Family businesses have reached a watershed moment. The baby boomer generation owns between 2 million and 3 million privately held companies. This is a large slice of the entrepreneurial pie — boomers own about 40% of all small businesses across the nation.
The cresting wave of boomer retirements has led to unprecedented transitions in the ownership of privately held companies. And despite owners’ best intentions, sometimes these transitions do not go smoothly. Here is a backgrounder on legal issues that often come up during transitional events, with some suggestions on minimizing the likelihood of disputes and protecting your interests in the business.
Many Boomer Retirees, Few Succession Plans
The overwhelming majority of business owners — estimates range between 66% and 80% — do not have an exit plan, making it far more difficult to transition their business. This has occurred particularly often over the past few years, as interest rates have risen substantially, making the cost to purchase a business more expensive. Moreover, the demand for privately held businesses has declined, as millennials and Generation Z are much less interested in owning businesses than prior generations were.
Though every situation is different, sellers usually have at least one of the following goals: to maximize their financial return, considering sale price, tax consequences and the timing of the payout; to ensure the company’s culture and mission are preserved by incoming ownership and management; to allow family members to stay employed after the transition; and, particularly for family businesses, to see the company through the transitional period, for example, as a paid consultant.
Once an owner has determined their goals, they must consider how the business should be sold or transitioned. Many retirees transfer ownership to existing partners or to younger family members. Others sell to third parties, including to private equity firms and competitors. Yet another option is to establish an Employee Stock Option Plan (ESOP) and effectively sell the company to its employees. Finally, in the absence of a going-concern business, an owner could liquidate and sell assets piecemeal.
However, an owner’s best-laid transition plans do not always align with those of other principals, including their family members. Disagreements in companies owned by multiple family members tend to bubble up to the surface as those companies approach transitional events. For example, one family member might want to retire and sell the business to the highest bidder, while another wants to keep the company in the family, even if that means yielding a lesser financial return. Family members might also disagree about their respective entitlements to sale proceeds if one owner thinks they deserve more (for example, because of changed circumstances or respective financial contributions and time commitments to the business).
These risks are ever-present but can be mitigated with planning and a proper understanding of the business owners’ rights, duties and obligations to the other owners.
Business Owners’ Responsibilities, Rights, and Remedies
In connection with any transitional event, it is important for you to understand your rights and responsibilities, which derive from two sources: the company’s governing documents, including contracts (operating agreements, shareholder agreements, employment agreements), articles of formation or incorporation and bylaws; and the laws of the state where your company was formed.
These documents should be dusted off and reviewed far in advance of any actual transition. For many owners and business partners, however, the company’s governing documents do not address the hard issues or account for changed circumstances. This is entirely understandable; nobody wants to address the difficult issues when things are good. But waiting to do so creates risk and uncertainty down the road.
Here we describe several rights of owners that are common regardless of your entity type — whether it be a corporation, a limited liability company or a partnership. While there are differences between shareholders in a corporation, members in an LLC and partners in a partnership, we use “shareholders” as a catchall term throughout this article.
Right to sell shares. The default rule is that departing owners have a right to transfer their shares in any way they want. However, owners often limit sale rights in their governing documents — these provisions are commonly referred to as buy-sell agreements. For example, there may be a right of first refusal, which requires an owner to offer shares to the company or the other shareholders before the shares can be sold to third parties. The agreement may contain a formula to set a price for shares; it may require a third-party appraisal to value the shares; and it may provide for payments over time, rather than immediately.
Duties to the company and other shareholders.Whether an owner wants to sell shares, sell the company, or not sell at all, he or she has fiduciary duties to the company and co-shareholders. These duties may be referenced in the company’s governing documents, but even if they are not referenced, they still exist. There are two general duties: the duty of care and the duty of loyalty. The gist of these duties is that the principal must act in the best interests of the company. A business owner can act in his or her own self-interest, but the interests of the company must come first. Fiduciary duties can be changed or limited by agreement (the extent varies by state), but principals generally have a duty not to unilaterally take money from the company, usurp business opportunities from the company, compete with the company, make self-dealing transactions (unless fair to the company and approved by the disinterested board members) or maximize their interests at the expense of other owners. Owners cannot exclude other owners by unilaterally limiting their right to company information, their pro rata share of profits, their voting rights or, sometimes, their right to employment. These are examples of conduct that we frequently see as companies are approaching transitional events, as one owner attempts to gain leverage or freeze out another owner.
