Most businesses in the world are family businesses. Most businesses in the United States are family businesses. Most small businesses are family businesses and, to the surprise of many, most large businesses are also family businesses.
While all of us follow the trading of publicly traded companies on the stock exchanges and assume that they represent the largest companies in the world, in reality of the fifty largest companies, the majority are privately held within a family, or a single family has a controlling interest. One does not know of them precisely because they are NOT traded publicly, are not interested in advertising their ownership, and therefore are not subject to both the scrutiny and interest that the publicly traded giants such as Microsoft or General Motors receive.
Gallo is an excellent example of one of the largest food companies in the world with interests in dozens of other entities-owned by a single family. Levi Straus is another example of an entity controlled by a single family who went to great lengths to buy back the publicly traded stock to once again own controlling interest in the company.
Well over ninety percent of all corporations and partnerships in the United States are controlled by one family and not publicly traded. It can be said that the family is the central factor in ownership of business in the United States as well as most of the world thus the family relationship is as vital to the success of most companies as any other factor.
It is an oddity of both business and legal writing that this key fact of business life is all but ignored in treatises on how to run businesses or the conflicts that can arise within businesses. It is one thing to fire or reprimand an employee who is not performing using a carefully written employee manual or procedures handed down by the "corporate office." It is quite another to reprimand one's son or daughter, one's father, husband or sister.
In terms of the dynamics of how a business runs, how its ownership is transferred, how monies are divided up, different criteria and stresses apply to the family business. This series of articles shall explore and attempt to identify those areas of difference and suggest legal structures and business methods that are useful in resolving disputes and avoiding problems and also taking advantage of the unique attributes of a family business that make it, without doubt, the most successful method of doing business in most areas of the world. By isolating those elements of a family business structure most likely to create problems, once can create legal structures that are appropriate for a family business and can assist in avoiding family problems if business problems arise.
This is the first of a series of articles on various aspects of the family business and how it differs in requirements from the non-family business. The articles shall range in topic from power and employment aspects to inheritance and issues involving divorce, differences between siblings, and the question of what to do with a child who has no interest in assuming the mantle of a family business.
The first article shall discuss the basic issue of power within the structure of a family business.
POWER IN THE FAMILY BUSINESS: STRUCTURAL AND EMOTIONAL
The reader is advised to review the web articles as to how power is allocated in the corporation and partnership, two web articles on the retainer website. It shall be assumed the reader has read both those articles before reading the rest of this article and therefore has a foundation in the essential power structures within the corporation and partnership structure.
Outside of the family structure, the power within a business structure is relatively simple and straightforward. If you have fifty one percent of the stock of a corporation or a majority of partnership interest, you can ultimately control the entity unless contractual powers counteract your ownership power. The legal or business steps to obtain control or wrestle for control are set by statute and case law and any professional experienced in the field can accurately predict the likely outcome of the battle provided the client carefully follows the rules and procedures inherent in the structure.
More importantly, the structures are established enough so that before any conflict begins it usually is clear to the possible adversaries who will have the upper hand, thus the conflicts either never arise or are conceded before damage to the business can accrue.
In those rare instances in which control is evenly divided among the owners, or where a contractual right counteracts equally an ownership right (as where an employment contract prohibits termination without cause despite the anger of a majority owner) struggles do arise but those instances can be predicted from the initial creation of the structure and at least the participants decided to take the chance of conflict that equal ownership or control entails.
In a family business, however, the structural or contractual protections and powers are often enmeshed in family loyalties, relationships and power sharing that both confuse the issue and often nullify all the best planning of the typical professional. For instance, it is common for a son or daughter of a business to be appointed to a position of authority and even given majority stock due to family feeling, and this "promotion" can often occur without talent or knowledge of the business being demonstrated by the promoted child. Equally common, an elderly president of a company retains his or her position of authority despite such deterioration in ability so as to make numerous errors and who would have been fired in any other company but retains his or her position because their family, who controls the business, do not want the emotional agony of firing the patriarch or matriarch...and often cannot even conceive of taking such an action although the business desperately requires that step be taken.
Equally common is the plus side of the family equation. We encounter employees who are family members who would otherwise be hired away to a competitor for more money but resist due to a desire to "save the family." A business can end up with truly excellent personnel who otherwise would branch out to their own competing businesses but do not since it is the family business. We often encounter a son or daughter who is a brilliant businessperson who would normally insist upon a raise or more power but who refrains due to a desire to maintain family relationships or not insult a brother or sister.
