/>iBusiness divorces take place in all types of private companies, including those owned and operated by family members. But families that are willing to engage in thoughtful planning can head off some of the internal conflicts that lead to business divorces, and if the exit of a family member from the company does becomes unavoidable in the future, the proactive steps discussed here can limit the negative impacts the business and the family may otherwise have to confront. The effort by the family to avoid or limit the downsides of a business divorce begins by adopting a clear governance structure and also requires all owners to sign off on a business prenup that controls when a family member/owner departs from the business.
Adopting a Clear Governance Structure: Start with an Experienced Board
Achieving success in a new business is a daunting challenge. As a result, the owners of new and emerging companies, including family businesses, tend to focus their attention on the steps to succeed in the marketplace and much less on steps to govern their company. This simple focus on launching the business may work for a time, but as the company grows, the family members will need to put a clear governance structure in place to avoid chaos and/or major conflicts that would otherwise derail their success.
There are two aspects to governance. First is the creation of a board and, second, is to appoint officers and then define their roles. For corporations and LLCs, the governance structure requires the owners to install a governing board or group of managers (we refer to this as a board for both types of entities). In creating the board, the business owners need to consider these critical components for effective governance: (1) the best boards bring solid experience in the industry to the table; (2) board meetings should be held both regularly and consistently to review the company’s performance; and (3) the board must be empowered to take the steps necessary to successfully manage the business.
Regarding the last point – the scope of authority – the board needs to have clear authority to make the final, “buck stops here” type of decisions for the company, including (i) hiring and firing each of the company’s officers and determining how they are compensated; (ii) approving the company’s annual budget forecast; (iii) determining what amount of profits each quarter to distribute, if any, to the owners of the business; (iv) evaluating whether to approve extraordinary expenses not included in the annual budget; and, finally, (v) developing a succession plan for the company’s executive leadership in the future. The board should fully disclose its work and the results of its decisions to the board members in written minutes and resolutions. These board actions also need to be sent to all non-board members at least in a summary format.
In a family business, the board typically includes multiple family members, but having non-family members also serve on the board should be considered, provided that they are truly independent, i.e., the non-family member(s) on the board should not have business or family ties to other members of the board. More specifically, it is generally best not to include the in-laws of family members on the board as this defeats the purpose of seeking independence.
The Roles of Officers Must Be Clearly Defined
The second aspect of governing is to appoint officers of the company and to ensure that they know their expected roles in some detail. Failing to provide clear definition of leadership roles has created many conflicts in business, and not just in family-owned companies. The board should lead this effort because it is not just assigning duties by appointing people to serve as officers of the company, but it is also defining the scope of authority that is being granted to these officers to achieve their specific business objectives.
The exercise of defining roles is so important to the business and to the people involved that it may be helpful to obtain input from outside management consultants. This is money well-spent, because leaders in business are best positioned to flourish when they know and understand the role they are expected to perform and have clear guidelines regarding their authority. When the roles of leaders are not clearly defined, however, turf battles will invariably break out, which will cause discord and dysfunction in the business that can lead to a business divorce.
The board should also be devising a succession plan for senior officers. Putting this plan in place provides the business with continuity, stability and a sense of purpose both internally and externally to customers and others. If the board fails to develop a leadership succession plan, that may lead to internal conflicts, lack of focus and a sense of instability. If employees, customers and third parties sense that the business has lost focus because a leadership change is coming, but there is no clear plan for the future, it can lead to employee turnover, loss of clients, and loss of prestige in the marketplace.
Adopting a Business Pre-Nup for All Owners
We have written extensively about buy-sell agreements in previous posts, and this type of agreement is an important part of partner exit planning that is even more critical for family businesses. In short, all family members with a stake in the business should consider entering into a buy-sell agreement as part of the governance document that is reflected in a separate shareholder/owner agreement. This agreement protects the interests of both those with a majority interest in the company, as well as those who are minority owners.
For those with a majority interest in the business, it allows them to purchase the interests that are held by a minority owner based on the fair market value of the interest. For those with a minority interest in the company, it enables them to to secure a buyout of their ownership interest if they do decide to depart from the business. Thus, minority owners are not “stuck” and unable to sell what amounts to an illiquid interest they hold in the business, and they will have a contractual right to require that their interest be purchased by the company or by the majority owner of the business, and for a price based on its fair market value.
There are some issues that are particular to family businesses in regard to a buy-sell agreement, and these can be addressed in the shareholder agreement. For example, the minority owners may fear that they will be removed from the business against their will when they want to continue to maintain their interest in the company. This valid concern can be addressed by requiring that a minority interest can be redeemed only with “super-majority” vote, i.e., the minority interest can only be redeemed by a high percentage vote taken of the total ownership of the business and not by a bare majority. In the family business, this will require a high percentage of the family to vote to oust another family member from the business.
Similarly, minority owners may also fear they will be bought out and then a transaction will take place in a short time at a much more favorable valuation, i.e., they will miss out on a large upside. This concern can be mitigated by including what is called a “look back” provision in the shareholder agreement. This term provides that the minority owner will receive additional consideration if a sale of the company or even another stock sale takes place for a higher price within an agreed period of time (usually within a year) after the minority owner’s interest was redeemed. This provision permits the minority owner to receive the full increased sales price if another transaction takes place during the restricted period after the redemption.
On the other side of the equation, majority owners may be concerned that a group of family members who are minority owners may all chose to exit at the same time and demand a payout of their interest. This situation can also be addressed by limiting the amount that will be paid out in redemptions to minority owners in any single year based on the company’s available finances. In short, minority owner redemptions will not be permitted to cash strap the company.
In sum, the benefit of a buy-sell agreement is that it provides a defined process for the exit of a partner from the business. The buy-sell agreement governs when a buyout can be triggered, how the interest will be valued, how the payment will be structured, and finally, how any disputes relating to the buyout will be resolved. The parties can choose to arbitrate any disputes, which will permit them to resolve their conflict more quickly and in a confidential manner.
Conclusion
Business divorces may be a fact of life, but in the context of a family business, they can do harm to the business as well as to family relationships. Fortunately, some conflicts may be avoided and relationships may be preserved if the family members engage in advance planning. If the family will install an experienced board, clearly define the roles of company officers, and actively participate in the governance of the company, they may be able to work through the challenges that arise in operating the business and avoid a business divorce entirely.
In the event that a family member wants to depart or is asked to depart by a majority of the other owners, this type of partner exit should not result in a harsh impact to the business or a major conflict in family dynamics. Instead, if the parties sign a buy-sell agreement, they will be able to chart a path setting forth when and how the partner’s exit will take place, which will include the method for determining the fair market value of the departing partner’s interest and the terms for the paying that value. Buy-sell agreements are not easily negotiated, but when the family goes through the hard work of putting them in place, everyone knows the rules that will govern if a business divorce does take place in the future. This will avoid a host of conflicts that might otherwise create problems for the business and fray family relationships.
