As a family enterprise, your business runs best if it is owned and managed by the family. So it is in everyone’s interest to make sure no family member can transfer ownership outside of the family. To do this (and do it right), your business should have a shareholders’ agreement (often called a “buy/sell” agreement) or buy/sell provisions incorporated into your other governing documents.
A buy/sell agreement restricts transfers of ownership in your business. The company and all equity owners sign the agreement and the parties agree that any future owners will be obligated to sign as well. The agreement will likely divide potential transfers into two categories: voluntary transfers and involuntary transfers.
Voluntary transfers are exactly what they sound like – a family member chooses to transfer some or all of his or her interest to a third party. In many jurisdictions, courts have ruled that outright prohibitions on these kinds of transfers are not enforceable. So, your buy/sell agreement will likely permit the transfer, but only on certain conditions (such as requiring the affirmative agreement of all other owners) and only after everyone involved in the company has had an opportunity to acquire the shares instead. This opportunity is referred to as a “right of first refusal” and courts have uniformly ruled that it is enforceable. Involuntary transfers include transfers of the ownership interest through non-negotiated means, such as divorce, bankruptcy or death. Involuntary transfers are generally handled the same way as voluntary transfers, but may present some additional wrinkles.
There are innumerable variations on this right of first refusal structure. Sometimes it is a threshold requirement on a voluntary transfer that some or all other owners approve of the transfer. Sometimes the company has the opportunity to buy the interest. Sometimes only the other owners have the opportunity. Sometimes it is only a subset of the owners. Sometimes it is both owners and the company. Sometimes the company has the right and sometimes it has the obligation. It all depends on what is right for your business and your family. Furthermore the price and the terms of the sale are also flexible. Most times, the price will be set by the company with some form of acceptable dispute resolution process, but this is not necessary. Frequently, the price will be payable in some combination of cash and notes, so that the company and the other owners do not have to have a substantial amount of cash on hand to be able to exercise their right. The other terms of the purchase, including timing, are generally set out in a buy/sell agreement with an eye towards expediency and certainty of completing the purchase.
And, with anything, it is important to be mindful of the tax consequences to all the parties involved. A purchase of the stock by another family member under this mechanism is just that, and in most cases will result in long term capital gain tax treatment for the selling family member and a step up in the basis of the stock for the buying family member. A purchase by the company can be more complicated from a tax perspective. A company’s purchase of its own stock may be treated as a redemption and, therefore, perhaps a distribution. The tax treatment of distributions, particularly from Subchapter C corporations, can be complicated and it is important to have tax counsel, in addition to corporate counsel, review these provisions.
So if you are concerned about keeping ownership of your family business within the family, you will need some form of buy/sell agreement. But not all buy/sell agreements are created equal – a good attorney can employ incredible flexibility that will allow you to protect your business, create the right incentives within the family and minimize tax burdens, all in a manner that is customized to your business.