One would think that such "non-business" criteria would adversely affect the family business and result in their failure more often than not. In reality, the family business has a greater success ratio than the average purely business entity and the question necessarily presents itself as to why this would be the case. After all, one would think including non-business criteria in the structure would hurt and not help; if one creates a machine and adds parts not related to the functioning of the machine, one could expect more problems with its operation not less. Why is this not the case with the family business?
In answering that question we travel to the very core of the legal and structural planning differences in a family business. It is apparent once one considers the matter in depth that the loyalty and longevity inherent in a family, particularly a family that elects to go into business together, is a tremendous advantage to the business, an advantage that must ultimately outweigh the disadvantages inherent in the family running a business. The wise family in structuring the business should seek to blend the structure useful for a typical business with that ideally honed for the family in question. In creating the appropriate structure it is vital to integrate those advantages of the family into the structure planned.
A. LOYALTY AND LONGEVITY
An overwhelming number of the structural features of a typical nonpublic business are created to protect the structure from disloyal actions of employees and to encourage good employees to remain in the business and not flee to the competition. Other structures are created to control actions of existing employees and officers so that they do not try to take over business control from less active owners. Thus strict rules of loyalty and restrictions on competition are often encompassed in powerfully written employment contracts and small amounts of stock are transferred to key employees so that restrictions on competition after they quit can be enforced.
From the employee's point of view, especially the proactive and innovative employee, there is a desire to eventually gain ownership and even control of the company that one has devoted years to improving yet a fear that the owner will have no incentive to sell the ownership in whole or part, or give up any of the cash flow that owners come to expect. The only real bargaining chip the employee has is his or her value to the company and whatever fondness the owners may feel to the employee. In both instances, feelings can change over time and an employee's value to the company may alter with changes in the market place. Owners, offered attractive buy out arrangements from other companies, are under no legal obligation to protect the employee if they sell their stock, thus the employee is constantly uncertain as to the long range relationship to the company.
Contrast the above with the typical family ownership situation. A younger family member may be sure that his or her mother or father, aunt or uncle, will normally consider family dynamics in the future of the company and most often feels pride and some sense of accomplishment in the transfer of the company to the "next generation." As decades pass, most family owned businesses take increasing pride in the concept of the company being held by the family over the generations and an unspoken assumption often arises that the next generation will be groomed to take over the reigns, or at least protected in some way if other owners are brought in.
Above all, a concept usually ignored and treated almost with embarrassment in MBA business planning becomes a central factor in the family controlled business - love. The very term, "love" seems almost out of place in business or legal planning for business, an emotional aspect that lawyers, CPAs and MBAs cannot easily integrate into their concepts of structure and planning- yet it is love that forms the cement and quite often the greatest motivating factor in the majority of family businesses. We thus find the professionals tacitly avoiding or ignoring the most vital and central aspect of the business they seek to counsel, instead speaking in terms of traditional employment motivational vocabulary when the owners of the business know very well that they love the current owners or love the next generation and hope that they will remain in business forever precisely because they love them.
While affection and mutual regard can develop in any business relationship, it is the exception. In the family business, it is the rule and an underlying factor in many decisions. In most business structures, such emotional connection is ignored or, at most, treated as an additional cement that will hold the business together and act in conjunction with the structural and legal tools that are designed to maintain business integrity. In a family business, emotional connection with your business colleagues is often a force as strong as profit motivation or power relationships.
What does the above difference in motivation factors mean?
1. The structures for protecting the parties from each other (be it owners to obtain loyalty or employees to avoid unfair termination) may be relaxed since family loyalties will normally suffice to give that protection. The structures become additional back up protection rather than the primary means of protection.
2. Indeed, structures may have to be created to compel family members to take those steps to protect the company despite family loyalties that overcome business realities.
3. And good planning will integrate into the business structure family considerations that are not only vital for the continued viability of a loving family, but those necessary to allow the continued viability of a family business.
Perhaps a typical example of the type of planning and the differential in thinking necessary would best illustrate the changes in structural planning called for.
In a typical business situation, a key employee who has spent fifteen years mastering the trade will be seen both as an asset and a dangerous potential competitor. The better he or she masters the skills necessary to run the business, the better he or she knows the customers and the secrets of the trade, the more catastrophic becomes the danger of he or she joining a competitor or starting his or her own business.
The key employee faces equally challenging problems. Unless she or he has money to "buy in" to the business, or unless he or she only wishes to remain an employee forever, then his or her future is stymied. The current owners may offer some type of long term buy in, but the employee soon realizes that the formula for the buy in is normally based on how valuable the company is...which in turn is increased by the very skill the employee brings to bear. Thus the employee is forced to increase the cost of the ownership interest he or she buys by the very success he or she brings to the company.
