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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)

Graziadio Business Report,  2007, Vol. 10, Issue 2
This article is copyrighted and has been reprinted with permission from Pepperdine University

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.

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

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.

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This article first appeared in Graziadio Business Report,  2007, Vol. 10, Issue 2

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