Insight on Estate Planning - February/March 2013: Strong governance enhances a family business’s value

by Adler Pollock & Sheehan P.C.
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A successful family business can provide financial security for the founder and his or her loved ones as well as employment opportunities for family members. To improve the chances of success and enhance the value of a family business, however, it’s critical to treat it like any other business.

Too often, family members view their business as a source of wealth without making sure that the company is managed by those best suited for the job, that family-member compensation is reasonable and that any “insiders” are held accountable in the same manner as outsiders. Good governance — carefully documented in writing — can help ensure a family business’s survival as it makes the transition from one generation to the next. It also reduces the chances of intrafamily conflict.

Lay a solid foundation

Good governance starts with the initial organization (or reorganization) of a business. For the sake of simplicity, we’ll focus on governance issues in the context of a corporation, which is required by law to have a board of directors and officers and to observe certain other formalities.

Other business structures, such as partnerships and limited liability companies (LLCs), have greater flexibility in designing their management and ownership structures. But these entities can achieve strong governance with well-designed partnership or LLC operating agreements and a centralized management structure. For example, they might establish management committees that exercise powers similar to those of a corporate board. 

For a corporation, the business’s articles of incorporation and bylaws lay the foundation for future governance. The organizational documents might:

  • Define and limit the authority of each executive,
  • Establish a board of directors,
  • Require board approval of certain actions,
  • Authorize the board to hire, evaluate, promote and fire executives — whether inside or outside the family — based on merit,
  • Authorize the board to determine the compensation of top executives and to approve the terms of employment agreements, and
  • Create nonvoting classes of stock to provide equity to family members who aren’t active in the business but without conferring management control.

For many family businesses, governance concerns don’t arise until the business passes to the next generation. When a founder remains active in the business and isn’t ready to cede control to a board, it may be appropriate to delay implementation of certain governance practices until the founder retires or dies.

One of the trickiest aspects of transitioning a business can be the communication to the succeeding leaders. This is especially true in a family business, where the expectations of the next generation may not be in sync with the intentions or desires of the current generation. To ensure a smooth transition, it’s critical to coordinate the business’s organizational documents and shareholder agreements with the founder’s estate and succession plans and to communicate those plans appropriately.

Create an independent board

Whether it’s part of the business’s structure from the beginning or implemented when the founder leaves, an independent board offers several important benefits. Outsiders on the board provide an objective voice on management issues and an opportunity to tap their expertise on financial, operational, legal or other matters. Independent directors can approve “insider transactions” between the business and family members and serve as an impartial forum for resolving disputes within the business.

To establish an effective board, the business’s organizational documents should clearly specify the number of independent directors, as well as the length of their terms and the mechanism for electing them. Staggered terms help provide some continuity and stability to the board. And cumulative voting can help empower minority owners by enabling them to combine their votes to elect one or more directors.

Keep the business in the family

Careful estate planning can ensure that a family business continues to benefit family members and that ownership of the business isn’t diluted — at least until the business is ready to accept outside investors. For example, a well-designed buy-sell agreement can prevent owners from transferring their shares outside the family, while providing the liquidity they need to exit the business. And prenuptial agreements can prevent married owners from losing a portion of their shares in a divorce.

Owners’ estate plans should use trusts or other mechanisms to restrict the ability of their heirs to transfer shares. If shares are held in trust, however, it’s important to include mechanisms for providing beneficiaries with a say in the business’s affairs — particularly if they work in the business.

For example, the trust agreement might give some or all of the beneficiaries control over how voting and other ownership rights associated with the underlying shares are exercised. Or, if the beneficiaries are minors or otherwise not ready to assume this responsibility, these rights might be exercised by a trustee, advisory board or other fiduciary (with or without input from the beneficiaries).

Have a plan

These are just a few examples of how good governance practices can help ensure that a family business is managed in a professional manner. Incorporating these practices into your business, estate and succession plans can help preserve the business’s value for future generations.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Adler Pollock & Sheehan P.C. | Attorney Advertising

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