Aligning goals of stakeholders in the family firm
Shareholders in family companies frequently come into conflict as the company grows, the shareholder mix changes, generations succeed each other, outside investors appear and non-family professional managers are hired. The biggest divergence of interest develops between shareholders who actively participate in the management of the company (“insiders”) and those who do not (“outsiders”). These groups tend to become misaligned in terms of their personal financial goals and their priorities for company operations, dividends and distributions, long-term corporate goals, governance and control.
Classes and types of stock
Insiders may be interested in the governance and management of the company and the influence they can exert through voting their shares to elect directors and run the company. Outsiders may be more concerned about the economic returns of ownership—a return on their capital. Some shareholders may prefer a predictable and steady stream of dividends to support their lifestyle. Other shareholders may be more interested in the capital appreciation of their shares and may not want to pay taxes on dividends. Some shareholders will have estate and tax planning as a priority, and others will not.
The traditional resolution to this dilemma is to establish different classes or types of stock. If governance is a priority consideration for some shareholders but not for others, a company may choose to issue different classes of common stock to certain shareholders, board members or company founders, to keep the voting power concentrated in the hands of a few. The company can establish one class of stock that has voting, or disproportionate voting, rights relative to another class. The non-voting (or low-voting) class may be compensated with a larger dividend payment as consideration for giving up voting power. They may retain the right to vote equally on certain extraordinary corporate events, but they will not have a significant voice in the governance of the company.
Occasionally shareholders are divided less by their concern about control of the company and their voting rights than by diverging economic interests. Some shareholders want current yield. Some want capital appreciation. Some are more concerned about reinvesting in the company, and some would rather see shareholder distributions.
There is a practical way to address the interests of yield-conscious shareholders who want higher dividends and less equity capital appreciation. The company (unless it is an S corporation) can establish a different class of corporate stock—a preferred stock—and exchange these shares for the common shares of the yield-conscious shareholders. Preferred shares are an entirely different type of security, affording their owners priority dividend payments and a higher position than common shares in the event of a liquidation or bankruptcy. For example, preferred shares will likely have a significantly higher (and cumulative) dividend and a fixed liquidation value and liquidation preference. They may have a sinking fund that would retire the preferred shares over time and such other rights as the parties might negotiate.
Preferred shareholders would not participate in any equity value appreciation unless their preferred shares were convertible back into common stock. If the company were to be sold, these preferred shares would be purchased at their par value, not the premium value associated with common stock in a change of control transaction. This common-for-preferred exchange will alter the ownership in the company because the exchanged common shares will be retired, increasing the ownership percentage of those who do not exchange their common stock.
The problems with different classes and types of stock: While the creation of different classes and types of shares may solve the theoretical problems and issues relating to different shareholder goals and interests, these equity changes are often instituted when some owners have leadership roles in the company and others do not. In solving one problem, the equity restructuring can create others. For example, a second class of stock is frequently used when a founder gifts or sells shares to children or minority investors to allow the founder to continue to operate the company as a sole proprietor. As long as the founder is in charge and the company is successful, few complain about this ownership structure.
If all the voting shares are held by the founder (wealth creator), such a system can be functional because children and spouses recognize that person’s moral right to be the decision maker. However, when the practice continues into the next generation by giving voting shares to a sibling who is leading the company and non-voting shares to the other siblings, significant strife within the company and the family can result. Siblings are often unwilling to allow another brother or sister to make parental-type decisions on their behalf. Likewise, most investors chafe at the thought that someone else has the ability to deploy their capital without asking their -permission.
Therefore, what was envisioned as a solution to family and shareholder dysfunction is likely to be the source of such problems in the future. Owners who do not work in the company may look at the salaries, bonuses, perks and other considerations afforded their siblings and feel they are paying themselves at the expense of dividends for shareholders. These questions will be asked even in companies with exemplary governance systems, but when some owners do not have a voice it becomes a time bomb waiting to explode.
Shareholders who agreed, or at least did not object, when shares were first classified may feel very differently when the company grows but distributions to owners do not grow at the same rate. Likewise when an economic downturn comes along and the company does not have the cash to distribute without harming the future of the enterprise, shareholders who feel their management siblings are dictating the terms of the reduction may push back. Even in good times when distributions are healthy, adults who have matured substantially may feel they are not being trusted with their own inheritance if it is held in non-voting shares.