The solution lawyers bring to bear is a series of contractual commitments and formulas which seek to balance the competing needs of the parties. An employment agreement is created by which the employee is "locked in" with sizable severance that only vests over time and a bonus system of stock vesting over time so that the employee will lose a great deal if he or she leaves ("golden chains") but at the same time will have to devote years of effort to build up stock ownership to allow eventual buy in at an affordable price. The ownership of a small amount of stock also allows enforceable clauses in California to restrict competition should the employee leave. (See article on this web site on buy and sell agreements.)
Complex formulas are brought to bear slowly affecting stock price so that the employee does not fear that he or she is ruining his or her chance to buy into the company by success, but the current owners still retain the benefits of such performance. Above all, by means of contracts and stock rights, a balance is sought to objectify the ownership and power relationships to "objectively" keep the competing forces in beneficial balance.
That same structure could be applied to a son or daughter coming into a company, but would be inappropriate in most cases. Most business owners intend to have their children inherit the business eventually and seek to train the next generation into the business both for pride in the family business and due to love of the child. Parents, used to giving gifts to their children, often have no problem with giving away stock so long as their power is not adversely effected until it is time to retire. Equally powerful is the need for the children to "perform" for their parents, approval and to "take care" of their parents in their declining years by use of a prosperous family business. Knowing that they will eventually own the business, and considering competing with parents a form of "betrayal" that would be unthinkable, the next generation is often delighted to work long hours mastering the business with no "guaranty" that they will own the business other than the love of parents to children.
Thus the structure often created is not employment contracts, but Wills and Trusts whereby parents leave the business to their children, or enter into a planned program of gifting whereby stock is steadily gifted to the children as the years go by.
Loyalty and longevity are the very hallmarks of the family business and what other entities strive to achieve by complex structural motivational tools is usually an inherent and automatic aspect of a family business. It is, quite possibly, the single greatest advantage that the family business has over its non-family rivals.
B. POWER AND THE FAMILY
The power structure of a family business, regardless of the legal formalities, often mirrors the family power structure and, like the family, is more give and take than one would find in the traditional business. As one client put it, one does not reprimand one's mother for bad accounting practices when one is going to be eating her turkey at Thanksgiving in two days time.
Thus while the Board of Directors may consist of a father, mother and three children, the three children will seldom vote as a block to take over control of the entity since such conduct would be considered tantamount to a declaration of war within the family. Likewise, firing a director or employee who is one of the three children in the business is normally considered a brutal betrayal of family values by parents despite their having that power, strictly speaking, within the business structure.
Does this mean that one simply ignores the traditional elements of power when dealing with a family business? No, for in those instances where the family unit is not capable of mediating a resolution, suddenly the structures come into play and their smooth operation may be the single most important factor in saving a family, for nothing is more destructive than a prolonged corporate battle within a family. Assuming the structure is created correctly, the fight will be short and predictable-meaning that the fight may not even begin.
What the family oriented business owner must determine in creating or improving the business structure is what blend of traditional business structures and family requirements will be created as to the power structure of the business and, to determine that, the following list of questions must first be addressed.
SETTING THE CRITERIA
1. Will Family Considerations Have Priority Over Business Structural Protections?
The current owners must determine if they are, under any and all circumstances, going to use the myriad contractual and structural protections the business attorney has in his or her arsenal. There is little point in spending the money and time to fabricate a system of checks and balances if it is effectively inconceivable that they would ever be used due to the countervailing forces within the family.
At the same time, a wise family member may decide that " business is business" and that a family which ignores the basic needs of a business will simply end up destroying the business. This is not academic. One aspect of business is that one cannot "lie" to a balance sheet. If family members who are incompetent or lazy are left in positions of authority or responsibility, ultimately the business will falter and fail.
So, the family must determine if there is a point at which influence within a family and love and respect must give way to harsh business realities and, equally important, how those business structures are to become effectively utilized.
Most families we know create traditional corporate power structures as "fall back" positions so that if worse comes to worse, the business power is there to effectuate needed change. Thus, a father may retain majority control of the stock and the position of CEO even as he brings his children into the business, knowing that if it becomes necessary, he can always vote his stock or use his office to eliminate family members who are destructive to the business.
Many families, recognizing that such decisions may have to be made, also recognize that making such decisions can be so destructive of the family or so agonizing to the family person in charge, that such decisions are put off time and time again...until it is too late. Those families who fear that danger often create objective business criteria that are applied and thus require the "boss" to fire or demote and, hopefully, put the matter beyond mere discretion which can be both abused and resented.
