This is part two of my post about why you should separate owner voting rights from equity in your family business. In part one of this post (dated September 28, 2020), I described owner voting rights, defined "equity" in this context, and explained why separating voting rights from equity is helpful for family business governance and succession planning. In this part of the post, I will describe several mechanisms for separating voting rights from equity.
As in the first part of the post, I will describe these mechanisms for a company that is organized as a corporation, but the same (or similar) mechanisms can be applied to a company that is organized as a limited liability company.
Voting and Non-Voting Shares.
The default rules under state statutes provide that a corporation will have one class of common stock and that each outstanding share of common stock will entitle its owner to one vote on matters requiring approval of the shareholders. Under that model, a shareholder's pro rata share of voting rights and economic rights will be the same. For example, if a shareholder owns 10% of the outstanding shares, then they hold 10% of the voting rights and they are entitled to receive 10% of the dividends and 10% of the net proceeds upon the sale of the corporation.
It is possible, however, to create, or authorize your corporation's board to create, a class of shares that do not entitle the owner to vote ("non-voting shares"), as long as the corporation also continues to have a class of voting shares. Further, the outstanding voting shares must always carry, in the aggregate, 100% of the voting rights.
Your corporation can issue a class of non-voting shares only if it is expressly authorized in its charter (a/k/a articles of incorporation). If your corporation's charter does not currently authorize your corporation to issue a class of non-voting shares, then the shareholders can amend the charter to provide that authorization.
The shareholders or board could then declare a stock split to divide each outstanding share into one voting share and one or more non-voting shares (provided that the split of each share must be the same). Usually, each share of non-voting stock will have the same economic rights as one share of voting stock. (In fact, this is required for an S corporation.)
For example, assume your corporation had 1,000 shares outstanding before the stock split. If you split each share into one voting share and 99 non-voting shares, then your corporation will have 1,000 voting shares and 99,000 non-voting shares outstanding. The 1000 voting shares will hold 100% of the shareholders' voting rights but only 1% of the shareholders' economic rights. In contrast, the 99,000 non-voting shares will hold no voting rights but will hold 99% of the shareholders' economic rights.
A stock split of this nature will help your corporation's senior generation owners to allocate voting rights with much greater precision in a succession plan, while at the same time allocating economic enjoyment of the corporation stock more broadly among the family.
Although this is a quick and simple means of separating voting rights from non-voting rights, it has one potential drawback, unless it is augmented by other planning mechanisms. The drawback is that the owners of the voting stock generally will not have a fiduciary duty to vote the stock in the best interests of the corporation or the other shareholders. This means that the voting shareholders will not be representing the non-voting shareholders and will not necessarily be required to vote the stock in a way that protects the interests of the non-voting shareholders.
If you wish to ensure that the shares will be voted by someone who owes a duty to some or all of the shareholders, you should consider using one of the mechanisms described below.
A voting trust is an agreement under which one or more trustees will be appointed to exercise the voting rights of any shares that are made subject to the voting trust agreement. A voting trust is like a cross between a common law trust (described below) and a business entity.
Pursuant to the voting trust agreement, shareholders transfer their shares to the trustees, and, in return, the shareholders receive voting trust certificates to evidence their continuing beneficial ownership of the shares. The shareholder retains the economic rights that the shares provide, but only the trustees can exercise the shares' voting rights.
Sometimes, a voting trust is used as a way to unify the voting of the shares of a group of shareholders. For example, if shares of your corporation are owned by a diverse group of family members, it may be desirable to unify their shareholder votes by aggregating them in a voting trust, so all the votes for those shares will be exercised by trustees who are presumably best qualified to vote the shares.
In exercising the voting rights, the voting trustees will owe a fiduciary duty to vote the shares in a manner that is in the best interests of the voting trust beneficiaries, as a class, but the voting trustees will not necessarily owe fiduciary duties to the corporation or the shareholders whose shares are not in the voting trust.
[Note: A voting trust is not perfectly suited to use for LLC units. I hope to write a future post on this topic.]
Common Law Trust.
A common law trust is what we usually think of when we use the term "trust" in the context of property law and estate planning. It is a property arrangement under which one or more trustees agree to hold and manage property for the benefit of a specific beneficiary (such as your spouse) or class of beneficiaries (such as all your children).
Under a conventional trust agreement, the trustees are empowered to exercise all of an owner's legal rights in the property that they hold in trust, including the right to vote corporation stock. It is now possible, however, to carve out particular powers to be exercised by trust fiduciaries other than the trustees. For example, the trust agreement may empower a "directing party" or a "trust protector" to have power to vote corporation stock held by the trust. These special fiduciaries are selected to exercise these specific powers because the special fiduciaries are deemed to be more suited than the trustee to do so. For example, if a bank serves as trustee, you might choose to appoint senior family members to serve as "directing parties" with the sole power to vote corporation shares held in the trust.
Generally, trustees or other trust fiduciaries will owe a fiduciary duty to the trust beneficiaries, as a class, when exercising the power to vote corporate shares. The extent to which the beneficiaries of a common law trust may enjoy the economic benefit of shares of stock held in the trust will be defined, and may be limited by, the language of the trust agreement.
Separating owner voting rights from owner equity in a family business using the mechanisms described above can be easy to do, and it can improve business governance and succession planning. Keep in mind, however, that you also should take steps to protect the economic interests of the shareholders who are not entitled to exercise any voting rights.
October 5, 2020