We the Family: The Benefits of Creating a Family Constitution

A recapitalization is a form of corporate reorganization involving a change in a company’s capital structure (that is, its debt and equity mix). For the purpose of this article, we focus on recapitalizations in a private business that are broadly used for one of two reasons: the owner is looking to raise capital, and the owner is seeking to reorganize ownership (typically involving other family members becoming shareholders).

Debt and/or equity recapitalizations, which require businesses to take on an outside partner, illustrate the first category. This can happen when shareholders seek liquidity to diversify their holdings or fund personal needs or when the business needs capital for a strategic purpose such as an expansion or acquisition.

While taking on debt or equity capital can certainly help those seeking liquidity for growth and expansion, a common objective in family businesses is the desire to retain voting control within a family group while expanding nonvoting ownership interests to a broader group of family members. Share reorganizations, an internal process that involves redistributing shares or creating new classes of stock, fall into the second category. For instance, parents may gift economic ownership to their children for estate planning reasons while retaining voting control of the business.

Before moving down the path of a recapitalization, the initial question should always be: What are the owners trying to achieve? Only after identifying the ultimate goal can owners determine the type of recapitalization to best accomplish the objective at hand.

What Are Some of the Key Considerations When Evaluating the Two Types of Recapitalizations?

To navigate this process, it is helpful to engage trusted advisors with experience in these complex situations. Advisors can help an owner clearly outline the problem, discuss possible solutions, including determining whether the recapitalization should involve a capital raise or a share reorganization, and then guide the company through the steps required to achieve its objective.

In the case of a recapitalization to transfer ownership among family members, an estate planning attorney plays the primary advisory role. An attorney can provide a summary of share types available given the legal structure of the business, offer legal advice and draft the legal documents to effect the transaction.

Situations involving a capital raise require hiring an investment banker to drive the transaction process. This role covers helping owners understand the company’s value, structuring the transaction, identifying the right capital provider, assisting with due diligence and resolving any other transaction execution issues. Additional advisors, such as legal counsel who draft transaction agreements and accountants who validate financial documents, are often involved.

Unsurprisingly, raising capital is typically more time-consuming (six months) than a reorganization of ownership (one to two months) given the involvement of third parties and additional steps in the process. For instance, when a business chooses to take on debt or equity capital, it is important to establish a fair market value of the business. Without this measure, there could be tension within the remaining shareholder group, as well as the selling parties, about whether they have been equitably compensated for redeeming their ownership position. Moreover, owners must develop a long-term strategic plan and demonstrate projected growth and profitability in the go-forward business to be attractive to potential investors and support this fair market value.

For families who opt to pursue a share reorganization to achieve their goals, the process is more straightforward. A common situation involves parents who own a family business and wish to bring their children into ownership but retain voting control. In such a situation, the parents can convert common stock to preferred voting stock and then issue a stock dividend on the remaining common stock – which is nonvoting – to the children. No money has exchanged hands, and no valuation is necessary, because the only difference in the two classes of stock is the self-explanatory voting rights. This simple conversion from common stock to voting and nonvoting stock enables the parents to make gifts and sell common stock to the children and grandchildren, or other employees of the business, without giving up control.

While the steps required for a share reorganization may seem simple, a great deal of effort is required to manage communications regarding governance changes. For family businesses in particular, shareholder communication is critical to ensure that there is buy-in and everybody ends up where they intended. It is important that shareholders understand the impact in terms of board seats, voting rights, preference, subordination and dividends vs. interest payments. For many family businesses, there is also an emotional aspect if the reorganization results in ownership differences between various family members.

How Can Shareholder Reorganizations Help with Succession Planning and Wealth Redistribution?

As noted, one of the key considerations when deciding on a recapitalization is how ownership changes affect control. In an equity recapitalization, an outside equity partner invests equity capital and receives ownership. Bringing in an investor, whether majority or minority, invites new nonfamily involvement in the business and heightens owners’ fiduciary responsibilities. With a new capital contributor, families no longer have the only say. Key decisions – whether they relate to major capital expenditures, dividend policy or management roles and responsibility – must henceforth incorporate the views of the new capital provider.

Unlike a debt or equity recapitalization, a shareholder reorganization can be effective in family business situations where the owner is focused on maintaining control while simultaneously redistributing wealth to the next generation in preparation for an eventual transition. As such, families, who tend to be conservative in their thinking, should consider this recapitalization type, as it allows them to avoid bringing on a partner or adding debt to the business.

However, even those who pursue a share reorganization must understand that if a company gives away stock, and the only difference in the stock is voting rights, all shareholders have the equal right to participate in the firm’s profits. Thus, owners must decide whether they are ready to give up a percentage of ownership in the company, even if through nonvoting rights. In short, in most shareholder reorganizations, all shareholders have shared economic interests whether they hold voting or nonvoting rights.

Shareholder reorganizations also allow owners to defer succession decisions. For example, if an owner has two children who are active in the business and believes one could eventually run the company, but neither is ready yet, a shareholder reorganization could enable the owner to transfer a portion of equity to the next generation but postpone a formal leadership transition, as the current owner retains voting control of the company. At the right time, holders of voting shares can complete the transfer of the business to the next generation.

It is important to note that the form of ownership to accomplish a share reorganization is not limited to a C corporation. While S corporations can have just one class of stock, that stock can be broken up into voting and nonvoting. In a limited liability company (LLC), a recapitalization is possible by converting from a member-managed LLC to a manager-managed LLC and then ascribing voting rights to shares.

What Estate Tax and Planning Considerations Come into Play During a Share Reorganization?

Estate taxes are another consideration that often drives a recapitalization, particularly as it relates to a share reorganization. Heirs are responsible for paying estate tax following a business owner’s death. To minimize surprises, it is in an owner’s best interest to transition the business to the next generation prior to death. By separating the voting from the nonvoting rights and transferring some ownership to the next generation through a share reorganization, owners can entice family members, who now have a financial stake in the business, to enter the company, as well as move some of the future appreciation and growth of the business out of their estate and into their children’s in a tax-efficient manner.

A share reorganization provides an elegant way to conduct estate planning and allows owners to make gifts sooner than they would if they did not separate the voting from the nonvoting rights. While the process of a share reorganization is straightforward in concept, transferring shares to the next generation introduces new considerations. Common questions include everything from, “What if my child gets divorced?” to “Are my children too young to start attending shareholder meetings?” to “How do I enable my daughter to become the first among equals who runs the company if all the kids own equal shares in the business?” These are difficult questions to answer, especially when transitioning leadership of the company seems like a distant future. The ability to transfer shares while retaining control through a share reorganization can encourage owners to begin making these difficult decisions.

Conclusion

A recapitalization can help a privately held company transition to its next phase. For an owner to achieve a successful outcome, it starts with identifying the owner’s ultimate objective and aligning the form and course of the recapitalization process. For private companies seeking liquidity and growth capital, and where control is less of a concern, taking on a debt or equity partner may be the solution. However, for family business owners seeking to retain control while beginning to transfer the business, the noncapital shareholder reorganization may be just the path to take to continue the family’s business legacy.

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