An example should suffice to illustrate certain approaches:
In a non family business, the CEO can be expected to terminate a salesperson who fails to perform and a typical employment agreement with a salesperson allows termination at will or provides that the CEO may, at CEO's discretion, terminate if sales do not reach a certain level.
In a family business, assume the CEO is a parent and the salesperson a daughter. It could be well for both parent and child to provide that if the sales do not reach a precisely stated level that the CEO must terminate the salesperson. This may protect the company by requiring such necessary action...but also protects the relationship since the parent and daughter both know that the rule has been set and must be enforced.
Or another family might decide that the dynamics of the family require retaining the sales person due to other family considerations. For instance, a divorce or an illness may have affected the sales person and the parents know full well that they will end up supporting her one way or another in any event. In such case, such objective criteria would be a hindrance and the family has in effect determined that business needs will be secondary to family needs.
Ultimately, the decision must be made on a case by case basis by each family-but note that the question of such criteria would not be even an issue...if it was not a family business.
Thus the first question to be presented is the balance of business needs and family needs...which must give way to which and will that be automatically enforced? Inherent in that decision is how to balance the inequality that might accrue from the business point of view to the other employees. (Assume the sales person kept on for family reasons was losing accounts thus hurting the bonus potential of her brother who was another salesperson since profits were plummeting. How is he to be compensated, if at all, since the family decision to retain a bad salesperson is effectively eliminating his bonus?)
2. Will Non Family Key Employees Have a Role in the Ownership?
This issue is a tough one for the average family. The tendency is to only have family members own the business and to relegate employees to a system of monetary but not stock bonuses if they perform which means non family members will never have ownership.
While this makes sense for the family, it can have extremely detrimental effect on the business. It often means that truly gifted employees, the type who are entrepreneurial and self motivated, will be forced to leave and seek employment in companies that do give them a chance for ownership. Nothing can be so enervating to a good employee as to work ten years becoming an expert...then see a son or daughter with six months experience arrive and immediately occupy a position of authority with clear sole rights to future ownership.
A system of "shadow stock" is often used to compromise this situation. Only family members receive actual stock with voting power, but key employees are given a bonus system by which if dividends are declared or the company sold, cash bonuses equivalent to "ownership" of a certain percentage are paid to the employees...as long as they are working. This grants monetary compensation equivalent to ownership without the family losing sole voice in the governing of the company.
Other families conclude that most very large companies have employees without ownership rights and the inability to own a company should not drastically reduce the pool of employees ready and willing to work well for the company.
Finally, some families see no problem of a mixture of family and nonfamily stock holders...so long as majority control of the stock remains in the hands of the family.
3. Spouses in the Family...Who is "Family?"
Even assuming the family decides that only family owns stock, that decision must then be defined. Are spouses of family members to be allowed to own stock? If not, then prenuptial agreements must be required for all married shareholders (See article on Buy and Sell Agreements) and very powerful contracts must be negotiated for each spouse and each new spouse to execute. This can be a traumatic event for a son or daughter who is thinking only about his or her honeymoon but confronts a parent who insists on a contract being executed prior to the marriage!
And if spouses are excluded, then what happens if an owner dies with children? A trust would have to be set up to hold the stock for the minor children. Who are to be the trustees? When if the children, brought up by the perhaps resentful spouse and his or her new husband or wife, are themselves hostile or untrained in the business? All these issues must be confronted and resolved by powerful written contracts and trusts.
4. All the Family in the Business? If Not, How to Equalize the Estate? If So, What to do with the Reluctant Owner?
Most parents wish their children to participate equally in their estates. Often, the family business is the single largest asset. The family must determine if all the children, regardless of aptitude and training, are to be given an equal share (and power and/or right to income) in the entity...and are they to be forced to work together even if they do not want to or have very divergent desires.
This writer well recalls a family that forced an excellent student in the life sciences to give up a promising professorship to come share power with his brother in a wholesaler of retail products or forgo the bulk of his inheritance. Ten years later a wealthy but discontented son brought the business to the brink of catastrophe by insisting on an immediate buyout so that he could pursue his long desired career.
Another family, perhaps wiser, sought to equalize the inheritance of two sons by giving most of the real estate to the "non-business son" and the entire business to the other son. That really did not solve the bitterness since one son felt he had to "work" for his inheritance while the other merely received real property of substantial value.
Equally complex issues arise when a desire to equalize inheritance results in evenly dividing power among children of unequal work ethic or aptitude which soon results in resentment, deadlock within the business and often litigation.
