We the Family: The Benefits of Creating a Family Constitution

For some family business owners, succession planning is simple: It begins and ends with giving each descendant an equal ownership stake and a role in the management of the business when the time is right. Owners who choose this route may back up their decision with generic reasons, such as “That’s the fairest way,” or “That’s how we’ve always done it.” They also believe that this method of planning can continue forever. For a small percentage of lucky businesses, this does work – at least for some time. However, the dismal rate of family businesses that survive for multiple generations proves that meaningful succession planning usually requires a more tailored approach – one in which ownership can be placed into the hands of those with the greatest desire and ability to help the business succeed. Of course, this is easier said than done. It is often difficult, if not impossible, for a current owner to predict which descendant should (or could) run the business.

When the interests or abilities of future generations are unclear, owners may want to consider offering descendants additional flexibility in determining for themselves which family members should be involved in the business. They may also want to provide well-structured exit plans that give family members who do not wish to be involved in the business the ability to sell their ownership at a fair price while causing minimal disruption to the company and, most importantly, the family. A tool that can be helpful to this entire process, albeit somewhat unconventional for intrafamily succession planning, is the buy-sell agreement.

Navigating the uncertainty of whether future owners lack the skill or the will to help a business succeed may seem like an odd goal for buy-sell agreements. They are typically used to address the need to liquidate an individual owner’s share of a closely held business, often due to death, disability, bankruptcy or divorce. Buy-sell agreements can act as a means of protection to ensure the business survives the buyout intact and are typically structured as a contract between owners and the business (redemption agreements) or between the owners themselves (cross-purchase agreements).1 However, in intergenerational planning, it may be more appropriate to think of the agreement as a means of streamlining free-market forces to allow owners who are active and dedicated to the business to obtain a larger stake in the company and those who want to exit the business to receive a fair price for their interests.

We the Family: The Benefits of Creating a Family Constitution

To illustrate how buy-sell agreements may aid succession planning, consider a hypothetical situation: Ben, a widower, is the sole owner of XYZ Inc. and the father of two children – Brenda, who is active in the business and has expressed a desire to continue running it after her father’s death, and Harry, who wants nothing to do with the business (or its profits) so long as he is given an equalizing share of his father’s estate at Ben’s death. Assuming Ben’s estate has sufficient liquidity to achieve his planning goals, XYZ should pass to Brenda, and Ben’s executor should use nonbusiness assets to equalize Harry after the company is transferred.

That model scenario is rarely the norm in succession planning. What happens if Brenda and Harry are both currently employed by XYZ, and each wants to keep the business in the family? Naturally, Ben may decide to split the company equally between his two children. An equal division may work at first, but what if Harry later decides, after seeing how much work running the business involves, that he prefers to take a more passive role in the company and stops coming into the office? He still owns 50% of the voting interests and receives equal dividend payments to Brenda. If Harry wants to keep his voting rights but Brenda does not have the means to force a sale of some of his shares, she may feel that she is doing 100% of the work but only receiving 50% of the upside. Alternatively, what should happen if Harry’s lack of interest is a byproduct of his sister assuming the CEO role and taking the company in a direction that he does not agree with? Should he be stuck holding the XYZ shares when he would rather use that equity to start another business?

These are just a few examples of how tension can build in future generations of family business ownership. It is impossible to eliminate this risk – an owner cannot be certain how involved each of his or her children (let alone grandchildren and later generations) will be in the family business years or decades after it is transferred. Hopefully future owners can solve these conflicts themselves, but when smart business decisions get clouded with family emotions, the outcomes are not always so harmonious. Often, creative “deadlock” solutions are built into a business operating agreement to address this possibility; however, a buy-sell agreement could put more power into a child’s hands to decide his or her own fate within the company as well as provide the ability to more easily walk away if a satisfactory resolution is not achieved. Buy-sell agreements can also remove some pressure from current owners to figure out what everyone’s future roles should be.

There are many ways to structure buy-sell agreements. However, owners should keep in mind a few universal ideas when working with an experienced attorney to build the agreement:

  • Communication is essential. The more owners understand about the next generation’s interest – and the more the next generation understands about potential roles and the owner’s intentions – the more likely any plan is to succeed. There is a chance a buy-sell agreement will not be necessary and that the planning situation will resolve itself, but this is impossible to know without an open discussion. In addition, if a buy-sell is put in place, understanding its purpose and how it can help is beneficial to all involved.

  • Current owners should liberally grant future generations the ability to exit the company. When an owner recognizes he or she is disinterested in contributing to the business, it can be helpful for all parties for that owner to exit the company. The seller gets capital back to pursue more productive opportunities, and the remaining owners can reap a larger portion of the company’s success. Additionally, this provides an exit opportunity when a co-owner who lacks management control grows frustrated with the business’s direction. The threat of an owner’s early withdrawal should also serve as additional motivation to those in control to listen and respect all owners with a sell option in order to avoid an early exit of important capital.

  • However, any ability granted to exit the business should not come at the detriment of the company. No sell option should be so extreme that it gives the seller the opportunity to bankrupt the company or severally impinge its operations. It is important that the business is capable of funding an exit option before it can be utilized, meaning an exit might need to be stretched over time. Typically, buy-sell agreements are funded with some type of life insurance, which may not be a viable option here. Instead, the business or its owners may need to rely on private lending to fund the exit, which is why the current owner should ensure the terms of any exit plan are reasonable to all involved.

  • Owners may want to conservatively grant themselves the ability to reduce the ownership stake of others not actively participating in the company for a fair market value. This may be a valuable tool for future owners who believe they are working disproportionately harder than others, yet not receiving a fair percentage of the profits. This can also motivate inactive owners to increase their participation or risk being bought out.

  • However, owners should recognize that any power to reduce another’s ownership can be used unjustly in favor of the option holder. For example, if the holder is aware of a future sale at a significantly increased valuation, he or she may use this power to prematurely buy out co-owners. To help counter this risk, several techniques should be used to minimize the likelihood of nefarious actions. For example, a forced sale could require that an owner keep a tail interest in the company for several years after being forced out to help reduce the risk of missing out on a significant growth in sale valuation.

  • A proper valuation method must be selected. The intricacies of how a valuation method should be structured within a buy-sell is beyond the scope of this article, but it is important to note that because these types of succession planning agreements vary from the typical buy-sell agreement, the standard valuation method may not work. Rather, the method may need to favor those with increased vulnerability – for example, any owner threatened with losing a portion of his or her interest in the company – to properly compensate them for their loss. This could be achieved, for example, by guaranteeing a premium is paid on top of any fair market value or by using a projected future valuation.

Buy-sell agreements may not be right for all families – especially those that have clearly defined roles and a strong structure for multiple generations to serve the family business. Even in situations where they might be helpful, a valid criticism is that they could make the planning process more cumbersome and time-consuming. However, planning for succession is rarely simple. No one engages in years of planning because it is easier than doing nothing. Instead, succession planning is used to increase the likelihood that a family business survives multiple generations, growing stronger over time while continuing to serve its founders’ mission. A buy-sell agreement may aid in that endeavor by giving future owners the flexibility to adapt to the evolving needs of the business and family.

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1 For more information on buy-sell agreements and their role in business succession and preservation, read our second quarter 2017 Owner to Owner article, “Buy-Sell Agreements: A Key Element of Business Succession and Preservation.”