Owners of closely-held businesses require guidance from
their business advisors to ensure continuity of management and
ownership in succeeding generations during the life cycle of the
business. Entrusting the management of the business to the proper
person(s) may determine the ultimate success or failure of the
enterprise. Yet determining which family members are to share in the
financial success (or failure) of the business is a separate question
that must be answered. Those family members to whom a business owner
may wish to transfer the ownership of the business upon his death or
retirement (for example, to his children equally) may not be equally
capable of running the business. For this reason, the business advisor
might consider separating management control from ownership of the
enterprise in designing a proper succession plan for the family
business. There are a variety of different control devices which can
be implemented for this purpose. This article will focus on the
utilization of the Articles of Organization and corporate bylaws to
ensure the appropriate continuity of management and ownership of the
business. Having a working knowledge of these business succession
techniques can be an important tool in strengthening an advisor's
relationship with the business owner and add value to the planning
To illustrate the application and
flexibility of these techniques, consider the following typical family
circumstances: Father owns a corporation, valued at approximately
$4,000,000, which manufactures and distributes a product. Father is
married with four children and wishes to divide his estate equally
among his children. He also wants to ensure that his children who are
actively involved in the business have control and that this principle
will continue through the succeeding generations. Father also wants to
minimize the opportunity for mismanagement which could cause a loss of
value to the non-participating shareholders.
The Articles of Organization
The provisions of the Articles of
Organization are often used to structure the management and ownership of
a business. The Articles of Organization may be viewed as a contract
authorized by the state between the corporation and its shareholders.
As long as a specially crafted Article is in furtherance of a
legitimate business purpose, many opportunities for creative planning
are available. Generally, the Articles define the corporation's
purpose, empower it to issue stock, and set forth the rights,
privileges, and qualifications of the various classes of stock. The
Articles can also impose qualifications and/or restrictions on the
ownership or transfer of that stock, the violation of which gives the
corporation a right to repurchase or "call" that stock.
In the above hypothetical, Father
may wish to ensure that only children who are actively involved in the
business own stock. A provision could added to the Articles which
mandates that only family members who are employed by the corporation
can be owners, and that if a transfer is made in violation of this
provision, the corporation will have the right to repurchase the shares.
This ability to keep shares within the family or within a specified
group of individuals is of great importance to the family business.
While a basic rule of publicly held corporations require free
alienability of the corporation's stock, restrictions on alienation
are allowed in the closely-held corporation as long as the
restrictions on transfer are reasonable. In this way, Father can achieve
his objectives as to future ownership of the corporation by his
To control the management of the
corporation, the Articles can also be drafted to contain provisions
creating classes of voting and non-voting stock. Other than the
difference in voting power, each class may possess identical rights to
corporate dividends and other distributions (e.g. liquidating
distributions upon sale of the company). Father would give the voting
stock to the children involved in the business, and give the
non-voting stock to those not employed by the company. Only the
shareholders actively participating in the business would control and
manage the affairs of the corporation. The Articles could enable the
nonvoting shares to become voting shares, in the event that a nonvoting
shareholder became an employee of the corporation.
Alternatively, the corporation's
bylaws can be used in place of the Articles of Organization to control
the ownership and management of the corporation. The bylaws are, in
essence, rules which govern the conduct of and relationships between
the shareholders, directors, and officers of the corporation. Unlike
the Articles of Organization, the bylaws are not filed as a public
record with the office of the Secretary of State. The duty of the board
of directors is to manage the business affairs of the corporation. In
order to take action on behalf of the corporation, a majority of votes
by a quorum of directors is usually required. This allows the board
to efficiently manage the affairs of the corporation without
consulting and seeking the approval of the shareholders - often a
cumbersome and time-consuming process.
Father's concerns still exist as the
potential of those in control to mismanage the corporation given the
broad managerial powers vested in the board of directors. Therefore,
to protect the corporation from mismanagement, the nonvoting
shareholders, though precluded from voting on most shareholder
matters, could be given the power to elect two members of a five
member board of directors. Additionally, a bylaw provision may be
adopted which requires a supermajority (i.e. 80%) vote on certain
fundamental transactions, such as increasing the debt to equity ratio
above a specified amount, mergers, acquisitions, the sale of business
assets, or a change in the nature of the business. Therefore, in order
to approve a fundamental transaction, at least four board members
would need to vote affirmatively, thereby requiring the consent of at
least one director elected by the non-participating shareholders. For
those transactions not deemed to be fundamental, the affirmative vote of
three board members would be sufficient to carry a proposal on
routine business matters.
As illustrated by the above
hypothetical, the flexibility afforded by the Articles of Organization
and the corporate bylaws can be successfully used to:
- Divide equity ownership equally among the owner's children;
- Separate management control from ownership of the corporation; and
- Give nonvoting and inactive shareholders a voice only on fundamental corporate matters.
Regardless of the control technique
implemented, the business advisor must always consider the possibility
of future conflict due to the nature of the family business and the
varying personalities of its directors, officers, and shareholders.
Courts are an expensive forum in which to resolve these disputes.
Therefore, including dispute resolution methods in succession planning
can be critical to the success of the business in future generations.
An outside board of directors or advisors can be created to offer
nonbinding advice and recommendations to the corporation. Alternatively,
an outside board could be given the power to make binding decisions
on any significant disputes which may arise. In addition, buy-sell
agreements need not be limited to controlling the ownership of stock
upon death, disability, etc... Such agreements can also appoint a
third party arbitrator to break a voting deadlock and can even
obligate a dissenting shareholder to sell his shares to the
corporation upon the occurrence of specified events.
Unless appropriate planning is
implemented to control the ownership and management of the
closely-held corporation, succession planning for a business owner
cannot be completed with any assurance of predictable results.
Creative corporate governance techniques can be used successfully to
resolve the possibly contradictory objectives of passing the family
business to the next generation while ensuring continuity of
management and control.
The authors are members of the Boston law firm of
Tarlow, Breed, Hart & Rodgers, P.C., concentrating in taxation and
succession planning for family-owned businesses.