If you own a family business and you are struggling to establish a succession plan, either because junior generation members are too young to commit to the business or because you are overwhelmed responding to the challenging demands of 2020, you should consider taking one step that could substantially aid your succession efforts, even if you were to die before you could complete the succession planning process: separate your company's voting rights from equity ownership.
For the sake of simplicity, I will discuss this topic in terms of a company organized as a corporation, but the concepts are similar for, and can be applied to, a company organized as a limited liability company as well.
What are a Shareholder's Voting Rights?
Under the statutory default rules that apply to corporations, each share of a corporation's stock entitles the owner of that share to one vote on matters that require the approval of shareholders. Primarily, shareholders are entitled to vote on the following matters:
● Electing and removing directors;
● Amending governing documents, such as articles of incorporation and bylaws; and
● Approving existential transactions, such as selling, merging, or dissolving the corporation.
A corporation's governing documents may increase the set of corporate governance matters or business activities that require approval of shareholders, such as admitting new shareholders, issuing more shares, declaring dividends, increasing corporate debt, or relocating corporate operations.
It is important to recognize that shareholders generally do not owe fiduciary duties to the corporation or other shareholders when exercising their voting rights (or other rights of a shareholder). Under the common law or statutes of most states, corporate directors and officers generally owe duties of due care, good faith, and loyalty, to the corporation and to the shareholders, when exercising their authority to govern and manage the corporation. In contrast, at least theoretically, a shareholder can exercise their voting rights in a manner that is reckless or completely self-interested.
In some cases, courts have held that a shareholder who holds a majority of the shareholders' voting rights cannot act in a manner that is oppressive to the rights of the other shareholders. In such cases, however, the majority shareholder often also holds power as a director and executive. It is difficult, therefore, to articulate a standard of conduct that the law imposes on a majority shareholder with respect to the isolated act of voting their shares.
When considering a mechanism for separating voting rights from equity ownership, as discussed below, you also should decide whether to impose duties on the parties who can exercise the voting rights and what those duties should be. (This is discussed further in the second part of this post.)
What is Equity Ownership?
Equity ownership in this context refers to the economic rights of owning shares of stock in a corporation. This also may be called "beneficial ownership." Under the statutory default rules that apply to corporations, all of the stock of a corporation is "common" stock, and each share is entitled to a pro rata allocation of dividends and net proceeds upon dissolution.
A corporation's articles of incorporation can authorize the board to create additional classes of stock that have different economic rights, such as "preferred" stock, whose shares might be entitled to receive special dividends apart from what the common shares receive.
The equitable owner of stock also is entitled to the proceeds from a sale of the stock. In this respect, the "value" of the stock is part of equity ownership, but that value may be diminished when it is separated from voting rights.
Why Separate Voting Rights from Equity?
Family business succession planning involves succession of leadership as well as wealth. The parties whom you select to succeed to the economic benefits of owning your family business may not also be the parties you would choose to succeed to your control of governance and transactional decision making. By separating voting rights from equity, you can establish a succession plan that is better tailored to allocate leadership different from how you allocate wealth.
Under the statutory default rules that apply to corporations as I described them in the two preceding sections (i.e., each share of stock is entitled to one vote and all shares of stock carry equal economic rights), the allocation of voting rights follows the allocation of the shares.
For example, under the default rules, if you pass your stock in equal shares to your six children because you want them each to receive an equal part of your wealth, they also will receive the right to vote 1/6th of the stock. That may be a fair result with respect to value, but it may be a poor allocation of voting rights. An equal division of voting rights could lead to deadlocks caused by recurring votes of three against three, or, if only two of the children are involved in business operations, it could allow voting control to be exercised by the children who are mere passive investors. In those scenarios, recall that the law might not require any of the children to exercise their voting rights in the best interests of the company or the owners as a group.
In part two of this post, I will discuss different ways you can separate voting rights from equity ownership. These mechanisms can allow you to divide your wealth fairly among your beneficiaries but allocate control of your family business to only the most appropriate decision makers. Further, these mechanisms can impose duties on the parties who have power to vote the shares so that they must act in the best interests of the business or the other owners.
September 28, 2020