Business Succession Planning With the Four Levels of Ownership and Control

Many family business owners struggle with business succession planning because they cannot envision a suitable way to divide their ownership and control among a diverse group of beneficiaries, some of whom are active in the business and some of whom are not. However, by recognizing that ownership and control actually consist of four separate component levels that can be divided differently among the beneficiaries, a family business owner can more easily conceive of a succession plan that rationally assigns leadership and management powers while equitably allocating the economic benefits of the business.

Business ownership is not the indivisible conglomeration of control, management, and economic interests that it may seem when the business is owned and operated by one individual or a small group of owners. As a legal matter, what is often thought of as "ownership" is actually four separate and distinct levels of rights and interests, as follows:

1.  Voting control, which is not necessarily exercised by shareholders and consists primarily of the right to elect directors, approve changes to governing documents, and approve fundamental transactions such as mergers or the sale of substantially all of the assets of the business.

2.  Board authority, which cannot be exercised by individual directors and consists primarily of the right to appoint officers/executives and oversee management of the corporation, raise capital by issuing debt or stock, and declare dividends.

3.  Executive management authority, which is conferred on officers by (and can be revoked by) the board and which consists of the power to bind the corporation in contracts and transactions and manage the day-to-day operations of the business.

4.  Beneficial interests, which consist of the right to enjoy the returns of the business and can be divided among employees (through compensation), holders of debt, and shareholders or the beneficial owners of shares.

By considering the succession of each level of rights and interests separately, a business owner can more easily decide how they should be allocated among his or her successors, consistent with what is appropriate for them and best for the business. This article will discuss the legal attributes of the four levels of business ownership and control in a corporation, the legal and practical considerations that should govern how they are allocated under a business succession plan, and various devices that can make that allocation most effective. Although this article focuses primarily on corporations, nearly all of it applies equally to limited liability companies, sometimes with different terminology.  

OVERVIEW

It may be easiest to think of ownership and control in terms of "levels" because each set of rights and authority seems to be conferred by or dependent upon the set of rights and authority that precedes it. A graphic representation of control could be as follows:

In the illustration of control, share voting is at the top and beneficial ownership is at the bottom, consistent with the flow of authority. In contrast, an illustration of economic interests might be inverted, consistent with the flow of economic benefit. A graphic illustration of economic interests could be as follows:


Summarized simplistically, a corporation is managed through a tiered system of checks and balances for the economic benefit of the relatively powerless beneficial owners.  

A limited liability company is different from a corporation in that the statutory defaults tend to collapse the four separate levels of ownership and control and vest their attributes in the same person or persons, without maintaining the formalities of separate levels.  Under statutory defaults, LLCs are owned by members and can be managed by the members or by one or more managers who are appointed by the members. To duplicate the corporate structure, it is possible for the members to elect a board of managers to function like a board of directors and appoint officers/executives to run the day-to-day business of the company.

A person who is planning for succession of a business that is organized as an LLC can use the more simplified structure while he or she is running the business, but then as part of the business succession plan install the corporate-type structure at the time of the business owner's exit. This would allow the business owner to benefit from the simplified, less formal structure of an LLC while he or she is in control, but then utilize the checks and balances of a corporate structure when the business is passed on to his or her successors and beneficiaries.

FOUR LEVELS OF OWNERSHIP AND CONTROL

By understanding the legal attributes of each level of ownership and control as well as how those attributes can be enhanced or limited, a business owner can more easily decide how they should be allocated among his or her successors and beneficiaries. The objective is to use these attributes to confer the economic benefits of the business on the business owner's beneficiaries in the proportions the business owner desires and to secure those economic benefits by allocating control in a manner that establishes the most effective leadership structure and system of checks and balances under the particular circumstances.

1.  Share Voting

The voting rights of shareholders are important but quite limited. Share voting can elect and remove directors; amend the corporation's governing documents; and approve fundamental transactions affecting the existence and form of the corporation. Shareholders do not "run" the business and have no direct effect on day-to-day management.

Under statutory defaults, each shareholder of a corporation is entitled to one vote for each share of stock he or she holds, but these statutory defaults can be changed, legally or in practice, by provisions in the articles of incorporation, bylaws, shareholders' agreements, proxies, or trust agreements. Voting rights of particular shares can be increased, reduced, or eliminated, and voting rights can be completely separated from the beneficial ownership of shares. In some cases, share voting rights may be exercised by persons who do not own any stock or who have no beneficial interest in the stock. Most shareholder actions are taken by majority vote, but even this can be changed by governing documents or shareholder agreement.

