Ownership of family businesses and handing over the reins

The effective transition of any family business requires a holistic approach, good structuring and controls in place. Considerable complications can arise within the family if not well-handled and considered.

Transition from the founder

If there are successors within the family then the founder will need to start anticipating the new management and/or ownership structure as he/she gets ready to leave the business. Owner-managers may find letting go of their management role very difficult and doing so over a transitional period is likely to be more realistic in many cases than a sudden break. A collaborative partnership between the founder winding down and the next generation gearing up is very helpful.

A change in management control need not necessarily also entail a transfer of interests in the underlying economic interests, but may do as part of wider lifetime planning.

Questions to ask yourself

• What’s the best way of transitioning the running of the business to the next generation without giving up completely but also without interfering?
• Where most of the family wealth is tied up in the business how can we divide profits fairly between those who may be running the business and those who are not – is there to be any change in approach to distributing profits or rolling them over within the business to power greater long-term growth?
• How can I/we pass on the business (in circumstances where there is to be a transfer of underlying interests as well as control) and still have enough to live on in retirement?

The founder will need to think about the way in which the transfer of control (and, if appropriate, economic interests) is to be effected, when it is to happen and how it is to be financed (making sure that their lifetime needs can be met).

If the transfer to the next generation of the family business cannot be achieved then an alternative structure will be needed (whether by bringing in an external management team to run the business, or potentially seeking a sale of the business and/or liquidation of underlying investments). The prudent owner will keep their options open and make sure the preparation is in place for this “Plan B” in case the preferred route of succession to the next generation does not prove to be possible for one reason or another.

Complications as the number of family members grows

Where there is a single person in the next generation who is able and willing to take over the family business and the older generation wishes to transfer the business to them, things are relatively straightforward. Matters become more complicated where there are two or more children and more complicated still where there is a difference between the children in their appetite and aptitude, even if they all wish to be involved. By the cousin company stage it is probable that many different members will have been introduced into the family as it has grown through marriage and children. Ownership of the company can become complex if careful planning is not put in place as shares pass down the different generations in different proportions and at different times.

Questions to ask yourself

• Should we restrict ownership of shares in the company to the blood line family only?
• How can we make sure ownership of shares in the company stays in the family if a member of the family gets divorced?
• Do we risk a division growing between those who are involved in the business and the family members who are not? Could that division spill over into disputes over the ownership and control of the business?
• How can we deal with the problem that the main wealth of many family members may be tied up in shares in the business rather than available in more liquid assets? Can we structure things equitably so that members of the family still receive an income from the family business even though they are not involved in running it?
• Should the children/family members be treated equally and, if not, how should I manage the succession of the business and my other assets between them?

Getting organised

A structure in the form of rules, policies and procedures can help. Typically this will involve:

• the legally binding structure of the company’s articles of association (and, if there are provisions which it is desirable to keep confidential, a shareholders’ agreement);
• a (non-binding) family charter and possibly a family council

Key considerations: The well-managed handover

In broad terms, the choices for the founder owner are to take money out of the business while they are the owner to finance retirement in due course, or to leave the money to build up on the balance sheet so that at retirement a restructuring can be arranged to provide an adequate retirement pot to the departing owner. Some key considerations for you:

Gift or transfer funded by a loan 

The transfer of the shares in the family company can be by a gift (whether during the founder entrepreneur’s lifetime or on death) or by a sale of the business to the next generation. Asking the next generation to fund a significant part of the purchase price, for example, with the loan secured on the assets of the business, can be a good test of the extent of their commitment to the business. A combination of the transfer by these different methods can be used.

Timing for ultimate succession 

When to make the transition and whether it should be phased needs careful thought. The founder will not want to transfer ownership and control until the next generation has proved to be suitable as new owners and managers. On the other hand, a founder staying on longer than they should can cause considerable tension between generations. A typical solution is to transfer management but retain ultimate control until the next generation has successfully run the business on its own for a while.

Valuations and funding

It is usually prudent to have the business valued when considering the transfer to the next generation, keeping in mind the possibility of selling to an outsider as an alternative. Expert advice is likely to be useful. Funding, perhaps from the business, may be needed to compensate children who are not to become shareholders. The incoming next generation will need to see reasonable remuneration for running the business to give them an income to live on. The retiring owner will need to think about pension arrangements and other funding for retirement, particularly where the business represents their main asset.

Tax

It is vital that the tax implications of transferring the business to the next generation are explored before any decision is taken. By taking account of the nature and structure of the business and the objectives and circumstances of the parties, the business owner will be able to settle on the most robust and tax efficient method of transferring ownership. Conversely, a failure to take account of the tax may land a party with an unwelcome and, in the worst case, an unaffordable tax charge.

Legally binding rules

Wherever there are multiple owners of a business it is sensible to have a carefully thought out legally enforceable constitution, specifically the articles of association and it may also be prudent in the circumstances to adopt a shareholders’ agreement. This applies to a family business as well as any other. In fact, where business issues can be overlaid with family stresses and strains, it is arguably even more relevant for a family business.

A shareholders’ agreement can include provisions for the resolving of arguments and disputes amongst shareholders, should they arise (as can a family charter, although that is not legally binding).

