GBR

2007, Volume 10, Issue 2

The Family-Owned Business

There are three major pitfalls to avoid when operating a family-run business.

 

Michael J. Conway, JD, and Stephen J. Baumgartner, MSc(Econ)

While there is entertainment value to the drama and intrigue which surround the Earnhardt, Wrigley, Murdoch, and Walton family-owned businesses, their highly publicized trials and tribulations can also provide real life lessons for family-owned businesses that operate well out of the limelight.

generations                            Photo: Michel de Nijs

Family-owned businesses face unique issues—succession planning, marriages and divorces, complicated relationships—as well as routine issues that emerge around turf battles, shareholder control, compensation structures, and processes for strategic decision-making. Without proper documentation in place to help address these and other issues when they arise, the family-owned business is at risk from an operational, management and financial perspective. Regardless of its legal structure (e.g., corporation, limited liability company, or partnership), the family-owned business can avoid many problems down the line and better position itself for success if relationships between business owners are carefully documented.

For the owners of a family business, a well-designed agreement for the business entity can help ensure that the owners/partners understand their rights, duties and obligations to the business and to each other. The written agreement should include provisions that address multiple issues, including rules for managing and controlling the business; how distributions will be made to the owners; restrictions on transfer of shares due to divorce or death; buy-sell provisions, succession planning; and how dissolution of the business will be handled if the owners can no longer work together.

Corporation and LLC rules require owners to file certain documents with the Secretary of State's office in order to officially form such businesses. However, a partnership is much less formal and generally is created whenever two or more persons engage in business as co-owners of a business for profit. Regardless of whether or not the persons intended to form a partnership at the time they began doing business together, a partnership may nonetheless have been created. For family-owned businesses, especially those with multi-generational owners, lack of a formal structure is a frequent cause of turmoil and legal disputes which often result in very contentious litigation and, ultimately, the dissolution of the business.

This article provides guidance on how to deal with three common pitfalls that can negatively impact the family-owned business: lack of written agreements, ignoring fiduciary responsibilities, and not planning for the future.

Pitfall #1: Failing to Document the Terms of the Agreement in Writing

The single most common (and costly) mistake that family business owners make is their failure to formally document in writing the terms of their business arrangement. In fact, many business owners assume when dealing with family members that there is no real need for a written agreement since, as the saying goes, "If you can't trust family, who can you trust?" Others won't even broach the subject with family members because they are afraid it would be insulting or imply a lack of trust.

While such concerns are common, the reality is that there is less of a chance of running into future problems if family business owners clearly define the nature of their relationship in writing. Without a formal agreement, the business and the family members will be at the mercy of the Corporations Code, which may result in unintended and unfavorable consequences for everyone. In the event of litigation, more often than not, the family members will find themselves arguing over the terms of their oral agreements. With as many recollections of "the agreement" as there are family members involved, the opportunity is ripe for more confusion, frustration, and anger. With no written agreement available, litigation must focus on secondary evidence and witness credibility issues which often lead to accusations of fraud. Clearly, not only businesses are at risk in this scenario—significant family relationships are at stake and in serious jeopardy of irreparable harm.

Document the Agreement

The best time to document an agreement is at the beginning of the relationship when both sides are still working together effectively and have fairly equal bargaining power. Although the agreement can be formalized at any time, lengthy delays may create significant problems for the partners/owners. For example, delays in obtaining spousal consent/waiver agreements becomes a problem when a spouse and partner have a falling out and/or file for divorce. Obtaining a spouse's signature on a waiver once a divorce is underway is unlikely. One of the primary purposes of obtaining a spousal consent/waiver is to get a spouse's agreement not to interfere with the operations of the business. This helps prevent business owners from being forced to take on a "new" partner who lacks the skills and experience to make appropriate business decisions.

Ensure Spousal Consent/Waiver Agreements Include All Issues

contract                                   Photo: bluestock

Spousal consent waiver agreements can prevent a multitude of business and family conflicts for family-owned businesses. The agreement typically includes language that:

  1. Provides security for all partners so that they do not have to worry about obtaining a spouse's consent for any business decisions;
  2. Provides an automatic buy-out mechanism for payment to a partner's spouse upon that partner's death in lieu of maintaining an ownership interest (usually done in connection with a buy-sell agreement); and
  3. Prevents situations in which the other owners are forced to enter into a business relationship with someone they never would have contracted with in the first place.

For example, Abe, Bill, and Christine are equal owners of their family's distribution company. Abe is married to Angela. Angela has no experience with a distribution company, but she does not think that should stop her from being involved in the family business. Angela also does not get along with Bill (the feeling is mutual). While Abe is married to Angela, Angela will typically own at least a community property interest in Abe's share of the business. Moreover, if Abe were to die, Angela would likely become the sole owner of Abe's one-third partnership interest. If Abe and Angela were to get divorced, Angela would likely demand 50 percent of Abe's interest in the partnership and would also very likely want to be involved in the partnership's affairs in order to protect her interests.

