Family-owned businesses have a huge impact on our West Michigan community. Family ownership and control provides unique advantages and unique challenges compared to other businesses. One particular dynamic arises when shares are held by multiple family members.
Interesting issues can arise when shares are distributed between parents and their children or between several siblings. But things can get really interesting when shares are held by a wide variety of family members, such as when a family business gets to the third or fourth generation.
The distribution of shares among family members frequently results in one family member, or perhaps a group of family members, holding a controlling stake. The family members who do not participate in control are sometimes referred to as minority shareholders.
What does it mean to be a minority shareholder? If you have voting shares, you have a right to vote in the election of directors, but generally you have no right to serve on the board or power to elect yourself to the board of directors. You do not have a direct right to be employed by the company or to direct its affairs. You don’t have the right to access or use company facilities. Generally, you are dependent upon, and in some respects at the mercy of, those who are in control of the company. You do have a right to certain financial and other information. Perhaps most importantly, you are owed a fiduciary duty by those who are in control.
From the perspective of a controlling shareholder, what does it mean to have one or more minority shareholders? As mentioned, you owe a fiduciary duty to shareholders — to deal fairly and in good faith and to operate the company in the best interests of all shareholders. A corporation is managed by or under the direction of its board of directors. An active and functioning board, ideally with outside directors, helps fulfill this duty and reduces the risk that a minority shareholder can make a claim against a controlling shareholder. Is this simply making the directors the target of the minority shareholder? Directors are generally protected provided they are using reasonable business judgment. And the protection of directors can be increased with appropriate provisions in an entity’s governance documents to limit the liability of directors to shareholders and to provide indemnification for most types of claims.
Those in control of the company may have particular exposure in areas in which they derive a direct personal benefit, such as setting compensation or a related-party transaction, such as leasing the building to the company. It is important that such transactions be on terms that are fair and reasonable and generally consistent with transactions between unrelated parties. Transactions are more protected if approved by members of the board that did not have a direct interest in the transaction.
Corporations are sometimes structured with voting and nonvoting shares. This can be a great planning tool to be able to transfer shares to other family members while retaining control. The retention of voting control may assure continued right to elect the board of directors and therefore to direct day-to-day operations of the company. But it does not eliminate the right of a minority shareholder to challenge actions that are unfair or oppressive to the minority shareholder. Duties are owed to holders of both voting and non-voting shares. This ability to look over the shoulder of controlling shareholders can be more meaningful than the right to vote.
A common scenario for tension in a family business is where the controlling shareholders are active employees and there are a number of minority shareholders who receive no economic benefit from the company. The active shareholders may want to plow profits back into the company by purchasing new equipment, paying down debt, or perhaps paying management bonuses. The inactive family members might prefer a dividend or even a complete sale and liquidation of the company. Within certain limitations, those who are in control can generally do what they decide is best. However, unhappy minority shareholders can make themselves a nuisance and distraction at the business level and can create a very uncomfortable dynamic at the family level.
So what can you do to help manage these issues? A whole column could probably be devoted to each of these, but here are a few ideas. Those in control of the company should use good corporate practices, including use of an active board and particular attention to the reasonableness and fairness of matters in which they have a direct financial interest. An appropriate shareholder agreement, voting agreement, or voting trust can be very helpful. Limitations on liability and indemnification for directors can help give comfort in making decisions and focusing on the business. A family council or family meetings can provide a vehicle for communication and a forum for raising and resolving issues.
If some shareholders are more interested in an immediate economic return, it may work for the company or other shareholders to purchase their shares. Instead of paying a dividend to all shareholders, some companies create a pool of funds for the purchase of shares. There are a number of mechanisms that can be used to determine whose shares get purchased, including a bidding process where shares offered to the company at the lowest price are the first ones to be purchased. Arrangements can also be set up in a shareholder agreement where a minority shareholder has a right to force the company to purchase shares or perhaps the company has a right to force a shareholder to sell shares. While a variety of options are possible, one structure might provide a discounted price for a shareholder forcing a sale and a premium price when the company is forcing the sale.
Understanding the dynamic between controlling and minority shareholders and having good mechanisms for communication and addressing concerns can be a key to whether the family business can continue from one generation to the next.
Bruce C. Young is a third-generation shareholder of The Behler-Young Co. and serves on its board of directors. He is a partner in the Grand Rapids office of Warner Norcross Judd where he counsels closely held and family owned businesses. He also serves on the board of directors of the Family Business Alliance.