The U.S. According to the U.S. Small Business Administration, 99.7% of U.S. employers are small businesses, 64% of new private sector jobs and 98% of exporting firms. Family-owned businesses account for more than 57% GDP and employ over 60% of the workforce. They also account for almost 80% of new job creation. Family businesses are the lifeblood and strength of our country. They are built on sweat, blood, and tears.
Family-owned businesses can be fraught with problems due to the emotional attachments, the money generated by these businesses, as well as the dynamic of working together. Proper planning can help avoid some of these problems. Some of these issues, regardless of any safeguards, cannot be avoided.
We will discuss some of the challenges faced by a family-owned business from the perspective a person who has represented family-owned businesses and litigated those issues.
Family Dynamics: The Goals and Values Behind The Business
It is important to understand the business’s goals and values when working with a family-owned business. Every business has its own goals and values. These goals and values are very important. However, when you work with a family-owned business, it is essential to understand more than the company’s website and advertisements. Many family business owners start and grow their business with the intention of eventually handing over the reins to their children. Some business owners know that their children are not interested in the business and want to make sure that they do not have to continue the family business. You need to discover the truth.
Many children see their parents as role models or superheroes. Children see their parents working hard to support the family and the business. Most likely, the children contributed to the family business as children and will eventually work in the family business. The family business has been a part of their lives for many years and the children are familiar with its products and how it is run.
This background can lead to the family having one of two options: either the children will continue the family business’ legacy or they will not. These ideas can change over time but it is important that you understand the goals of the business.
It can be very rewarding for children to learn the ropes and take on more responsibility as they grow up, eventually reaching executive level. Many times, the founder of a family business is also the CEO. These roles can become so closely intertwined, it may be difficult for the founder to gracefully retire and allow the next generation to take over.
This is not a good idea. Younger relatives can feel frustrated by their inability to move up and leave the family business, despite their dedication and years of experience. Family relationships can last a lifetime but the chief executive’s position does not have to. A succession plan or plan for retirement should be developed by the chief executive of the company. This will help to prepare the business for a smooth transition and reassure children about the possibility of ownership and advancement.
Alternately, let’s say that either the parent nor the child doesn’t want their child to work for the family business. It is crucial to understand this information so the parent can plan on who will take over the business, when the business will be sold, and how much. The family business is often the biggest asset of the owner, and it will most or all fund his retirement. It is important that the business continues to operate after the owner leaves, but it is equally important that the business can be sold for the highest possible value. The owner can look for outside sources to purchase and run the business if they know that their child won’t be involved in its continuation or purchase.
For example, in this instance, the author represented the father of a family business. The meat processing company was started by the father and his deceased mother. The business was also run by the parents’ three sons. The parents decided to sell the business. They hired an appraiser to help them determine the value of the business. The appraisal resulted in a buy-sell agreement where the parties agreed to pay their sons a monthly amount for their shares in the business as well as the building that the business is located. The parents would be available for consultation on operations. The building would remain in the parents’ ownership until all payments are made. Both parties had completed everything correctly, including independent valuations, disclosure of financial statements and the engagement of attorneys to draft any applicable agreements.
The bitter and prolonged litigation between the parents and their sons lasted for several years. The sons couldn’t make the agreed-upon payments and claimed that the business had been overvalued at the time they purchased it. They needed the agreed-upon retirement income and were unable to resolve it otherwise. The parents had to go to court with their three sons. The parents demanded that the agreements be performed in a specific manner. The sons claimed that their parents were guilty of fraud in the sale of the company. Six-year-long legal battle followed, with five lawsuits and bankruptcy. The father, who had lost his mother and was now old enough to be fully retired, bought the shares of the company back from the bankruptcy trustee. The sons have ceased speaking with their father and are no longer in touch with their mother.
The moral of this story is that even with the best intentions, family business dynamics and emotions can sometimes override the best-drafted legal documents. This can lead to costly and painful litigation.
Valuing and Dividing Family Business Assets and Interests
The Operating Agreement of a limited liability company, the Bylaws or Shareholders Agreement of a corporation will often outline how to value and divide business assets and interests. These Agreements should be referred to by the owner if applicable. If the agreements do not contain an exit plan, this section will address how to exit the family business.