          a.  Matters for Share Voting

The corporation's governing documents or board resolutions can expand the matters that must be put to a vote of shareholders and thereby increase the authority of share votes to directly influence the business decisions of the board of directors and the executives.  For example, the governing documents could prohibit the corporation from increasing its debt over a particular threshold or issuing new stock outside the current group of owners or issuing bonuses to executives without the consent of the shareholders. However, shareholders, as shareholders, cannot participate in the day-to-day management of the business and cannot sign contracts or otherwise engage in transactions on behalf of the corporation.

          b.  Means of Acting

Most shareholder actions require the affirmative vote of at least a majority of shares voted at a shareholders' meeting at which a majority of share votes are present or, if the shareholders are acting without a meeting, the unanimous written consent of all holders of share votes, but those defaults can be changed by the articles of incorporation and bylaws. The corporation's governing documents control who can call special meetings of shareholders, how many share votes must be present at a meeting to constitute a quorum, and how many affirmative votes must be cast to take each type of action that is put to a vote of shareholders. These elements of share voting may effect, for example, whether a director is removed by the shareholders before the end of his or her term or whether the corporation's board is expanded to add more directors when the board is considering a critical matter. Share voting for board members is especially flexible, because directors do not need a majority vote to be elected. (See the discussion of electing directors below.)

          c.  Voting Classes

Statutes allow a corporation to establish different classes or series of stock with different voting rights, so long as that fact is disclosed in the corporation's articles of incorporation. Although S corporations cannot have more than one class of stock with respect to economic attributes, S corporations are allowed to have different classes of stock as to voting rights. A class of shares can have more than one vote per share, less than one vote per share, or even no voting rights at all, as to particular matters or as to all matters that are put to a vote of shareholders. The only requirement is that all outstanding shares, in the aggregate, must possess 100 percent of share voting rights.  

          d.  Lapsing or Vesting Voting Rights

A corporation's governing documents, stock subscription agreements, or shareholders' agreements can provide for voting rights to lapse or vest upon the occurrence of a particular event such as the shareholder's exit as an employee of the corporation (lapsing rights) or failure of the corporation to pay preferred dividends (vesting rights).    

          e.  Fiduciary Voting

Under voting trust agreements, equitable trusts, or proxies, fiduciaries can be appointed to vote the stock of any or all shareholders. This is a common way to structure voting of stock owned by minors, but it can be used in a variety of circumstances, and it can be temporary or it can be relatively permanent. Under these arrangements, the fiduciary generally has to vote the stock in a manner that is in the best interests of the beneficial owner. If an equitable trust is used to hold and vote stock, usually only the trustee can exercise the rights of a shareholder to bring direct or derivative legal claims against the directors and officers, and thus it may be a way to control the use of litigation to hold management accountable.

          f.  Debt Holder Voting

In some instances, holders of debt can be given voting rights through the terms of debt instruments, pledge agreements, or proxies. Debt instruments issued by the corporation can provide for conversion of debt to voting stock at the election of the debt holder or upon the occurrence of an event. These types of arrangements can be used in business succession planning to provide a voice to family members who are redeemed in exchange for payments over time.

          g.  Voting Agreements

In many instances, shareholders can execute shareholders' agreements among themselves that govern how they will vote on specific matters. Voting agreements can be part of other agreements affecting shareholders as well, such as trust agreements, stock subscription agreements, loan documents, or stock pledge agreements.

          h.  LLCs

Virtually all of these modifications to default voting rules can be applied to member voting in an LLC.

2.  Board Authority

A corporation's board of directors determines business strategy, oversees management of the business, and authorizes transactions that are outside the ordinary scope of business (such as expansions or joint ventures). The board appoints or removes officers/executives, determines their compensation, and defines the scope of their responsibility and authority. The board can cause the corporation to issue new stock or redeem stock at prices the board deems appropriate, and the board can cause the corporation to pay or withhold dividends/distributions. The board can only act as a group; individual directors cannot, in that capacity, sign contracts or otherwise engage in transactions on behalf of the corporation.

Under most statutory defaults, a board must have at least one director but may have many more. Shareholders and employees may be directors, but persons who are neither also may be directors. Directors are elected by plurality vote of all the share votes at the annual meeting of shareholders. However, these statutory defaults regarding board powers, board composition, and director elections can be changed in the corporation's governing documents and other agreements.

