new hotel would compete with any of the family's existing hotels.
Information Rights
The business's governing documents can be written to increase the amount and type of information that the executives, the board, or the business is required to share with the minority owners. In such cases, it is reasonable to also require the minority owners to agree to keep such information confidential.
Alternative Dispute Resolution
Litigation is expensive. If litigation is the only means by which a minority owner can protect their interest against wrongdoing by the majority, the minority owner may not be able to afford it. Also, litigation among owners of a family business can damage both the family and the business. To avoid the costs and damage arising out of litigation, a business's owners' agreements can require the owners to submit all disputes to mediation and then, if mediation fails, to binding arbitration. Such alternative dispute resolution provisions should include procedural details and may include fee-shifting provisions.
Nondilution
When a business issues more ownership interests, the voting rights and economic benefits of some of the owners may be diluted unless the new interests are issued to the owners in pro rata amounts. For example, if a corporation issues shares to a majority owner in exchange for consideration that is arguably inadequate, the other owners' rights in dividends and future appreciation will be permanently reduced without fair compensation. Therefore, the business's governing documents can limit the board's authority to issue more ownership interests without the other owners' approval.1 In addition, or in the alternative, the owners may be given preemption rights as a means of avoiding dilution.
Dividend/Distribution Policy
A dividend (or distribution) policy can help ensure that owners receive cash flow from the business except when the board has good reason to retain net income. In a flow-through entity, 1 See the discussion above in Approval Rights. such as an S corporation or an LLC taxed as a partnership, it can be most important to ensure that owners will receive distributions of net income in amounts that are at least enough to pay their share of tax on the business's income.
Puts and Exit Opportunities
It may be desirable to allow minority owners to liquidate their ownership interests with a put option under which they can require the business to redeem their ownership interest in exchange for a purchase price based on a fair market or discounted valuation.
Incremental Puts
In some cases, it may be sufficient to give minority owners the right to put a small amount of the owners' interests to the business from time to time to provide the selling owner with enhanced cash flow or a way to diversify their investments. Note that in some cases, structuring the put as a sale to another owner (i.e., a cross purchase) may produce a better tax result than a redemption.
Exit Puts
In other cases, it may be best to give a minority owner the right to exit ownership as to all of their interest, especially if they are truly unhappy being an owner. The exit can be accomplished in a controlled manner that is fair to the business and to the person seeking to exit, with a fair redemption price and payments to be made in installments. Sometimes the installment obligation can be secured with a pledge of the interest being redeemed or other assets, or the other owners can provide personal guarantees of the payment obligation.
Valuation
A buy-sell agreement, signed by the business and its owners, can control how the business's interests will be valued for purposes of owner puts and other transactions among the owners and the business. Valuation is one of the principal subjects of owner disputes and litigation. Therefore, it is important to set forth a valuation methodology in the owners' agreement that is fair and enforceable. For example, the owners' agreement can provide that if the parties receive an opinion of value from a qualified independent business valuation professional, the valuation is to be treated as an arbitrator's binding decision.
Tag Along or Change of Control
If the majority owners sell their ownership interest, minority owners might not want to be co-owners with the buyers. To avoid that outcome, the owners' agreements can require the buyers to purchase the minority owners' interests at the same price and on the same terms as the majority owners' interests. If the buyers acquire control in a merger or in exchange for their ownership interests, the minority owners can be given the right to require the majority owners or the buyers to pay cash for the minority owners' interests at a price that is fairly determined to be comparable to the value of the consideration paid for the majority owners' interests.
THE HOLDING COMPANY AND TRUST OWNERSHIP PROBLEMS
Sometimes, the family does not directly own the operating business, but rather the operating business is a subsidiary of a holding company that the family owns. Minority protections must take this structural complication into account and ensure that they are accomplishing what they are intended to accomplish. For example, consider whether board composition is more important for the holding company, the operating company, or both.
Similarly, if ownership interests are held in trust, the terms of the owners' agreements should specify which terms are meant to apply to the beneficiaries as well as the trust fiduciaries. For example, information rights, conflict-of-interest policies, and employment provisions might all be more meaningful when applied to individual family members rather than the trusts that hold their ownership interests. The owners' agreement should be explicit about which terms look through trust ownership and apply to the beneficiaries, and the beneficiaries should sign the owners' agreement to be bound by its terms.
CONCLUSION
When assisting a family business owner with estate planning, it is crucial to consider the rights of minority owners in the next generation. Protecting these rights can improve the succession plan and maintain family harmony. Carefully planning a governance and economic structure that values all owners strengthens the business's prospects—as well as a family's legacy—and ultimately helps ensure a prosperous future for both.
Originally published by WealthCounsel Quarterly
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
