Family businesses come in a variety of shapes and sizes, from SMEs employing multiple generations to global giants like SC Johnson, still owned by a successful US dynasty, employing 13,000 staff with revenues of over $11 billion.
Whatever the size and structure, family run businesses are an important part of the UK economy but it is typical for these businesses to give limited thought to their structure due to close nature of the relationship of the owner managers. This is often a mistake. The choice of structure can have a significant impact on the liabilities and rights of the owners, particularly in the unfortunate circumstances of a dispute.
So what structures are available to family businesses. Whilst there are many corporate structures through which a family business can operate, in the majority of cases, family businesses are operated either as a partnership or a limited company.
Family Business Structures
Partnerships are very flexible structures and require little to no formality to arrange. In fact, no agreement is necessary to establish a partnership and one will ordinarily be deemed to have arisen if the family members are simply “carrying on a business together with a view to making profit”.
The absence of a partnership agreement is invariably because the owners have not considered the structure and/or felt that detailed terms regarding decision making, disputes and the shares of profits and capital can be left to a mutual understanding.
In these circumstances, whilst some elements will remain flexible, legislation and case law (notably the Partnership Act 1890) will, by default, impose certain rules on the rights and responsibilities of the partners, both between themselves and third parties. Notably, the automatic position under the legislation is that all partners are equal and will share profits, losses and capital on an equal basis. This is the case even if one of the partners contributed substantial cash or assets to the business. The legislation also imposes rules relating to the effect of a partner ceasing to participate in the business (whether by choice or due to incapacity or death) which can lead to the automate dissolution of the partnership, even if the intention was that it should be preserved by the remaining partners.
As between the partners, there is a general duty to act in the utmost good faith to each other for the benefit of the partnership and not to place themselves in situations of conflict of interest and to fully disclose such conflicts.
Importantly, in relation to third parties, partners have joint, unlimited liability for all partnership debts.
Suffice to say, very often, the rights, obligations and consequences provided under legislation dating back to 1890 can fall far short of the parties’ intentions in running a modern, successful business.
Unlike with many partnerships, operating a family business through a limited company will be a deliberate act that requires the incorporation of the company, the allocation of shares and the appointment of directors. Again, there are default rules that apply should the owner managers not seek to put in place bespoke articles of association and/or a shareholders’ agreement but the Companies Act and the model articles that it imposes are, in general, a sophisticated and detailed set of shareholder and director rights, obligations and duties that have developed over the last 150 years, most recently with the Companies Act 2006.
The default rules include, amongst other things that:
- The company is operated by its directors who have the right to bind the company and, when making collective decision, decide by a majority.
- Each share will, on a poll, carry the right to one vote and participate pro rata on any distribution of capital and income.
- Certain (albeit very few) decisions that are to be determined by the shareholders are either a majority decision (such as the removal of a director) or need to be based on a special majority, being the holders of 75% of the voting shares.
The legislation is substantial and complex and deals with a wide range of other issues such as compliance and transparency (including filings at Companies House), the duties of the directors and how dividends can be lawfully ascertained and paid.
Bespoke arrangements for family businesses operated by limited companies can cater for family members who hold shares but cease to pull their weight in the business and deal with what happens on death. They can provide rules for deadlock if parties cannot agree on a course of action, policies regarding the payment of dividends, veto rights for senior family members and the valuation of shares if a family member needs to be bought out. The arrangements also often restrict transfers (to keep the shares in the family) subject to exceptions for certain familial transfers and family trusts.
If there are disagreements in a family business set up as a limited company, there are multiple options available including claims against the company for breach of the articles, against the director/s for breach of fiduciary duty, against the shareholders for breach of any shareholders agreement and petitioning the court for relief. Successful actions can result in damages, the court making orders relating to the company’s governance and a mandatory purchase of shares from one shareholder by another.
If any of the shareholders are spouses, it should be noted that financial orders on divorce, family courts are not bound to comply with the transfer and ownership provisions in written shareholder arrangements. For instance, provisions that provide for a shareholder to transfer share to his/her spouse on divorce may well be disregarded.
Of course, in addition to the options available to set out the rights and obligations of the parties, one key benefit to a limited company is the concept of limited liability which, broadly means that the owners’ liability in relation to the debts of the business is limited to the value of his share capital in the company.
It would be remiss not to also make brief reference to a creature of law that can arise in relation to a family business operated through a company, the “quasi partnership”. This has nothing to with partnership law or the Partnership Act 1890 and is not something that business owners can devise themselves. Instead, if a family company (formed due to the close relationship between the parties) is established and operated on the basis of mutual trust and confidence and/or there is an understanding that the shareholders will participate in the conduct of the business, the law may step in to apply a special set of rules if disputes arise.
These include protections from majority shareholders who are seeking to enforce their will and/or marginalise a minority shareholder (often involving their removal as a director), permitting them to bring a claim for unfair prejudice to ask the court for relief. The result is often that the majority shareholders are forced to buy the shares of the minority holder but, crucially, without any discount to reflect the minority interest. It should be remembered that without this protection (or something similar expressly agreed in the articles or shareholders agreement) shares that represent a minority interest are not automatically valued pro rata to the company’s value and can suffer a significant discount (in extreme cases, we have seen discounts of 90%).
Key points to remember when choosing the structure for your family business:
It’s important to consider your business structure early, even when the owner managers are family members.
In most circumstances there will be a better outcome if owner managers are deliberate about the terms on which their business will be operated as default rules can have unintended consequences. This can apply to both partnerships and limited companies.
One of the key things to consider when establishing a family business is what will happen if disagreement arises. Well-drafted provisions in agreed documentation often prevent disputes as the pre-determined outcomes can disincentivise behaviours.
There are some limitations on what agreed documents can provide for in certain familial situations. Issues relating to spousal transfers (at below market value) and quasi-partnerships need careful thought.
It’s not just internal rights and obligations that are determined by the choice of structure. The liability of owner managers to third parties with whom they do business can be very different depending on the chosen structure.
Finally, documents should be reviewed and updated regularly, for instance if the business or shareholder dynamic changes, including if the family receives investment from a would-be shareholder who is not part of the family.
How can Morr & Co help your family business?
If you would like to find out more about how to set up, change or formalise the structure of your family business or you are in need of advice in relation to a dispute relating to a family business, speak to our team today on 01737 854 500 or email [email protected]