Three Corporate Governance Considerations for Family-Owned Businesses

Summary — Family-owned businesses can face challenges around share ownership and potential sales. Proper planning, including documenting board membership, setting share transfer rules and establishing a framework for sales, can help families avoid disputes and ensure smooth decision-making.

A significant proportion of the roughly 36 million small businesses in the United States are family-owned businesses.¹ And while they span a variety of industries and provide a spectrum of goods and services, they share one significant challenge: how to navigate corporate governance issues broadly related to board composition, ownership of shares, and sale transactions.

Consider a hypothetical family business where the patriarch owns 100% of the stock of a corporation and has traditionally voted his shares so the board of directors included the patriarch, the matriarch, and each of his three adult children. On his death, the patriarch plans to devise his shares to the matriarch and his three children in equal parts, 25% each. He would prefer that the business remain in the family but wants to have a framework in place should the family determine that a sale would be advantageous.

What steps does this business need to take to help avoid potentially costly disputes, ensure continuity of ownership by family members, and/or efficiently navigate a sale transaction?

Document Board Membership and Include Specific Voting Provisions

Oftentimes, families have informally approved the practice of everyone serving on the board but have not put that in a shareholder agreement, or the documents are brief, informal, and incomplete. It is critical that families prioritize reviewing their articles of incorporation, bylaws, and shareholder agreements, as well as articles of incorporation and operating agreements for limited liability companies (if applicable) and updating the documents where appropriate to formalize these practices and to include clauses that address various voting scenarios.

In the hypothetical example above, sudden death of the patriarch may create an acute issue for the business. A shareholder agreement that requires each of the shareholders to vote their shares to ensure a representative nominated by the matriarch and each of the three siblings is elected to the board could be beneficial.²

Place Limitations Around Share Transfers

The patriarch in this example wants to ensure that the business stays family-owned absent a sale. Businesses with a similar goal may want to consider including restrictions on transfer of shares that are more tailored than a right of first refusal in documentation. Further, rights of first refusal may need to be narrowed with language that permits transfers to descendants. Similarly, other shareholders may need a purchase right if someone’s shares are transferred by operation of law outside of the family (for example, to a creditor).

Establish a Framework for a Sale

Finally, if this hypothetical family-owned business now owned by the matriarch and her three children experiences an unexpected challenge, like the illness of the matriarch, and the company needs to be sold expeditiously, a drag along provision in the shareholder agreement may help. A drag along provision typically requires all owners to sell and vote in favor of the sale, if some subset of the owners and management approves the sale. So rather than requiring the matriarch and three siblings to each individually approve the sale, perhaps its just three of the four. This can help to avoid a situation where one or more holdouts block a transaction that is beneficial to the family or the business.