Who should get how much stock in the family business?
Ownership tips revealed.
April 2, 2012
Many business ventures begin with two-family members coming together and sharing ownership on a 50-50 basis, which may make sense for the first generation entrepreneurs. After all, an equal split is only fair, right? But when this logic is carried over into planning for transfers of ownership to the next generation, a number of unanticipated problems can arise.
These are just a few examples of the kinds of situations your family business clients can encounter when they don’t allocate stock ownership appropriately:
Providing Guidelines for Ownership Allocation
In advising clients on the issue of ownership allocation, there are some guidelines we can provide as trusted advisers. In my experience, a critical consideration is whether the prospective family members are active or inactive in the business. For the typical small- to medium-sized family business, I strongly encourage my clients to avoid providing ownership to children or other family members who are not active in the business. Conflicts frequently arise as a result of inactive family members looking over the shoulders of those family members who are actively managing the business on a daily basis. There are better options available to allow nonactive family members to participate in the inheritance without placing an ongoing burden on those family members who are running the business day to day. This is especially easy to do when there are significant assets held outside the business and, if not, we as CPA advisers need to find a clever, tax-efficient way to extract them for use in meeting our client’s goals in passing wealth along to family members.
Another key guideline for allocating stock to the next generation is that in order to gain ownership in the business, the family member’s role or contribution to the business should be vital to its ongoing success. In other words, a key executive who sees, understands, and impacts the success of the business makes a far better ownership candidate than someone who fills a role that any number of others (family or otherwise) can easily fill.
Longevity in the business (of at least a few years, depending on age at the point of entry) can be another good “qualifier” for ownership. As leaders of CPA businesses we know that taking the time to thoroughly evaluate a potential owner and giving them the time to carefully evaluate the firm generally works out better than awarding an equity interest when a new person initially signs on at an executive level. A big part of successful co-ownership is having compatibility of vision, business philosophy and ethics, as well as a sense of mutual satisfaction in working together and being part of a team.
How much ownership?
Outside of entrepreneurial start-up organizations, family-member contributions to the business are rarely equal. Assuming that only those family members active in the business will receive a share of ownership, providing the CEO/president with voting control of the business further supports the success of the next generation. Considering that this person has been determined to be highly capable and trustworthy to lead the organization, he or she should have the final word on significant directional decisions. Without this power, it becomes very difficult for this individual to carry out important initiatives and truly lead.
If the business is larger and has enough active, contributing family members to make up an executive committee or board that can govern the business, it is less critical to have ownership control resting with the CEO/president. However, the company by-laws or governing documents should provide sufficient powers to the president to lead the business operations without having to involve the executive committee or board in excessive details. Conversely, key decisions such as mergers or acquisitions, admission of new owners and the sale of the business should all require support by two-thirds or more of the owners to ensure a major change in direction is carefully considered and agreed upon.
A valuable tool that I have seen parents use when they are grooming one or more children to assume top leadership roles in the family business is to structure stock ownership so that children have less than a controlling interest and the parent retains the “swing vote” for a period of time as illustrated below:
This approach allows for the time needed to assess the compatibility of siblings in decision-making, with the parents using their 2% interest to effectively call the shots. Of course, gifting or selling less than 50% to a child also has the advantage of lowering the stock value through minority discounts applied to less than controlling shares. While having siblings act as co-presidents is growing in popularity, it is more complicated and strongly dependent on positive relationships between the people involved.
The other essential element with multiple owners is a buy/sell agreement that makes very clear how to determine who gets how much under a variety of scenarios in which an owner may choose or be forced to exit the business. When to craft a family buy/sell agreement and whether to distribute stock in smaller portions or in a lump-sum are topics that will be covered in upcoming issues. With an abundance of our baby boomer clients transitioning their businesses, there are plenty of interesting topics for all of us to think about.