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Shareholder Agreements – A Must

By October 1, 1998July 12th, 2023Succession Planning10 min read

The stock market wasn’t the only thing that crashed on “Black Monday,” October 19, 1987. The Phillips siblings (real case, fake name) remember the day all too well. On this particular day one of the five Phillips children was killed in a grotesque car wreck while another announced, hoping to end the abuse from years of an unfaithful and physical husband, that she had “moved out and filed for divorce.” These events, it turned out, only served as the starting point for many more painful family realities.

The five Phillips siblings each inherited equal amounts of shares in a Southwest based multi-unit, retail clothier with revenues exceeding $150 million. As children, they were truly the best of friends and the outward affection for one another gave their immigrant parents the confidence to believe “the children would always do what is right and look after each other.” The parents were correct. But they didn’t consider how marriage, divorce, taxes, and litigation can challenge relationships and alter ownership.

If there is one area ripe for the explosion of interpersonal relationships in a family business, it is when shares are passed down to family members through inheritance. While many business founders perceive this as a great blessing and benefit to heirs, it often has the opposite, almost detrimental effect on the family business. What is viewed by the founder as a great legacy can be fruitful ground for future problems, even in the most close-knit, loving families.

The Phillips battle began on that fateful Monday when the wife of the dead brother inherited his shares in the business. Two years later she remarried, according to one sibling, “a scoundrel who has never worked and is interested only in her money. He views himself as an owner and, frankly, there is not much we can do about it.” To settle a very costly and protracted divorce case, the divorced sister ended up splitting her ownership in the family business with her now ex-husband. “I am sure that my ex and his new wife appreciate the income from my family business.” All four siblings comment that they feel trapped in a bad situation. “We try to just ignore them as minority shareholders, but they keep tying us up in paperwork and litigation. It is really unpleasant and a distraction to the business.” They agree universally, “We wish Mom and Dad had put into place an agreement that kept ownership within the blood relatives.”

A partial resolve to thwart this virus is to establish a Shareholder Agreement with a “Buy/Sell” provision. Whereas Shareholder Agreements usually address a broad range of business related issues, Buy/Sell Agreements define the rights and privileges of what shareholders, or their estates, can and cannot do with their stock. “Without question”, says Dallas, Texas based attorney Tom Hurtekant, “Buy/Sell Agreements are advisable wherever ownership in a private company is held or will be held in the future by more than one individual.” Surprisingly, however, not all family owned businesses have Buy/Sells. According to a recent Arthur Anderson/Mass Mutual study, an amazing 44% of family-owned businesses do not have a valid Buy/Sell in place.

WORTH THE PRICEThe cost of establishing a Shareholder Agreement or a Buy/Sell agreement ranges from under $1,000 to tens of thousands of dollars. But the cost may be worth it to save a company, even when no children are involved.Esprit de Corps is a successful clothing design company based in California. The founders, a husband-wife team, divorced but remained business partners. They battled constantly over company control. Neither had the resources to buy the other out. No prenuptial or separation contingency plans had been made, and no Buy/Sell agreements had been established. Though the owners’ bickering didn’t directly affect creative design or business decisions, it created uncertainty — the kiss of death. In the most successful decade for American clothing designers, Esprit de Corps lost ground by losing talented designers and failing to recruit top talent. In 1996, a non-family Chairman and CEO was brought in to refocus the company efforts and once again, Esprit de Corp. is delivering quality clothing to fashion conscious consumers with enthusiasm, devotion, and honor.

When no Buy/Sell is in place, family members who inherit stock in the business may legally sell them to anyone. When divorces, lawsuits, employee terminations, or even deaths occur, stock shares may end up in the hands of strangers, competitors, out of favor ex-relatives, or even worse, out of favor ex-relative’s new spouses. Unless majority shareholders have contractual controls over stock share purchasing procedures, a family business may face expenses and hassles that could destroy it. These procedures should be set in place long before ownership changes occur.

“Buy/Sells have been around throughout the twentieth century”, says Hurtekant, who has represented families for the last 20 years. “But recently, more people are looking to Shareholder Agreements and Buy/Sells as a vital part of estate planning.” One reason for this is the vast number of businesses which were started after World War II are being passed to heirs — an aggregate wealth transfer of $12 trillion. Estate planners and family business consultants encourage use of Buy/Sells in trusts and when gifts of family stock are made to children. Buy/Sells simplify bequests and help to preserve and guard the family business from future hostilities.

The word “gift” may be misleading. Often the family business patriarch starts from scratch. He or she believes their children are fortunate to own stock in a business that has supported and nurtured them throughout their life. Typically, ownership is passed in equal amount to each offspring, including those not involved in the business. (Our consulting experience tells us that on average, one-half of the family will join the business and the other half will have other professional or personal interests.)