The important thing to remember is that the above problems can mostly be eliminated by careful advance planning of the family with experienced legal counsel. For instance, to avoid the danger of deadlock, a "tie-breaker" method can be used if the children cannot make a decision. Essentially, if a vote of the board of directors is even, and this deadlock lasts for a certain period of time, either child can require the election of a third director to break the tie and if that third person is needed more than twice in any quarter, that third person serves for an entire year. This method protects the company but, even more important, since each child effectively loses control the moment the director is appointed, both children will do all they can to avoid the deadlock and compromise their differences.
As for a child inheriting the value of the business while another child inherits a different asset to equalize it, a useful idea is to "freeze" the value of the business for determining value in ultimately dividing an entire estate at the value that exists when a child begins to work there. In that manner, the child does not feel that his or her efforts to increase the value of the business by his or her work ethic does not indirectly simply result in a lessening of the value of the remaining estate that goes to that child.
Again, structures can be created to resolve most issues...but if not created in advance, such structures are often not available due to already cemented hard feelings.
Above all, it is vital for the parents to have a long and honest talk with the rest of the family to determine who truly wishes to participate in the family business and to devote the energy and time to "earn" their way into control. Too many parents merely assume that the business they love and worked decades to create will be desired by their children or nephews and nieces...when, in reality, the next generation has interests far removed from the business. To force a child into a business that is not desired is to endanger the family as well as the business and ultimately accomplishes nothing but turmoil and resentment. It is a wise parent and business person who makes the first step in determining structure the identification of those members of the family who truly wish to be in the business...and determines how to integrate them in without unfairly penalizing other family members.
It can be done and should be done as early in the process as possible.
5. Role of the Elder Generation: What Protection for their Future?
The two most common dangers a family faces as the next generation comes in are delay in the elder generation giving up the reigns of power (and the income); and, conversely, the elder generation leaving too early and attempting to have an untrained or undedicated child take over a complex and difficult business. Both dangers are encountered quite often and both can have disastrous effects on the family and business.
All of us can easily envision the elderly and experienced business owner who simply cannot give up the power that he or she has enjoyed so many years or cannot conceive of the "child" he or she raised being in a position of real authority. Indeed, many such situations do exist, but such situations are usually ultimately resolved by the simple fact that the child learning the business becomes more and more experienced and the effects of age unfortunately must eventually force the parent to give up more and more of the duties.
A greater danger is the parent too wiling to give up power and this is remarkably common. Few of us can view the accomplishments (or lack of accomplishments) of our children objectively and parents often wish to give up the power and income as quickly as possible out of love for the child. Unlike the above problem of holding onto power too long, this problem is NOT self correcting and this writer knows of a dozen examples of businesses effectively destroyed by sons or daughters in a year or two after the parent retired, expecting to receive an income from the retained ownership for the rest of the retirement years. In one case, the parent continued guaranteeing the debts of a construction company gifted to a child who had only been in the trade for five years and was entirely ruined when the company went bankrupt three years later. The parent was forced to work for the rest of his life while the son was shattered by this "betrayal" of his parents and became an alcoholic. The "gift" of the parent had become a curse upon all of them.
An essential part of integrating the next generation in is integrating the last generation out and that requires a carefully planned and implemented program of gradual transfer of power and income stream. It is vital that by the time the parent gives up control the parent is no longer guaranteeing the debts of the company and that the child is objectively capable of running the business in an effective manner. Criteria should be created and agreed to in writing so that both parent and child know what to expect...and the risks that both are undertaking.
IGNORING THE FAMILY IMPLICATIONS IN THE POWER STRUCTURE: MAKING IT SIMPLE OR COURTING DISASTER?
The questions and issues presented in the prior sections are difficult ones and the family who can address them without incurring stresses and possible hurt feelings is rare. More often than not, the family member, usually the parent, who confronts these types of questions evades and avoids the turmoil and does nothing or uses a structure not planned specifically for the family at issue. Is that so bad?
This depends on the complexity of the family and its disputes; the complexity of the business; and much luck. Quite often a family, when love and good will abounds, can "muddle through" the lack of planning and it is also true that the very act of planning can often cause the tensions and stress that families hope to avoid.
But hoping to create the transition of power and control to the next generation without making careful plans and structures is akin to driving in a dangerous locale without checking the amount of fuel in your vehicle or determining when it had the last tune-up. It is taking tremendous risk when such risk can be mostly avoided by preparation, careful thinking, and review and selection of the various tools available. One elderly business owner who succeeded in transferring the power despite a divorce that affected two of his three sons commented to the writer, "Not planning how to get the business to my sons would be like not planning how to teach them to drive. I'd deserve what I'd get."
The next article will deal with the methods and advantages of transferring ownership and duties to the next generation in line.