What Happens to a Business When the Family Parts Ways?
A family business can be incredibly successful—or a complete failure. While running any business can be a complex endeavor, participants in family businesses also face the unique challenges that stem from intertwining “the business” with everyday family life. That is to say, family businesses operate with two separate but deeply interrelated systems—the business and the family.
Family businesses are extensions of family relationships, and, as we all know, managing family relationships can be challenging. Family businesses can involve myriad combinations of family members playing numerous business roles, including spouses, ex-spouses, parents, stepparents, children, stepchildren, extended family members and different generations serving as shareholders or owners, directors or managers, and employees or advisors.
It’s easy to see that dealing with conflict is a regular, recurring feature of family business ownership. The stakes are high. Discord and strife, left unbound, can sink businesses and wreck family ties. We’ve all heard about (or even watched movies with plot lines revolving around) cases of siblings who compete for parental favor in the business, aging matriarchs and patriarchs who refuse to cede control, parents who distribute business assets to untrained or indifferent children, and hardworking, active family members who resent that uninvolved relatives derive income from the business. Serious family business disputes tend to be ugly, protracted and devastating for all involved. However, there are steps every family business can take to manage conflicts among family members and ensure that family disagreements don’t result in dissolution of the business.
Structure and Formal Agreements
For starters, every family business should establish the right legal entity structure for the business’s and the family’s long-term objectives. In Virginia, most family businesses should be conducted as a corporation (including the S-corporation) or a limited liability company (LLC)—or, in some cases, a limited partnership. Too often, however, family members starting out together in business fail to establish the most-appropriate legal structure for their needs—or worse, embark upon the business venture as sole proprietors or general partners, without any appreciation of the significant personal liabilities to which they’re exposing themselves or the adverse tax and longer-term business consequences resulting from misinformed structuring decisions.
Housing the family business in a formal legal entity has the added benefit of subjecting the business to an established body of law (namely, the Virginia Stock Corporation Act or the Virginia Limited Liability Company Act). These Acts outline many of the rights and duties of a business’s constituents and establish basic procedures for governance of the business (in good times and in bad).
Every family business should also have good written agreements among the family member owners, tailored to the unique circumstances of the business and the family and pulled together ahead of time (before a major family disagreement erupts). While handshakes might suffice for managing a family business in an ideal world, we don’t live in one—and whether in the form of an operating agreement among members in the case of an LLC, or a shareholders’ agreement among shareholders in the case of a corporation, these agreements put black and white parameters around the relationships of family member owners. They address, for example, the extent to which managerial decisions may be influenced by feelings and responsibilities toward other relatives. They also set forth the parties’ allocation of control and other rights and, importantly, address uncomfortable questions easier dealt with up front. It may seem awkward to talk about difficult issues now, but it will be much more awkward after something goes wrong in the business or in the family—and something will.
By entering into well-drafted agreements, everyone in a family business makes clear their expectations early on—including thoughts about operations, management and voting (and resolution of executive disagreement), and major company events (even a sale or dissolution, and who has veto rights concerning the same). Among the most important of these written agreements is a “buy/sell” agreement. Buy/sell agreements, in basic form, establish a “buy out” procedure and pricing methodology among owners for events such as death or disability, withdrawal from the business, termination of employment and/or, importantly, failure of family members to reach agreement about major business decisions. These contractual arrangements operate to provide an “out” for deadlocked parties, with the family business continuing to exist notwithstanding an otherwise fatal disagreement.
Similarly, as tempting as it may be to handle family personnel matters in a family business informally without volumes of written employment policies and procedures, it’s a recipe for problems. In some family businesses, it’s expected that all family members will have places in the business. But this can wreak havoc—especially if positions are sinecures or the roles of each family member are left undefined. Written employment policies, and even employment agreements, are must-haves for setting forth the business’s expectations of each family member and defining each family member’s duties and job responsibilities. Establishing written employment criteria—and sticking to them—helps eliminate surprises and uncertainty in family employment arrangements and can mitigate the risks of resentment or even litigation by family members.
Worst Case Scenario: Divorce
The end of a marriage does not have to mean the end of a jointly held business. If a marriage fails, and the spouses own a business together, it is a marital asset and it is subject to equitable distribution. Equitable distribution in Virginia is typically an even split of all assets gained during the marriage. There can be some deviation from that rule, but in most cases it is the reality.
That does not mean that the business must be dissolved because of divorce—rather, it must be determined how the business will be divided between spouses. A business valuation may be required to determine the worth of the business. The value of the business may be offset by the value of other marital assets to create an even split. For some businesses, each spouse may end up with a portion of the business after divorce, but not all businesses can be evenly split and continue to function.
In order for the business to continue to operate successfully, it may need to remain intact. Of course, there are those rare people who cannot continue to be married to each other, but can continue to work together—but for most people, that is not a realistic option. The family business is likely a major source of income, and every effort should be made to preserve its income potential. This is best done before any signs of trouble in the marriage arise, or even prior to marriage. While soon-to-be newlyweds dislike the idea of the possibility of failure, if there are significant assets, including a business, they should consider having a premarital agreement drafted to address how the assets will be divided in the event of a divorce. This option will make the most sense if one spouse owns the business prior to the marriage. If a married couple decides to start a business after marriage, they should make sure they spend the time to have a plan in place if they want to discontinue their partnership, including a buy/sell agreement. With a little forethought and planning, the dissolution of a marriage does not have to mean the dissolution of the business.
Planning for the Future
Lastly, while conflict can arise from any direction, business succession often poses one of the most serious challenges for family businesses. Succession planning in a family business raises legal and strategic challenges that traditional businesses rarely face—and while the complexities of succession planning are beyond the scope of this article, family businesses must address succession planning as a long term strategic process (not left to the last minute), providing for a smooth transition of ownership and control while maintaining family harmony.
If you haven’t already addressed these matters, it’s never too late to get the necessary legal infrastructure in place for your family business. Success for most family businesses is driven, at least in part, by the quality of the advice and input you receive from your professional advisors, such as attorneys and accountants, who should be experienced with the needs of family-owned businesses. If transactional attorneys have done the job well in structuring and advising your family business upfront, then it should be equipped to manage family conflicts and survive most any family dispute. After all, isn’t that the point of the family business in the first place?
To keep it all in the family.