If the LLC members do not adopt an Operating Agreement, then the default provisions of the Minnesota Revised Uniform Limited Liability Company Act (“LLC Act”) will apply (Minn. Stat. SS 322C.0110 subd. 2). Section 500 of The LLC Act outlines the nature and method of transferring a member’s interest. A member may transfer their interest under Section 502 (Minn. Stat. SS 322C.0502 subd. 1(2)). The transferee, however, is not permitted to take part in the management or conduct the LLC’s operations without the consent of the other members. They also are not permitted to access records or any other information about the LLC’s activities. (Minn. Stat. SS 322C.0502 subd. 1(3)(i) & (ii). The economic benefits that the interest offers are only available to the transferee. (Minn. Stat. SS 322C.0502 subd. 2). The member who transfers less than half of their interest to another member retains all rights, except the right to vote and access to information. (Minn. Stat. SS 322C.0502 subd. 7). The members must agree otherwise. The transferee has the right to all the economic benefits and no say in the management or operation of the LLC. This is often taken into account when the membership price includes a discount for those who do not have control.
Section 600 of The LLC Act also provides information on how and when a member may separate from the LLC. A member can withdraw as a member at any time and rightfully or wrongly, from the LLC. SS 322C.0601 subd. 1) and giving notice of the LLC. (Minn. Stat. SS 322C.0602(1). However, dissociation is distinct from a buyout or transfer of interest in the LLC. An LLC member who wrongly dissociates can be held liable for the LLC and the other members. (Minn. Stat. SS 322C.0601 subd. 3). Furthermore, dissociation doesn’t automatically release a member from any obligation or debt owed to the Company. (Minn. Stat. SS 322C.0603 subd. 2).
The Minnesota Statutes Section 602 describes several events that can cause mandatory dissociation, including the death of the member. SS 322C.0602(6) (i) bankruptcy by a member of a member-managed LLC SS 322C.0602(6)(i): bankruptcy by a member in a member-managed LLC (Minn. Stat. SS 322C.0602 (11)(i), or the LLC ceases to exist. (Minn. Stat. SS 322C.0602 (14).
Transfer restrictions in corporate contexts are allowed by the Bylaws and Shareholders Agreement. However, the Minnesota Business Corporation Act (“Business Act”) doesn’t impose default transfer restrictions. (Minn. Stat. SS 302A.429. Further, the Business Act provides that shareholders have the right to appraisal rights and the right to receive payment of fair value in the event of, among other things: the consummation or termination of a merger (Minn. Stat. SS 302A.471, Subd. 1(c), share exchange (Minn. Stat. SS 302A.471, Subd. 1(d), disposition of assets (Minn. Stat. SS 302A.471, Subd. 1(b), and certain amendments of the articles of incorporation. (Minn. Stat. SS 302A.471, Subd. 1(f)).
It is not surprising that family businesses are often subject to restrictions in their Operating Agreement, Shareholders Agreement, or Buy-Sell Agreement. These restrictions limit how, for what amount, and who can be sold.
Northern Air Servs is a prime example of issues that can arise in family business management and sale. Link v. Link 804 N.W.2d 458, (Wis. 2011,) a Wisconsin case that involved a multi-year, multimillion-dollar litigation over Jack Link’s meat business. Jack Link’s beef jerky is the company that makes the “Messing With Sasquatch” commercials. It is located in Minong in Wisconsin.
The Linkcase is about a bitter interfamilial conflict between John Link (“Jack”), his two sons Jay Link (“Jay”), and Troy Link (“Troy”) and the various companies they own that produce and distribute cheese snacks and meat. Jack started selling meat snacks in Minong (Wisconsin) in the middle of the 1980s. Jay and Troy, Jack’s two sons, purchased shares in the company. The business grew steadily and became completely family-owned in 1995.
The three Links entered into a Buy-Sell Agreement as a condition to owning company shares. This agreement gave the company the “option to redeem all or part” of Jack’s or Troy’s shares. The Buy-Sell Agreement stipulated that the purchase price would equal the “fair market value”, as determined by an appraiser. This was mutually agreed upon between the parties.
The Links lived in a state where they could co-exist, but only until 2002. The somewhat friendly relations between Jack, Jay, and their children began to deteriorate. Conflicts between them arose more frequently. Jay and Jack had serious disagreements over how to run the business, which culminated in Jay and the company signing a 2005 Departure Memorandum. The parties reached an agreement in the Departure Memorandum that Jay would be fired as an officer and employee of the company and its affiliates. They would negotiate an amicable purchase-out of Jay’s rights.
After Jay executed the Departure Memorandum there was an unsuccessful period of negotiation about the documents required to close Jay’s share purchase. The litigation that followed was more than six years long and involved a multitude of claims by the parties against each other, including specific performance of the Buy-Sell Agreement as well as breaches of fiduciary obligation, shareholder oppression and other tortious conduct. Jack and Troy wanted to buy Jay. Jay wanted the company to dissolve or to receive Jay’s “fair value”, as opposed to his shares’ “fair market value”.
