How to Avoid Multiple Shareholder Madness

You can be fair to all family members while leaving control concentrated in a few hands.

By Randy Bliss

Recently, a young man called me with a vexing problem. His father, Joe Johnson, had started a home construction company in Georgia 42 years ago, and with great effort had created a solid, profitable business. The caller was Joe’s son, Larry. He had six brothers and sisters, but was the only child to make his career in the family firm.

Larry was destined to succeed his father, and there was no question he was capable. He worked well with customers. His rapport with employees was excellent, and he was rapidly taking over decision-making, enabling Joe and his wife to spend more and more time at their vacation home

Larry told me he looked forward to leading the business to even greater heights. But he was worried about the way his father was transfering ownership. On the advice of his accountant, each year Joe was gifting shares of the business to all seven children and to six grandchildren. The aim was to reduce Joe’s estate, and to eventually save on estate taxes.

The problem Larry foresaw was how, down the road, he was going to come up with cash when a brother or sister or niece or nephew wanted to redeem stock. He couldn’t possibly just buy back shares whenever a family member felt like redeeming them. How would a family member feel when he denied their request for redemption? What would happen, later, if he allowed a different family member to cash out? Would Larry have to keep this potential liability in mind when he considered other cash needs and debt service? Where would the stock end up if a family member died or divorced?

Larry realized he would eventually be building the value of the business more for the benefit of the rest of his family than for himself and his wife. Larry saw himself rapidly becoming wedged between a rock and a hard place.

Over the years I have worked with many family business owners who have made the same mistake. In an attempt to be fair, they transfer stock to family members who are not involved in the business. Invariably, this causes conflict or resentment. The family members participating in the business pay themselves salaries, reinvest earnings, and perhaps allow themselves a fringe benefit or two. The family shareholders outside the business want to know why their siblings don’t pay higher dividends or make greater distributions. They begin to question basic business decisions. As time marches on, the family reunions become less frequent. More jealousy, envy, and suspicion develop.

Anyone who has run a business knows how important it is to be able to make decisions without the undue influence of people who don’t understand the inner workings of the company. Minority or non-voting shareholders can be demanding and distracting, especially if they are relatives. What’s more, they are within their legal right to obtain information, review your decisions, and add pressure.

Even families that try to limit the control of shareholders not working in the business fall into the trap of thinking they can still spread some wealth through ownership.

Bill Porter and his wife, Mary, who owned a successful machine tool company in the Midwest for 30 years, succumbed to this idea. Their business had grown to several million dollars and employed 85 people, including their three children. One of the sons, Pat, had been employed many more years than the other siblings. As a reward for his loyal service, Bill and Mary gave Pat more stock in the ownership transfer plan, but they insisted that the children share ownership. Consequently, they gifted stock in such a way that no two children could force the third to capitulate on major decisions. To make the plan work, they also had to gift some stock to the children’s spouses, none of whom were employed in the business.

Three years after the parents had retired, decision-making had come to a standstill. Pat, who had been named president, was being undermined. There was considerable maneuvering behind the scenes. Because each child and spouse owned stock, they felt they had a right to be involved in management, even day-to-day decisions. Though it was an attempt to be fair, Bill and Mary’s stock transfer plan had compounded Pat’s problems in running the business, jeopardizing everyone’s wealth, even their own.

The problems facing both Larry Johnson and Pat Porter are very common. As the business passes from one generation to the next, the number of family members expands from parents to children, to cousins, and so on. If fairness prevails, the ownership tree grows, and control is diluted. Invariably, this compromises the integrity of business management.

If you are contemplating a transfer of ownership and want to spread the wealth, you should carefully design a plan that concentrates business control in the hands of a few, yet still compensates the rest. Such a plan can work, if you keep the following guidelines in mind:

Keep the number of stock owners to a minimum. Find other ways to reward family members who work in the business but will not be part of senior management, such as bonus plans or high salaries.

Rather than bequeathing stock to family members who are not involved in the company, achieve fairness by gifting or bequeathing non-business assets such as real estate to them.

Use life insurance to help provide liquidity for estate taxes, or as an asset in your estate planing, to minimize the need to transfer stock in the first place.

Avoid placing your business is long-term trusts. Trusts may be convenient mechanisms for holding and distributing assets, and they may provide tax benefits, but the terms of trusts tend to work toward equitable distribution. If you must use a trust, make sure to write in specific instructions about which family members get what types of stock, how much they get, and when they get it. You can also establish several trusts—one that holds stock just for successors, and another to provide for the rest of the family.

If you must transfer stock to non-participating individuals, reclassify it into voting and non-voting shares. Transfer the voting shares only to those involved in the business.

Before you transfer any stock, insist that all parties execute a stock control agreement which specifies what will occur if a shareholder leaves the company, dies, becomes disabled, or is divorced.

Draft a specific policy that spells out the maximum number of shares that a given family can redeem each year. Consider a provision that states that if the company does not make money in a given year, it is under no obligation to pay dividends or distributions.

If stock is already in the hands of non-participating individuals, be prepared to repurchase it. This may require you to set aside funds, or to adopt a policy that allows for redemption only if funds are available.

If you have highly motivated family members or other loyal employees who want ownership but are not part of the ownership plan, consider creating a subsidiary or an affiliated company that they can own in part. Or set up a phantom stock plan, in which the compensation for key employees is linked to the value of the real stock.

A strategy for transfering ownership is an integral part of your succession plan. Be sure to communicate it to all family members and key employees. This should be done as soon as possible, and regularly, so people will not develop inappropriate expectations. Help family members understand that if voting control is vested in a discrete group that runs the business, the company will operate more effectively. Running a business today requires swift, decisive action—an impossibility when you must manage by committee. In the long run, a well-managed company will generate more income for all family members, even those who have no ownership or control, than one which is under the heels of relatives not qualified to make decisions.

 

Randy Bliss is president of YHB Consulting Inc. in Farmington, Conn., which specializes in ownership planning for family businesses nationwide.


Tools for transferring ownership

When you are ready to pass along ownership of your business, you will best be served by a range of tools, which will provide for successors and protect your own financial security in retirement. A correctly designed transfer plan will minimize tax burdens on both the company and the family. It might include a combination of the following:

Gifts. You can gift up to $10,000 of stock per year to each successor using the annual gift exclusion. Your spouse can do the same. Or, you can utilize your total unified credit and gift up to $600,000 of stock in your lifetime. Again, so can your spouse. Keep in mind that the value of the business, as estimated for gifting purposes, must be the fair market value.

Grantor Retained Annuity Trust. You can leverage your unified credit gifts by using this type of trust. Stock is gifted to the trust, and the grantors (the parents) receive income from the trust for a specified term, say, 10 years. At the end of the term, the stock and any appreciation pass to the successors.

Installment buyouts. These are simply purchases of business stock by successors. You can pay successors a series of bonuses to enable them to afford purchases. Or they can get a loan.

 

There are two other tools to consider that will protect the successors, the company, and the retirees. They may also make the transfer plan more tax-effective and affordable.

Covenant not to compete. This is an agreement that the retiring owner will not open up shop somewhere else and compete with the successor. For this promise, the retiree is usually paid an annual amount for two or three years. The payments are tax deductible for the company.

Deferred compensation plan. Prior to retiring, the owner can begin a deferred compensation plan. It enables him or her to receive annual payments from the business. The payments are tax deductible for the company, and because they are considered retirement benefits, payroll taxes do not have to be withheld. A survivor benefit can be added so that payments would continue to a benefactor.—R.B.