FAMILY BUSINESS: Reorganize family business to treat all children fairly

Many family-business owners have children who work with them in the business as well as children who do not. The challenge they face is simply put: How can they treat fairly those children who will not inherit the business?

There may not be enough non-business assets to give to the
children who don’t work in the business. Life insurance, payable to the non-business children, is sometimes suggested, if the business owner is insurable and the premiums are affordable.

Some estate and business-succession plans call for the family business to be reorganized, so that the owner has both voting and nonvoting stock. Voting shares would be given to the children who work in the business, and non-voting shares to the others.

This sounds fair, but how will that type of plan really work?

The children who hold the non-voting stock would have no say in the business, including the decisions about distributions to the owners-even though in an S corporation, a limited liability company or a family limited partnership, profit is taxable to all the business owners, regardless of whether cash is distributed to them.

They essentially would be at the mercy of their siblings who received the voting shares-not a good feeling to have.

Although the non-voting shares may have value, how-if at all-can the owners ever realize that value?

If there is a buy-sell agreement in place prohibiting sales outside the family, the owners of non-voting stock are stuck with shares they can’t cash in. Instead, I recommend the children with non-voting stock have an “exit strategy” that enables them to realize its value.

Organizational documents-a buy-sell agreement for a corporation, the operating agreement for an LLC or the partnership agreement for an FLP-can include a provision allowing the owners of non-voting stock to force the other owners to buy those shares over time, with interest.

Even if the owners of the voting shares see no reason to buy out their siblings, they must do so under this scenario. Each owner of non-voting shares is given a “put,” so that he or she can convert their shares into a promissory note. They put their stock to other owners, who must then buy the shares for a value determined according to the organizational documents.

No favors are being given to children who receive these non-voting shares unless they also get a way to realize the value of the stock. Ideally, the earnings of the business will pay to buy them out.

The children involved in the business, on the other hand, would receive voting stock. They are in charge. So why wouldn’t they be pleased to be put in this control position?

Recall that the success of the enterprise after the death of the current owner will result entirely from the efforts of the children who own the voting shares. If the business continues to appreciate as a result of those efforts, the owners of the non-voting
stock share in that growth. The business children, in effect, are working as much for their siblings as they are for themselves.

Is that fair to the children who are working in the business? Of course, they will receive reasonable compensation for their efforts; nevertheless, if the value of the business appreciates after ownership passes to the second generation, the owners of nonvoting stock will share in that appreciation, even though they made no contribution to it.

Therefore, the business owner should consider whether to give a “call” to the children who receive the voting shares. That is, they can call the non-voting stock and buy it
for a pre-determined price, whether or not the owners of the non-voting shares wish to sell. Once again, the purchase price can be paid over time, with interest, hopefully out of the business earnings.

After the non-voting stock is exchanged for a promissory note, the prior owners of those shares become creditors. They are no longer equity owners. If the value of the business appreciates while the promissory note is being paid, that does not increase the amount owed. Rather, it increases only the value of the remaining outstanding stock, which would be owned by the children involved in the business.

Inclusion of puts and calls in organizational documents provides an exit strategy for the owners of the non-voting shares and provides a mechanism for the owners of the voting shares to keep all the appreciation that results from their efforts.

These additional provisions can help convert what appears to be a “fair” division among children into a plan that really keeps the family intact. Failure to include puts and calls, on the other hand, can easily lead to unnecessary family discord.