After two years of discovery, the parties went to trial in May 2008. The trial court ordered that the trial proceed in three phases due to the complexity of issues. Phase I dealt with equitable claims that were not subject to appeals.
The second phase was a six-week jury trial that resolved legal claims and damages against each other. Jay was awarded $736,000 in compensatory damages by the jury and $5,000,000 in punitive damages by Jack. Jay also breached his fiduciary obligations to Jay before he left. The jury awarded Jay $1 in compensatory damages and $5,000,000 in punitive damages. Jay was ordered to pay the respective companies $3,500,000, and $1,500,000.
The trial court informed the parties that post-verdict motions were due July 29, 2008. Jay submitted his motion on July 29, 2008 at 4:32 pm. This was two minutes after normal business hours closed. However, the clerk of the court accepted Jay’s motion. Jack sent his motion via mail from Chicago on July 29, 2008. One day before the deadline, Jack’s motion was filed by Jack’s clerk on July 30, 2008. Both their motions were granted by the trial court, which reduced the damages awards. Jay was ordered by the trial court to pay $1 in compensatory damages, $1 in punitive damages, and Jack was ordered Jay to pay $736,000 in compensatory damages, and $736,000.
The Court attempted the third phase, which involved claims for specific performance as well as judicial dissolution. Jay was not subject to oppression, the Court denied Jay’s claims of judicial dissolution and granted Jay’s motion for specific performance under the Buy-Sell Agreement. Jay was ordered by the Court to give up his shares in company.
$19,400,000, implicitly authorized the buyout, even though it was not explicitly authorized by statute.
These issues are then appealed to the Wisconsin Court of Appeals, before reaching the Wisconsin Supreme Court. The Wisconsin Supreme Court affirmed the trial court’s decision and reinstated Jack’s $5,000,000 punitive damages award. This was because Jack’s post-verdict motion had been untimely. Even though Jay’s postverdict motion was untimely by two mins, the Supreme Court ruled that the clerk of court had the discretion to accept the motion two minutes late. Jay’s motion came in two minutes late. This resulted to Jay’s $5,000,000 punitive damages award being reduced from $2 to $2. Jack’s motion however, was received on the same day but was not timely. The $5,000,000 punitive damages award was reinstated. It was $10,000,000 more.
The Wisconsin Supreme Court also confirmed the trial court’s determination that Jay was not oppressed. It held that Jay did not have the right to contest the decision because he had sold his shares. The Wisconsin Supreme Court reversed the trial court’s decision and remanded it to decide on evidence Jay could present about Jay’s theory of damages arising from the breach of fiduciary duties claim against Jack, Troy.
The litigation lasted six years, resulted in multimillion-dollar damages awards, a $19,000,000 buy-out and severe family relationships. This litigation was triggered by the parties having put in place what they believed to be a Buy-Sell Agreement, to limit the amount of litigation that would follow. Despite the best intentions, there was a lot of litigation and hundreds of thousands of dollars in attorney’s fees.
Management and Employment of the Family Business
Most businesses are clear about who is in charge of making decisions for different departments and the whole business. The lines between family businesses can blur with siblings or parents second-guessing one another. This can cause problems in business operations and create conflict.
It is best to avoid these problems by having a family business set up formal lines and follow them. Family harmony can be maintained by parents communicating their expectations and wishes to their family members. Employees of family members should treat one another with the same respect as staff at other businesses.
Family members can bring a special dedication to their businesses, but they are often unable to provide the knowledge and experience that the business requires. The best person for every position is the only way a business can survive. Sometimes, this person might not even be a relative. It is important that you are open to the possibility of hiring professionals from outside your family. These professionals should be treated with the same respect, compensation and opportunities as a relative who holds the same position.
Non-compete agreements and non-solicitation agreements are also important considerations for family members involved in the business. Non-compete and non-solicitation agreements are often part of any family employment relationship.
Although Minnesota courts disapprove non-compete clauses, and will scrutinize such claims by employees, a reasonable and needed non-compete could be enforceable. It is usually enforceable when it is tied to the sale of a company. Employers in Minnesota may use non-compete clauses, as established by a 1997 appeals court case. This is to protect customer goodwill, confidential trade information, and customer contacts. Although they are less suspect than trade secret and confidentiality agreements, they can be used to protect proprietary information.
