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Creative Succession Planning for Managing and Owning the Family Business By Edward D. Tarlow, Esq., Richard P. Breed, III, Esq., Jeffrey P. Hart, Esq.

Tuesday, October 16, 2001 - By: Edward D. Tarlow, Richard P. Breed, III and Jeffrey P. Hart

By Edward D. Tarlow, Richard P. Breed, III, and Jeffrey P. Hart

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 process.

A Hypothetical

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 descendants.

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.

The Bylaws

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.

Dispute Resolution

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.