Shortly after receiving this “gift”, the non-business heirs get the bill from Uncle Sam: they owe the IRS 55% of the value of the business — in cash. Desperate, the heirs may seek professional advice and learn that the only way to protect themselves from total financial ruin is to sell the entire business or force the business to buy back the stock.

This is the beginning of many problems in the family business — maybe even the beginning of the end if, for example, the business cannot fund a repurchase. Family members may have to sell out, borrow money, liquidate assets or, as a last straw, partner with “vulture” investors to raise the cash.

Family business consultants are chock full of such horror stories. As consultants, we have worked with many family-owned businesses that have experienced the wrath of unknown taxes and sudden changes in ownership as well as the “unanticipated inevitables” that come to pass. We have seen the frustration and hurt on both sides of the table.

“Think how you would feel owning an asset worth a lot of money, that you can’t liquidate — you can only hold it,” says Hurtekant. “You can see how this can be fertile ground for litigation and all kinds of trouble for the family business. This is when heirs challenge sibling’s compensation and management decisions and do everything in their power to make their siblings wish they were not a shareholder. It can literally explode a business.” Or family.

Numerous businesses without shareholder agreements and Buy/Sells have been sold, suffered litigation, or were forced to go public. However, it is not always feasible to go public in the same manner as for example, a Ford Motor Company. The costs and risks involved can be tremendous, even for significant companies.

Although there is much prestige attached to being a publicly held company, it is not simple and is not usually the best option for many family-owned businesses. The Pandora’s Box of going public usually requires new management controls with “outsiders” at the helm. Family shareholders are accountable to public shareholders and quarterly financial results take priority over long-term developmental projects. Because of strict regulations, complete disclosure of company information is required. Public companies have greater formalities including more reporting forms and paperwork, and salaries are reported to outside stockholders and the IRS and is even available to competitors.

Preserving the Legacy

Are you setting your kids up for conflict? If going public is not a viable option, how can a family business owner preserve the legacy? What can be done to ensure harmony when ownership or financial complications arise?

Our advice is to educate and communicate. Sit down with family members and tell them about the business. Even if they don’t appear to be interested today, they may be forced to make some critical decisions in the future. Help each family member understand the capital needs of the business, how the business works, what makes this particular business “tick”, how decisions are made, and what the strengths, weaknesses, and needs of management are. Discuss every aspect of the business, including realistic salaries and what you expect from future ownership. And above all else, create or update a shareholders agreement with a particular emphasis on a Buy/Sell provision.

Sometimes ownership expectations are unrealistic. Trusted and neutral professionals from the outside can help family members adjust their “far-out” thinking and help paint a more realistic portrait, as in the case with a family in the picture frame business. One brother who did not work in the family business was a schoolteacher earning $30,000 a year. When the discussion of salary came up during a family council meeting, he was shocked to learn that his younger sister, the executive VP for 12 years, was earning a salary of $100,000 plus bonus. He literally came out of his chair. As independent consultants we were able to show him that his sister’s salary, compared to both regional and national norms in similar companies, was actually less than her peer group.

Nothing and nobody in the world can guarantee instant resolution to family business ownership problems, but the following five safeguards can promote it:

  1. Create the Shareholder Agreement while participants are healthy. Do not put this off until the founder or one of the owners is ill or near death. This agreement should be central to every family’s estate planning.
  2. Create a liquidity plan for all family owners with a special emphasis on providing financially for those family members who are not active in the business. These family members are usually happier with assets that produce income rather than holding a minority interest in the family business which does not provide income or tangible benefits.
  3. To create liquidity in the event of a death of an owner, have the business purchase life insurance to repurchase the stock.
  4. If a Buy/Sell is not funded with life insurance, provide contractually for a payout. Repurchasing stock on a moment’s notice may place an undue strain on the day to day business operations. A contractual agreement to repurchase over time will enable the business to avoid potentially excessive and immediate debt.
  5. All in the family. Control future stock ownership through a Buy/Sell with a Right of First Refusal for the business, then the family owners. To make a Right of First Refusal agreement work best, owners need to agree on a methodology at which a price for stock will be sold internally.

As the Phillips learned the hard way, planning for the unexpected is not an option. Buy/Sells insure that the company will have the first shot at any stock that may, through inheritance or divorce, termination or transfer, end up in the hands of someone other than a family member or friendly stockholder. This will help safeguard the business against competitor takeovers should a hostile or cash-desperate family shareholder want to sell to a competitor.

The conflicting objectives of family business ownership and the complications that result from multiple owners can be resolved — or greatly reduced — by preplanning. Often it is the hopes of family business founders to leave a legacy for future generations and to ReGENERATE the spirit and unique talent that originally launched the business. With planning, founders can insure continued growth and safeguard the business even through unforeseen storms future descendants may encounter. Just ask the Phillips.