Rights and remedies. Owners, including minority owners, have rights and may be entitled to a broad set of judicial remedies in the event a principal breaches these duties. Such remedies are designed to achieve fairness in the event of a breach. State laws vary, but these are among the most common rights and relief:
- Books and records. Shareholders have a statutory right to financial information and other company records as long as they have a proper purpose, which includes valuing one’s interest in the company. This is a far more cost-effective method of gathering information than through civil litigation discovery.
- Money damages: Damages are intended to compensate a litigant for their economic loss and disgorge ill-gotten gains from a defendant. So if one principal has misappropriated the company’s assets or engaged in improper self-dealing, that owner may owe money back to the company.
- Injunctions: This is where a court requires a defendant to do or not do something. A court can, for example, require a party to comply with their obligations under governance documents, preserve assets, or in some cases even prevent a change in control of the business.
- Forced buyouts and management change: Courts may require an owner to buy out the stock of other owners at a fair value, to be determined by the court or an independent appraiser. Similarly, courts can remove directors for misconduct, appoint directors to break deadlocks, or even appoint a third-party custodian to manage the company’s affairs.
- Statutory appraisal rights: If the majority owners decide to sell to or merge with another company, the minority owners may have a right to require the company to obtain a valuation and then repurchase the minority owners’ shares at a price equivalent to that valuation. In other words, a minority owner can effectively opt out of a merger or acquisition. The nuances of this statutory right are different from state to state.
- Involuntary dissolution: As an extreme remedy, a court can dissolve the business if principals act illegally or oppressively, engage in corporate waste, or are deadlocked and there will be irreparable harm to the company and its shareholders absent dissolution.
Planning Strategies and Takeaways
Effective planning increases the chance of a smooth transition. But it’s not easy. For owners approaching a transitional event — any time in the next decade — the time to start planning is now.
Engaging professional advisers early will help, including an appraisal firm to determine the enterprise’s value; an accountant to advise on the tax consequences of a sale or other transition; a forensic accountant to follow the money in the early stages of a dispute or if there is evidence of financial improprieties; and an attorney to advise on legal rights/remedies. If an owner has concerns about misconduct in connection with transitional events, or severe harm due to deadlock, it is important to understand legal rights and options.
Seamless transitions are best achieved through carefully negotiated contractual arrangements, but disputes are sometimes unavoidable. Litigation of private company disputes can be ugly, time-consuming and emotional, especially when they involve family members. It is almost always expensive and adversely affects the business. And while winning feels good, the juice may not be worth the squeeze.
For these reasons, the most efficient and cost-effective resolution of these disputes is often a pre-litigation settlement. Of course, that requires compromise. But when you’re approaching a transitional event without a clear-cut agreement and careful planning, your chances of getting what you want are drastically reduced.
Owners equipped with professional advisers can better attempt negotiation and reach an amicable resolution. But settlements are complicated and require rational decision-making on both sides, which is not always possible. Moreover, settlements are not as simple as one party paying a lump sum to another. They inevitably involve transactions, complex financing and tax issues, along with changes of control. If out-of-court negotiation is unsuccessful, private dispute resolution — think binding arbitration or nonbinding mediation — can also be helpful, but they require all parties’ consent (if not required in the company’s governing documents). Sometimes, litigation may be the best alternative, but it requires careful consideration before going down that road.
With these considerations in mind, you may reduce the risks of dispute, establish better governance, foster more certainty and, finally, provide for a better path to retirement. Start your planning now, because playing kick the can will hurt you in the long run.