One of the most difficult issues to solve in a family business transition is the policy regarding who should own stock in the business.
There are generally two camps. The first camp says that only those family members working in the business should own the stock. This is the most common practice and comes from the point of view that those family members who have really committed themselves to the business deserve to benefit from their hard work as well as the upside potential, because they also assume the downside risk. The other camp views the stock as a family legacy asset. All family members should share equally in the asset – regardless of whether they work in the business – because they are all equal in terms of their family status.
These points of view can become even more complex when stepchildren and in-laws are factored in. And it makes figuring it out one of the thorniest, most difficult issues for family businesses to resolve.
Those in the “only family members who work in the business should own the stock” camp have a very valid point of view. The reality is that running a business is hard work and it is made more complicated by the dynamics of family members working together. The effort involved and the risks are substantial, but so is the upside potential. Those in the business who experience the stress and effort firsthand feel it is only fair that they reap the benefits. Also, there is a general concern that since family members who don’t work in the business don’t draw a salary from it, they may be primarily interested in dividends. That can cause conflict within the family and may lead to decisions that are not best for the long-term success and viability of the business.
Those in the “all family members should own stock in the business” camp also have an important point of view to consider. First, the family business is an asset that has value. Also, many family businesses were developed before the current generation took over. The argument is that the value that has been created is a result of the prior generation’s efforts, so it is fair to divide it equally and allow equal participation in profits or dividends. This group is also often concerned that separation from family business ownership can cause separation within the family.
Most people involved in a family business are in one of those two camps. But we believe there is a third option – a happy medium that can address both ends of the spectrum. There is a hybrid approach that grants ownership to both the working and non-working family members, but it may not allocate the ownership equally.
As an example, suppose that there are five family members but only two work in the business. Under an equal split, each of the five would own 20 percent of the business. The problem is that the two who work in the business do not have control of the business since their shares only represent 40 percent of the stock.
An alternative is to allocate ownership in a way that allows participation by all the family members but does not impede the decision-making authority of the people working in the company. You can do this by allocating a disproportionate share of the profits to those working to create them. In this example, 70 percent of the ownership could be allocated to the two family members working in the business and the remaining 30 percent would be split among the three who are not working in the business.
This hybrid approach maintains decision control and allocates the majority of the profits and value to those family members doing the heavy lifting in the business. It still allows the non-working family members to participate in the profits, albeit on a lesser scale.
There is no right answer and every family has to figure out what works uniquely for them. It is important, however, to know that it is does not have to be an either/or decision. A hybrid approach may offer a way to strike a balance between the working and non-working family members’ competing interests.
In concluding, I would offer a few items that can help you increase your odds of making a structure like this work for you:
- Capital Allocation Plan – Paying dividends or profit distributions is not an issue unless there are unreasonable expectations about the amounts. This is often caused by non-working family members comparing their profit distributions to family members in the business who are also receiving compensation. The solution is to establish a Capital Allocation Plan which is a formula-based model that considers the company’s cash flow and how much should be allocated to the various needs of the business first (working capital, capital expenditures, debt, taxes, etc.) before monies are allocated to profit distributions or stock redemptions. The point of this plan is to protect the company first and then provide a reasonable expected return for shareholders of the family business stock.
- Estate Rebalancing – Estate rebalancing is a way to bring fairness to the non-working family members if they don’t have equal ownership in the company. If you allocate a disproportionate amount of equity in the family business to the working family members, you can disproportionately allocate other family assets (real estate, investments, etc.) to those family members who did not get an equal share of the business.
- Board of Advisors – A board of advisors that includes some non-family members provides increased governance structure and can monitor compensation as well as profit distribution policies. A board can also help solve family disputes since it can provide an independent, objective point of view.
- Family Ownership Policy – A well-crafted family ownership policy should clearly spell out all of the above issues, including stepchildren and in-laws. This sets the right expectations for everyone involved, preventing future disputes and keeping the family on the same page.
Mario O. Vicari can be reached at Email or 215.441.4600.
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