At all times, the board owes fiduciary duties to the corporation, and the shareholders as a class, to be loyal and to act in good faith and with due care. These duties cannot be eliminated, but their scope can be narrowed, and directors can be protected from liability for claims arising out of some of these duties.

          a.  Matters for Board Discretion

The corporation's governing documents or board resolutions, buy-sell agreements, debt instruments, and shareholders' agreements can expand somewhat or limit the authority of the board to act on certain matters. For example, the board could be prohibited from causing the corporation to assume debt over a certain threshold unless the shareholders approve, or the board could be prohibited from declaring a dividend unless debt holders approve. If the corporation has authorized but unissued shares, the board is allowed to issue those shares to whomever the board may choose and upon terms the board determines to be appropriate, but this power may be restricted to require the shareholders to approve the issuance of any new shares.    

          b.  Means of Acting

Most board actions require the affirmative vote of at least a majority of directors in attendance at a meeting at which a majority of directors are present or, if the directors are acting without a meeting, the unanimous written consent of directors, but those defaults can be changed by the articles of incorporation and bylaws. The corporation's governing documents can increase or reduce quorum and voting requirements for meetings and can provide for written action to be effective if it is signed by as few as two-thirds or even a simple majority of directors.

          c.  Conflict-of-Interest Transactions

Transactions between the corporation and a director or a controlling shareholder may be subject to challenge by a shareholder if they are approved by the board under standard procedures. The corporation's governing documents or board resolutions can provide for special rules to ensure that such transactions are fair to the corporation and are fully enforceable. Such transactions may include compensation decisions, stock redemptions, or transactions between the corporation and a business owned by one or more of the directors. In most instances, the controlling documents may provide that interested directors must recuse themselves from voting on a conflict transaction or that disinterested shareholders also must approve the transaction.

          d.  Director Voting

Each director on a board is entitled to one vote on any matter that comes before the board, except in special circumstances (such as a conflict-of-interest transaction, as discussed above). Directors cannot vote by proxy or otherwise delegate their voting rights. The bylaws or board resolutions may provide for non-voting, advisory "directors" to participate in board meetings and provide input, but without authority to vote and without the corresponding duties and liabilities of a director. The bylaws, board resolutions, stock subscription agreements, debt instruments, or shareholders' agreements may give some shareholders or debt holders the right to appoint an "observer" who can attend board meetings but cannot vote or otherwise participate in the meetings.  

          e.  Advisory Board

A corporation may have an advisory board or shadow board that maintains familiarity with the corporations' business and operations and provides non-binding guidance to management, and may be designated to become the corporation's legal board upon the occurrence of a particular event such as the death of the business owner.

          f.  Delegation of Board Authority

A corporation's board may delegate some of its powers to committees, whose authority and responsibilities are governed by charters approved by the board. Committees are composed of directors, but they may include advisors or employees who attend their meetings but do not vote. In some cases, a committee can be delegated the power to exercise the authority of the full board as to specific matters. Common committees include executive, governance, finance, and personnel/compensation.

          g.  Board and Committee Composition

Statutory defaults generally do not impose requirements about who may serve as a director or how many directors there must be on the board or a committee. Such requirements, however, can be imposed by the articles, bylaws, board resolutions, or committee charters. The corporation's governing documents may fix the number of directors and how that number may be changed. The corporation's governing documents may require a certain number or proportion of "outside" directors (i.e., directors who are not employees or shareholders) or "independent" directors (i.e., outside directors who have no economic relationship with the corporation) to be on the board or serve on any particular committee. For example, the bylaws could require the board to have a majority of independent directors, or a charter approved by the board could prohibit any inside director from serving on the personnel committee, which would make employment and compensation recommendations to the full board.

          h.  Election of Directors

Under statutory defaults, each year, at the annual meeting of shareholders, each director is elected or re-elected to a one-year term by plurality vote of the shareholders (i.e., the candidate receiving the most votes, even if not a majority, is elected). These defaults can be changed by the articles and bylaws of the corporation in a variety of ways. Directors may serve longer terms, and the terms of various directors may be staggered to terminate in different years (referred to as a "staggered board"), or directors may be required to receive a majority (not just a plurality) of share votes to be elected. Shareholders may be allowed to cumulate their votes and cast them all for one director (so, for example, if a shareholder has 100 votes per director and there are three open seats, the shareholder could cast all 300 votes to fill just one seat) (referred to as "cumulative voting"). Some board seats may be "classified" so that only a certain class of shareholders or only a particular shareholder may be allowed to elect a director to that seat (such a director is sometimes referred to as a "representative" or "constituency" director). Even debt holders can be given the right to elect a representative director. Shareholders can execute agreements among themselves as to how they must vote their shares to fill open board seats.

          i.  Director Liability

Under common law, shareholders can bring direct actions (i.e., on behalf of themselves) or derivative actions (i.e., on behalf of the corporation) when a loss is caused by breach of a director's fiduciary duty. This can be an effective means of holding a directors accountable, but it also can be a disruptive force and source of abuse by shareholders. Therefore, many jurisdictions allow the corporation to protect directors from the costs of litigation and potential liability arising out of such litigation by exculpating (i.e., exonerating in advance) directors for claims arising out of breaches of their fiduciary duty to act with due care and by indemnifying them for losses they may incur in any litigation except for successful claims involving intentional wrongdoing. Often, indemnification of directors may be funded with errors and omissions insurance for directors and officers (referred to as D&O insurance). The exculpation or indemnification of directors can effect the system of checks and balances in a business succession plan.

          j.  LLCs

Although statutory defaults for LLCs do not require an LLC to have a board, the company's LLC agreement can establish a board of managers that can be composed and can operate the same as a board of directors of a corporation.