Minnesota law requires that non-compete agreements be reasonable in terms of geography and time to be valid. A non-compete agreement cannot be extended beyond what is required by the employer to train and replace employees. It also can’t cover an area outside of the employer’s market. Unenforceable would be a non-compete agreement that covers the entire United States for 20 years. Minnesota courts decide the reasonableness and enforceability of non-compete clauses individually. There is no standard.
Minnesota courts are more likely than other states to uphold nonsolicitation agreements. However, restrictive covenants may be subject to greater scrutiny. Non-solicit agreements are not subject to geographical limitations, but they do need to be within a reasonable time limit. Minnesota courts usually uphold non-solicitation agreement once an employee moves up within the company or takes on additional responsibilities.
While non-compete and anti-solicitation agreements are not always easy to come up with for a family-owned business, it is often necessary due to the family members’ knowledge.
Business Succession and Other Estate Planning Considerations
Most family business owners are small- to medium-sized business owners. Their business is a significant part of their retirement savings and assets. They have invested a lot of their time, blood, sweat, and savings to keep the business afloat. It is crucial that they ensure the business they have worked so hard to build is maintained in the best possible way or sold to maximize its value. This is why business succession planning must not be ignored. It should not be delayed until it is too late. Too often, business owners die without having a succession plan, leaving the business and its heirs in unfamiliar territory with no clear way forward.
The business succession plan must address the transfer of management and ownership. The succession plan should contain, as minimum, the following information regarding the management of the business:
- Development, training, support, and coaching of management successors
- Management successors can be delegated responsibility and authority;
- Whether advisors or outside directors are required to bring objectivity and independence to management successors;
- Maximizing retention of key employees by ensuring equitable compensation planning for family, non-family, and management employees.
The business succession plan should also include ownership. Co-members and co-shareholders may own shares in the business. This is often a reason to consider buying the interest or shares of the deceased owner. The Operating Agreement, Buy-Sell Agreement, and Shareholders Agreement will usually contain a clause requiring the deceased owners or entity to purchase the shares or interests from the estate. To cover the costs of the buyout and to ensure liquidity, life insurance or an irrevocable trust in life insurance can be created.
The Operating Agreement, Buy-Sell Agreement, and Shareholders Agreement will establish the procedure for selling stock or membership interests upon retirement. The selling owner will typically offer the ownership interest to non-selling owners using a pre-established formula, or make a bonafide offer to third parties. The remaining owner has the right to keep control of the entity, if they wish. The selling owner can then sell their ownership interest to a third party if the non-selling owner does not exercise the right of first refusal.
If the entity is owned solely by one owner, the business succession plan must coordinate who will run it and who will manage it, if any, and the timing of ownership transfers. A non-compete clause is often included in the purchase to prevent the seller from competing with the buyer if the selling owner decides to sell the business. The succession plan will outline who and how much ownership is given to each person/entity if the business is sold after the death of the owner.
The succession plan should include a retirement section if the owner plans to sell during their lifetime. The selling owner should look into non-qualified retirement plans, such as an executive retirement plan or profit-sharing plan. This will help to achieve financial security. Leasing personal and real property that is necessary for the operation of the business may be an option to increase retirement income. This is why many owners establish both a holding and operating entity. The land and buildings are owned by the holding entity, while the operation entity manages the business and retains the goodwill. Separating the entities is prudent for retirement planning and selling options ( that is, the ability to sell both entities), but it also helps to protect liability.
When the torch is passed between business owners, liquidity issues can also arise. The business needs liquidity to cover future costs and maintain capital reserves. The business or business owners may need to liquidate in order to fulfill obligations under the Operating Agreement, Shareholders, Buy – Sell, or Operating Agreement. The family of the owner may have to fulfill estate tax obligations. An irrevocable insurance trust can be used to ensure liquidity in the event of the death of an owner, which could trigger a buyout or estate taxes. The owner can also set up a payment schedule to buy out the owner after retirement. This helps avoid a significant upfront payment and also reduces the tax burden of large lump sum payments.
To complement the business plan’s objectives, it is important to complete appropriate estate planning. To take into account the estate tax exemptions and gift taxes at death, the estate plan should include standard marital and family shares. The business objectives of transferring ownership at death or during life should be carried out in an estate plan that minimizes disruption to the business operations and minimizes tax obligations.
One of the most rewarding aspects of owning and running a family business is being able to do so. Family members are often there to support each other and create a special bond when they work together toward a common goal. This article should have highlighted some of the areas where family disputes can arise, and how they can be avoided. You can’t choose your family but you can decide whether or not to do business with them.
Family Business Legal Challenges was first published on Attorney at Law Magazine.