Checklist for Protecting Next-Generation Minority Owners in a Family Business

Written by Gregory Monday, JD

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 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 . . .

Continue reading the full article for free by subscribing to the WealthCounsel Quarterly—the legal magazine for estate planning and elder law attorneys!