By: Barry E. Haimo, Esq.
June 27, 2013
Challenges Created by Minority Ownership Interests
Bottom line: You may have control of an entity by owning a majority interest in the company. However, in some circumstances, the law protects minority owners’ interests, which can wreak havoc on your ability to exercise that control. The good news is that there are solutions for these problems. Read on to find out more.
In family owned businesses, there are two (2) main ways that stock, member interests, or partnership interests can get diluted: 1) they get passed on to key personnel such as informal partners, employees or independent contractors; or 2) they are passed down to subsequent generations via inheritance.
Employees or independent contractors
We often see the first situation in families where owners distribute shares to non-family members, partners, executives, employees, independent contractors, etc. as part of a compensation package. The reason is simple: you want them to feel like owners, take ownership, feel like they have skin in the game, take initiative, be proactive and get results. Trying to align incentives is a good idea in some cases, and families certainly want to reward these individuals when the business is successful. That being said, the family needs to exercise great caution when giving non-family members ownership interests. At the very least, provisions must be inserted to govern how these interests will return to the family when the individual exits the business, dies, becomes disabled, etc.
In general, it’s more practical for families to construct compensation packages that reflect the risks and rewards of ownership rather than to distribute shares outright. By way of example, owners may grant shares of what’s called, “phantom stock” to non-family members. The phantom shares align incentives without distribution of any legal ownership. This is sometimes referred to as a profit interest, which is a share of the profits rather than a share of the company itself. Since the value of these shares is based on the company’s actual performance, non-family members are rewarded similarly to the owners. At the end of the day, these non-family members do not possess a legal ownership interest in the company so the family retains control.
Another challenging situation presents itself when branches of families own portions of ownership in a family owned business. In other words, the family interests are owned in branches or segments, with one or more branches or segments representing the controlling (majority) interest. The problem with this approach is that families grow geometrically rather than arithmetically. This approach is therefore not ideal.
Solution: Options for Families with Closely-held Businesses
There are a variety of options available to family businesses dealing with similar situations. As usual, we recommend to always communicate with each other. Remember, 90% of wealth doesn’t reach the third generation (WSJ Money). A big cause of this is a lack of communication among family members. In this regard, it’s important to set clear rules or establish a clear mechanism about how shares can be transferred among family owners. Then it’s important to respect these rules or mechanisms. They should regulate the frequency of sales of shares and establish a formula for ascertaining a fair and reasonable valuation that protects the business. One solution is to provide family members with a right of first refusal that enables them to limit the sale, transfer, disposition or otherwise multiplication of shareholders. When set up correctly, such rules can enable the majority owner to consolidate control over time, while also providing an orderly exit for those minority shareholders who wish to sell. Another approach is for each branch to establish its own holding company that keeps its shares of the business. This way, each branch can pass on its shares as it wishes, but—as with phantom stock—the total number of shareholders of the business is minimized. In either case, owners should seriously consider the governing structures and processes that are required to keep the broader business family unified.
By way of example, in the case of the proposed IPO for the Empire State Building (Malkin Family), 80% was the threshold required vote to approve the IPO. The minority 20% interest was represented by a plethora amount of shareholders, some holding as small as one-half share. The law gives them the right to dissent to action taken by the majority owners. It created a problem in this case and it is something to seriously attend to if you own and operate a family business. This is just one way that minority shareholders holding different interests can challenge even the best-laid plans.
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Barry E. Haimo, Esq.
Strategic Planning With Purpose
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