This is not to say that all schemes of stock classification have bad results. Certainly good family and company strategy can result from the classification of shares. Alan Mulally credits the supervoting shares that allow the Ford family to maintain control of Ford Motor Co. with enabling his brilliant strategy to strengthen the company during the last recession. These success stories may be the result of family education, communication and involvement plans as much as a system of stock classification.
Taking steps to educate family shareholders about the company they own together and structuring a proper system of corporate governance that requires managers and shareholders to communicate is the prescription for future company success and continued family harmony.
Alternatives to different classes and types of stock
While different classes and types of stock might work in one case, they may not work in another situation. Other ways of addressing these issues should be considered. Importantly, no one structure of ownership or equity will be right for all family entities or circumstances. The structure instead should be the result of a tailored approach for each family enterprise that incorporates flexibility and addresses the goals and objectives of the company and all the stakeholders (shareholders and other interested parties like non-shareholder management).
The structure must address four primary considerations: governance, economics, operations and legal ownership.
Governance: Governance is the function that holds management accountable for company operations. Rather than have the governance of a firm controlled by a small group of operating owners, some families have established operating agreements that determine the manner of governance and who may participate. Family constitutions and family advisory councils can help the extended family to formulate its vision and values and coordinate the vision and values with the activity and purpose of the company. The discussions involve identifying appropriate roles for boards, managers and owners along with criteria for participation. The family should consider whether independent directors/advisers should be involved and, if so, in what manner. Family constitutions and other family decision-making tools can also aid in developing good shareholder relations.
For example, an operating agreement of an LLC could require third-party (non-shareholder) involvement in addition to representation of various family constituencies. This type of provision could persist regardless of changes in the holding of shares or interests. Governing provisions—such as a requirement that periodic meetings of family shareholders take place, or that certain decisions or changes require consent of supermajority shareholders—could be adopted to stabilize the governance over time.
Economics of ownership: The economic consideration involves how family members are to benefit from the family enterprise. In addition to title ownership, it can address other matters, such as compensation, charitable foundations supported by the family, participation in governance and operations, use of the family assets, credit support and use of collateral and company assets.
Frequently, the use of trusts is considered as a means to separate ownership from how benefits are to be distributed and shared. Wealth generated by the family company could be set aside in a trust to provide benefits that supplement compensation of those who are active in the company and provide an alternative source for those who are inactive. For example, a trust might provide for distributions to different family members depending on participation in the company. It could also provide for access to other assets to maintain lifestyles or to achieve educational or other family or corporate goals.
Management of operations: Management issues include decisions about who can be employed and requirements to be considered, what authority would exist for family and non-family members, how compensation would be determined and whether and when functions should be performed by independents. The decisions regarding these questions can be reflected in by-laws, operating agreements, employment agreements, etc., which can function regardless of the manner in which the shares are held. For example, a family member’s participation in management could be conditioned on something other than ownership, such as education, experience and drive.
Legal title: Owners of the family-held enterprise must be listed for legal purposes. The family does not have to let that requirement dictate who is entitled to participate in the enterprise or enjoy the benefits that can flow from it. As previously discussed, the classic example of separating legal title of the shares from the benefits is the use of a trust to hold shares. The trustee is the legal owner of the shares or interests but may have no interest in the economic benefits of the company. The economic interests are split off from ownership and held for designated family members. A family member might never own a share in his lifetime, but could enjoy the benefits as if he did. It can be structured such that he might never actually own shares or memberships.
What the family needs to consider is not necessarily how the shares should be owned (although there are significant tax, wealth and asset protection considerations in such decisions) but rather how the title is to benefit family members both now and in the future.
Unraveling the issues
The issues separating shareholders, stakeholders and other constituencies in family companies can be very knotty. The best way to try to unravel the issues and ensure sustainability of the company through many generations is to separate governance, economics, management and ownership and align the various interests with each consideration. This may lead to a traditional dual class of stock solution, or it may lead to a more tailored solution that uses a number of mechanisms to accommodate the different demands, goals and needs.
Otis Baskin, Ph.D. is a consultant of the Family Business Consulting Group (www.efamilybusiness.com). Fred Floberg is managing director of The Chicago Corporation, an investment banking firm (www.thechicagocorp.com). Michael Zdeb is a partner at the law firm of Holland & Knight in Chicago (www.hklaw.com).
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