The articles of association would typically deal with the transfer of shares, for example either where a family member no longer wishes to be involved in the business and would like to realise their value (assuming a willing purchaser within the set of permitted transferees is prepared to buy), or, conversely, where they wish to carry out some of their own lifetime planning and transfer their shares to their own descendants. A right of first refusal can be included to ensure that shares are tightly held by the family. Some families restrict ownership absolutely to the family bloodline; this limits the ability for individual members to seek an exit, but ensures shares remain within the family.

Another provision can be that there should be a compulsory offer of shares to the family in the case of divorce or death for example where shares would otherwise be held by the non-bloodline spouse of a member of the family.

More broadly, the articles of association can, in particular, limit the opportunity for outside, potentially hostile, investors to acquire an interest in the company.

Members of the family who are not managing the business can be involved through an ownership interest in the company with the business adopting an appropriate dividend policy. Another alternative is for “inactive” members of the company to be bought out by the other shareholders or by the company through a share buy back.

Distinguishing between ownership/control and financial benefit

Most family businesses have a limited liability company as the operating entity. The shareholding structure for the company can be very simple where there is a single owner as there is no need to think about the interests of other shareholders. However, matters can become more complicated where there are two or more shareholders. For example, it may be appropriate that some shareholders are to exercise greater control than others or for some shareholders to have a greater financial interest than others.

Questions to ask yourself

• What controls can be put in place to ensure that members of the family who are involved in management do not make fundamental changes without general agreement from the family?
• Can we structure things so that members of the family still receive an income from the family business even though they are not involved in running it?

In deciding what works for your family two approaches can be adopted, either separately or in combination:

• The first can be to create different classes of shares having different rights and restrictions. For example, enhanced voting and veto rights can be attributed to the class of shares to be held by the founder to maintain overall control as members of the next generation are introduced as directors and shareholders. It is also possible to compartmentalise economic interests in shares, by having shares which only participate in value up to or in excess of certain ‘hurdle’ amounts, so benefiting just in future growth in value.
• A second route is to have some or all of the shares held in trust. A trust arrangement, which creates a division between personal financial benefit resulting from the ownership of the shares and control of the shares and how the votes attaching to the shares are exercised, can be extremely helpful for business-owning families. For example, tax considerations permitting, a founder may place all of the shares of the family company in the hands of a trustee for the benefit of the next generation. As another example there might be branches of a large family and here the shares of each branch could be held in trust rather than have a multitude of individual family members as direct shareholders.

These approaches can be combined, for example a ‘golden share’ with veto rights or other classes of shares may be held in trust.

Different share classes

A “share” is a bundle of rights and restrictions covering control (voting, vetoes and management representation), income, participation on return of capital (whether on a sale, winding up or other capital event), participation in management, rights to information and transferability of the shares. One class of share can have a different blend of these ingredients from another to allow a different balance of control and participation between the holders of one class and another. For example, the founder could continue to maintain a level of control by having a ‘founder share’ or ‘golden share’ giving the founder the right to veto certain actions, such as the sale of the company. This could be for a limited ‘sunset’ period and so be a time limited right. It may be appropriate for certain members of the family to have income rights only (and not be involved in voting at shareholder meetings) and a ‘dividend-only’ share would achieve this objective.  Care must be taken as HMRC can value shares which carry control at a premium to the economic rights they hold, and so not result in the founder passing as much value out of their estate as they may have planned.

Trusts

The creation of a trust structure is an attractive method of passing a family business to the next generation, providing long-term protection of wealth.

At its core a trust splits ‘legal’ and ‘beneficial’ ownership of an asset, to establish a separation between title/control on the one hand and financial benefit on the other. For example, where a family company is held in a trust structure, the trustees will own and control the shares and will therefore be able to vote on shareholder resolutions and, ultimately, sell the shares. The trustees hold the shares and the dividends and other financial benefits that derive from the shares for the benefit of the beneficiaries. Unless a trustee is also a beneficiary, he or she will not be permitted to benefit financially (or otherwise) from the trust.

This separation of control from financial benefit can be extremely helpful for business owning families. The undiluted ownership of the trustee business owners allows them to be decisive and the business to remain agile. The model protects the shares for multiple family members and across generations and, even following a sale of the business, the trust structure can ensure that provision is made for beneficiaries via the trustees on the basis of their needs (collectively and individually).

Trusts are particularly helpful where the business is entering a second, third or fourth generation situation and where, in the absence of a trust, the ownership of the business would be spread across a diverse group of minority shareholders.

Having the shares held by experienced trustee shareholders who are not personally interested in the family wealth provides objectivity and fairness and promotes long-term thinking. Trustees can be made up of family members and independent trustees to ensure a breadth of approach and experience.  In addition, a trust structure can provide some protection to beneficiaries in the event of a claim against their assets, for example, on divorce or bankruptcy.

Transition of assets across generations – tax issues

For wealthy individuals and families who are intending to transfer assets (or control over assets) to younger generations, tax is a major consideration.

Detailed tax and legal advice should be taken when seeking to transfer ownership and/or control to the next generation to make sure reliefs are available and/or to minimise or manage tax events in order to avoid disruption to the business.  At the time of this note major changes are underway in respect of business property relief (BPR) a form of relief which would have previously enabled a transfer of trading assets in an inheritance tax effective way.  As tax laws and guidance constantly change it is necessary for up-to-date advice to be taken before any structures are implemented.