Laying Down the Law on Shareholders

Intentionality of Decision-making

Over the past couple weeks, the U.S. Supreme Court and the Delaware legislature both made moves that could affect how family businesses are owned, transitioned, and governed.

The Supreme Court decision in Connelly v. United States ruled that certain life insurance proceeds should be included in the value of the business, even when they were intended to be used to redeem the ownership of a deceased shareholder. And in Delaware, the state legislators proposed a bill that could give influential shareholders the ability to make decisions without board oversight through the use of stockholder agreements.

These specific changes don’t worry me too much, but they do both highlight the important of intentionality of decision-making by family business owners.

Here are some of the things that stood out to me from the WSJ articles where I first learned about these decisions.

• “Begin by checking the company’s buy-sell agreement, especially if no one has reviewed it in years. Buy-sell agreements are crucial contracts explaining what happens if an owner dies, retires, or otherwise leaves the business.”
• “The law raises some fundamental questions about corporate governance,” said Stephen Bainbridge, a law professor at the University of California, Los Angeles who signed the letter in opposition. “The issue of, ‘Should boards be able to essentially give away their powers through contract?’ There is a lot of disagreement about that.”
• “Taxpayers should never think they’ll beat the IRS if they ignore the terms of their own agreements,” says Martin Shenkman, an estate-planning attorney in New York.

The big lesson here is that, as owners, you must know and understand what your shareholder and estate planning documents say about the highest likelihood scenarios you will face:

• How is decision-making authority allocated between the shareholders and the board? How and where is that documented?
• How will economic benefit transfer to future generations? What about ownership control?
• How will the company be valued upon transfer? Will that methodology satisfy the IRS?

These questions may seem irrelevant when an established family leader is calling the shots, but they become important very quickly when that person is no longer around. The death of a leader is always a shock to the family system. Not knowing the answers ahead of time only adds confusion to an already emotional and chaotic time.

We have seen families fall into traps they didn’t know existed. Here are three recent examples:

• We worked with a family who realized that all legal control (and no economic benefit) went to the spouse of the CEO upon his death. She wasn’t expecting (or desiring) that, nor was the rest of the family.
• Another family we know had two different valuations methods in their shareholder agreement. You can guess which one the IRS used.
• One founder realized that upon his death all of his assets would be controlled by a single trustee, someone he had not spoken to for 20 years.

Those were serious wake up calls for those three families. How can you avoid similar situations in your family business? The best way to understand your current documents is to scenario test them. Only by walking through exactly what will happen in some higher likelihood scenarios (e.g., a family member dies, someone wants to sell shares, a family member has an addition issue), will you get a real sense of what you want to keep and what needs revision.