An Idea for Family Business Succession: Classify Stock by Lines of Descent

If your family business will pass to multiple next generation owners in equal percentages, you can improve and simplify your succession plan by creating a separate class of stock (or LLC ownership units) for each line of descent.  This approach has advantages for almost all elements of family business succession planning, including voting rights, board composition, and owner exits.

What is a "class" of stock?

Under state statutes governing corporation stock, the default rule is that a corporation's board of directors can issue only one class of stock.  Each share of stock entitles the holder of that share to one vote as a shareholder, and each share carries the same economic rights as every other share, such as the same share of dividends and the same share of proceeds upon liquidation of the corporation.

A corporation's articles of incorporation (a/k/a charter), however, can authorize different classes of shares, meaning shares that carry different voting rights and/or different economic rights.  For example, a corporation could have a class of voting shares and a class of non-voting shares.  Similarly, a corporation could have a class of shares, like preferred shares, that have economic rights that are different from the corporation's class of common shares.

Similarly, a limited liability company ("LLC") can issue different classes of ownership units with respect to voting rights and economic attributes.

Note, however, that if a corporation has elected to be taxed as an S corporation, it cannot issue classes of shares that have different economic rights, or it will cease to qualify for S corporation tax treatment. This same rule applies to an LLC that has elected to be taxed as an S corporation.  Fortunately, the classification technique that I discuss in this blog post does not run afoul of this rule.

How can stock be classified by lines of descent?

Before you transfer family business stock to your children, you could amend the corporation's articles of incorporation to create a separate class of stock for each of your children, and then you could split the corporation's outstanding stock into shares that fall into each of the new classes.

You could differentiate each class of stock by designating it with a different letter, such as A stock, B stock, C stock, etc.  If you wish to more easily associate a class of stock with a particular child's line of descent, you could designate the class of stock using the letter of the child's first name.

For example, old Fyodor Karamazov could have created a class of "D" stock for Dmitri, a class of "I" stock for Ivan, and a class of "A" stock for Alexei.  (In this example, we can assume that Fyodor would not have created a class of P stock for Pavel Smerdyakov, a decision that, of course, would have further embittered Smerdyakov toward the old man, with predictably tragic results.)

Each share of stock, regardless of class, would have identical economic rights, including a pro rata share of dividends and a pro rata share of liquidating distributions.  Thus, if each child received a different class of stock but the same number of shares, then each child would own an equal percentage of equity in the corporation.

How would classification by line of descent affect shareholder voting?

Dividing your corporation's stock into classes based on line of descent could help you create corporate governance structures and systems for shareholder decision making that remain workable and equitable in future generations.  For example:

● Board seats.

Under state statutes governing corporations, the default rule is that each open seat on a corporation's board of directors is filled by a plurality of share votes.  In other words, the candidate who wins the most votes is elected to the board seat. As a practical matter, this means that a shareholder or block of shareholders holding a majority of voting rights could elect every director on the board, and the other shareholders could elect none.

In contrast, if you classify your children's shares, you can designate certain board seats to be filled only by vote of shareholders who own a particular class.  In the Karamazov case, for example, Fyodor could have created a board consisting of seven seats, with two seats to be elected by each class of shares, and the seventh seat to be elected by a plurality of all shares or some other means.

● Other shareholder decisions.

Under state statutes, the default rule is that most other decisions of shareholders are made by vote of a majority of shares represented at a meeting at which a quorum is present.  A quorum is a majority of shares entitled to vote.  The default rule can produce harsh results in a family-owned business.

Under those default shareholder voting rules, some of your children's families could aggregate their votes in a way that would effectively outvote their siblings' families on every shareholder decision.  As that rule would apply to the Karamazov's boys, for example, Dmitri's family and Ivan's family could outvote Alexei's family on every issue (even though Alexei is the only one who is NOT suspected of murdering Fyodor!).

In contrast, if you classified stock by lines of descent, you could then amend your bylaws to provide for at least some shareholder decisions to require approval by a majority of the shares of each class of stock.  You also would have greater flexibility to adopt other special voting rules for special situations.  These voting rules would become more and more valuable as ownership of the shares of each class is dispersed among more and more members of each line of descent.

How would classified shares remain in a particular line of descent?

To maintain an equitable allocation of shares within a particular line of descent, you could adopt a buy-sell agreement providing that whenever a shareholder wants to exit ownership, the other shareholders owning the same class of shares would have the first right to purchase the exiting shareholder's stock.  This could help ensure that the members, collectively, of each line of descent would always own and control all of their family's share of shareholder voting rights and equity in your family business.

That's it for now.  Be thoughtful.  Lead by example.

Gregory Monday