The Importance of Shareholder Agreements in the Succession of a Family Business

Daniel B. Harris
Dec. 3, 2013
two people shaking hands across a desk

Orlando, FL - Often when a closely-held business (i.e. a non-publicly traded LLC, Partnership, or Corporation, hereinafter “Family Business”) is created there is a single shareholder who owns 100% of the voting units and thus makes all of the decisions concerning the business (hereinafter the “Founder”). As time goes on and this person ages, they will begin to think about their goals for estate planning, as well as what they would like to happen with the business when they are gone. Generally people tend to favor splitting up all of their assets equally among their descendants.

However, when the largest asset is the Family Business, resolving these matters may become very complicated. For instance, it is common that certain children will be involved in the Family Business, while others have nothing to do with it. Further, between the children who are involved in the Family Business, there will often be different degrees of involvement, skill, and dedication. Other issues that frequently arise involve children who have substance abuse problems, or mental health issues. Additionally, there is always the possibility that one or more children will go through a divorce, which could create the risk of ownership of the company being transferred to an ex-spouse. It is also not uncommon for a non-family member to be involved in the Family Business.

The Founder may wish to reward their hard work and dedication with partial ownership and/or control of the company. The purpose of creating a unified Estate and Succession Plan, including a Shareholder Agreement (or Operating Agreement or Partnership Agreement, as the case may be), is to avoid as many of these issues as possible on the front end. Doing so is both good for the family and good for the business.

By and large the most important issue for the continued success of the Family Business comes down to who controls the company. Therefore, it is often advisable for the Founder to recapitalize the Family Business into voting and non-voting units. This helps to facilitate the goal of the children having “equal” inheritances in terms of value, while ensuring the Family Business will continue to operate and prosper by allowing control of the company to be separated from the right to income generated by it.

The Shareholder’s Agreement is important because it creates the rulebook for governing the company and will be the foundation moving forward. Dividing control of the Family Business will depend on a variety of factors including the nature of the business, and the experience, age, education, and responsibility of the family members. There are many different ways to define control. On one end of the spectrum, one child will have total control of the Family Business (i.e. control of day-to-day business operations, and the right to do anything with the business that they please).

This model works as a continuation of the one created by the Founder. However, the success of the company will depend solely on that one child, and this situation is very likely to create disharmony and friction among the family members. When voting power is shared among family members there can be many different arrangements. Toward the middle of the spectrum, one child may have a majority of voting power, and thus that child will have control of day-to-day business operations. Other issues may be left to a majority vote, which that child would solely determine, giving them an additional level of control but not total control. And, certain “Issues of Major Importance” will require a “super majority” vote, so that at least one other child joins and agrees with the majority holder.

At the other end of the spectrum, one child may be given 50% or less voting power, and have control of day-to-day business operations as president or director, but other items will be put to a majority or super majority vote, depending on the particular issue. There can be many Issues of Major Importance, depending on the nature of the business and how the voting control is divided, but often the issues that will be put to a majority or super majority vote include the following:

  • Sale or disposition of substantially all of the company’s property, or of any property in excess of a certain value;

  • Entering into a lease;

  • Creating, modifying , or terminating any agreement affecting compensation of an officer or manager of the company;

  • Incurring or refinancing debt;

  • Mergers and joint ventures;

  • Amendments to the Operating Agreement;

  • Filing bankruptcy;

  • Dissolution or Liquidation of the company;

  • Issuing additional units in the company;

  • Hiring of family members;

  • Changing the nature of the business;

  • Purchasing property in excess of a certain amount; and

  • Making distributions or payments to owners or employees of the company in excess of a certain amount, or percentage of book value.

Other issues that the Shareholders Agreement addresses include what events trigger rights to a put or call on voting and/or non-voting units. These can include:

  • The permanent mental disability of a shareholder;

  • The death of a shareholder (the terms can vary depending on whether life insurance was purchased to facilitate a buyout or not;

  • Divorce or separation of a shareholder;

  • Retirement of a shareholder;

  • Involuntary transfers of units; and

  • Transfers of units in breach of the Agreement.

Additionally, the Shareholders Agreement may contain provisions known as “Drag Along / Come Along” rights. The former allows the majority holder to force the minority holder(s) to agree to a sale even if they do not wish to sell. While the latter allows a minority holder who does want to sell to benefit from the same terms that the majority holder has agreed to, even if the buyer is otherwise uninterested in purchasing the minority interest.

The Shareholders Agreement is important due to the wide variety of issues it addresses and because it has the ability to act as a referee among the family members. Thus, no one family member has to “be the bad cop;” the rules are simply the rules and the whole family must follow and respect them. In addition to creating the Shareholders Agreement, it is often advisable for the Founder of the business to begin transitioning control and/or decision making authority away from themselves while they are still alive.

This method will allow the people succeeding to control of the company to have a safety net, as well as to allow suppliers, contractors, employees, and clients to get to know the new players in the game. The ultimate goal is for a seamless transition of the Family Business upon the death of the Founder and for its continued success thereafter.