However, because Angela does not have any experience in the distribution business and because Bill has no desire to be in business with her, it is in all of the partners' best interests to keep Angela away from the partnership's operations. Unfortunately, without a spousal consent/waiver agreement, it may be very difficult, if not impossible, to keep Angela out of the business. If there were a buy-sell agreement, Angela would receive a predetermined price (i.e., a price determined through a previously agreed methodology) for her share in the business. If Abe were to die, the same buy-out provision would apply, or Angela could be the beneficiary of a "key man" life insurance policy, the premiums for which are paid by the business, with a previously agreed death benefit amount as payment for Abe's interest in the business.

Pitfall #2: Ignoring Fiduciary Responsibilities in the Event of a Dispute

Whether family business owners are general partners in a partnership, officers or directors in a corporation, or managing members in an LLC, each of these entity structures carries a fiduciary obligation for the owners to act in the best interests of the business and to treat other owners fairly in their business dealings. This fiduciary duty applies regardless of the type of dispute involved, the egregiousness of the other side's behavior, and whether or not the parties are family members. Fiduciary duties also apply from the inception of the business until its dissolution.

When family business owners become involved in a dispute, they frequently believe that they are justified in taking advantage of the other owners based on some actual or perceived slight that may have occurred. Although the law recognizes the equitable doctrine of "unclean hands" in resolving such disputes, it does not look favorably upon those who take advantage of others. Ignoring fiduciary responsibilities is risky business for family business owners/partners. They could be subjected to significant punitive damage claims from the other family member partners or from the non-partner spouse who can claim under community property statutes.

Instead of responding in kind to the bad behavior of their partners or of their spouse's partners, family business owners or non-partner spouses are better off to immediately seek relief from the courts rather than taking justice into their own hands. Such relief may include a temporary restraining order and a preliminary injunction against the offending party or business, imposing a receiver to manage the affairs of the business pending dissolution, and/or a substantial damages award against the offending party.

Pitfall # 3: Failing to Plan for the Future

Even the most conscientious family business owners often overlook succession planning. There are many reasons why, but it often boils down to the same reasons why people fail to create a will. All family business owners should put as much time and attention into their business succession planning as they do (or should do) for their personal estate planning. Without a plan, the entire business could collapse if and when the business owners can no longer effectively work together to manage the business.

Family business owners should consider these issues when creating a business succession plan:

  1. How will a divorce involving one of the owners impact the business?
  2. If an owner dies, how will his or her interests be distributed?
  3. What happens when an owner wants out of the business at some point in the future?
  4. What options or mechanisms will allow the purchase of a deceased member's interest without bankrupting the entire business in the process?
  5. How will the fair market value of an owner's interest be calculated in the event of a buy-out?

Thinking through the best solutions for each of these issues will help protect the business and ensure that the needs and concerns of the owners are reflected in all legal documents. Family member owners will need to have the best tools available to effectively manage and grow their business.

Even in the most efficiently run businesses, nerves can fray among co-owners and partners. When family issues and personalities enter the picture, things can only get more challenging. Having the proper documentation in place can help ease the stress for any enterprise, especially for those that are family-owned and operated.

Resources are plentiful for the family-owned business and include:

Consult your attorney for specific information regarding the type of legal documentation that is best suited for your business.

Michael J. Conway, JD, is the General Counsel for the Baja Fresh Mexican Grill chain of restaurants in Thousand Oaks, California, where he focuses on general business matters including contract disputes, employment issues, arbitration/mediation, and litigation of commercial, insurance, and real estate matters. He is the immediate past president of the Loyola Law School Board of Governors and is active in The Alliance for Children's Rights where he provides pro bono legal services to adopting parents through the organization's legal assistance program. He was selected by Law & Politics and Southern California Super Lawyers magazine as a "Rising Star" in both 2005 and 2006. mconway@bajafresh.com

Stephen J. Baumgartner, MSc(Econ), teaches strategy at the Graziadio School of Business and Management and consults at the Encino, California, law firm of Greenberg & Bass, LLP (www.greenbass.com). As a strategic planning and financial analysis specialist, he has extensive expertise in litigation support, forensic analysis, financial modeling, debt restructuring, reorganization plan preparation, new venture start-ups, and project management. Baumgartner has more than 20 years of experience in finance, information systems, manufacturing, real estate, and management in firms including Xerox and Rand. stephen.baumgartner@pepperdine.edu


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The opinions expressed are solely those of the authors and do not necessarily reflect the views of the Graziadio School of Business and Management nor Pepperdine University.