3.  Executive Management Authority

Under statutory defaults, officers and executives are appointed by the board and have authority to manage the day-to-day business of the corporation. The scope of authority of any officer/executive is determined by the bylaws, board resolutions, and common usage. The board also determines compensation of officers/executives and can terminate them without cause. Officers/executives typically cannot engage in transactions that are outside the ordinary scope of the corporation's business without approval of the board.

Most corporations have a president, at least one vice president, a secretary, and a treasurer, but the bylaws and the board may establish other officer and executive positions that may be appropriate for the corporation's particular structure and business. The terms of service of officers/executives can be indefinite, but employment agreements, approved by the board, can further define the scope of their duties, responsibilities, and authority, and the amount and form of their compensation. An employment agreement also can limit the board's authority to remove an officer/executive. The board can delegate some board powers to officers/executives to the extent that delegation may be prudent and the bylaws may allow. Officers/executives may be exculpated or indemnified, like directors, against liability arising out of claims of breaches of fiduciary duties.

The members or managers of an LLC also may appoint officers/executives to manage the day-to-day business of the company, even when the LLC is organized as a manager-managed LLC.  

4.  Beneficial Interests    

Usually, the shareholders are thought to be the economic beneficiaries of a corporation because they are entitled to receive net profits in the form of dividends and in the form of net appreciation when the company is sold. However, employees and debt holders also have beneficial interests in the corporation. Thus, there is a variety of means for conferring the economic benefit of operations on a business owner's successors and beneficiaries.

          a.  Equity

With regard to equity interests, S corporations are only allowed to have one class of stock, but C corporations and especially LLCs can have multiple, unique profits interests and distributions preferences, so long as all such interests, in the aggregate, are entitled to 100 percent of the proceeds of the liquidation of the entity. For example, Class A stock could be entitled to an annual dividend equal to a five-percent return on investment plus the first $1 million of proceeds on liquidation, and Class B could be entitled to all returns net of Class A's preference. By using these preferences and allocation formulas, the corporation or LLC can allocate risk and reward in a targeted and perhaps more equitable manner.

          b.  Debt

Debt is another way to confer a beneficial interest in the business on a business owners' successors or beneficiaries. For example, if a shareholder has the right to put his or her interest to the corporation for redemption in exchange for payments over time, the interest and principal payments provide the seller with cash flow and liquidity over time, based on the corporation's performance to a lesser extent than an equity interest. Payments to a debt holder would have preference over payments to a shareholder, even a preferred shareholder.

          c.  Compensation

Compensation is a natural method of conferring a disproportionate amount of the economic benefit of the corporation on those shareholders who are active in the business. Compensation may include salary, retirement plan contributions, deferred compensation, fees to be paid on a change of control, and fringe benefits. These rights for an active shareholder, or a non-shareholder employee, can be defined and quantified in an employment agreement approved by the board.

          d.  Liquidation or Sale

The possibility of liquidation or sale should be considered with regard to each of the beneficial interests mentioned. First, the economic interests of shareholders or debt holders may be made assignable or assignment of such interests may be prohibited. Second, shareholders, debt holders, and employees may be given special rights in liquidation or sale of the corporation. The corporation's governing documents, shareholders' agreement, or buy-sell agreement may control the proportion of shareholders who must consent to a liquidation or sale of the corporation. Under the terms of debt instruments, debt holders may have the right to veto a sale or may have rights of first refusal to purchase the corporation, and, in any case, may be allowed to accelerate payment of the debt in the event of a change of control. Employees can be given the right to bonuses, severance payments, or deferred compensation if the corporation is liquidated or sold.

PUTTING IT TOGETHER: AN EXAMPLE

In the process of business succession planning, after a business owner has considered the attributes of each level of ownership and control and has tentatively decided how they should be allocated among his or her successors and beneficiaries, he or she can then consider how each level will interact and whether that will produce appropriate results. Again, the objective is to confer the economic benefits equitably, while installing checks and balances in management to protect the value of those economic benefits.

The following is a random example of how the four levels of ownership and control could be customized and combined in a business succession plan:  

1.    Share voting: In a C corporation, shareholders who are not active in the business will receive preferred stock that will be entitled to a one-tenth vote per share and will be held in a voting trust to be voted by a single fiduciary.  (In this plan, the non-active shareholders are given lesser voting rights and those rights are exercised by a fiduciary because the non-active shareholders are not expected to understand the business well enough to vote their own shares wisely.  In exchange for their reduced voting rights, these shareholders are given a preference on dividends and liquidation, discussed below.)  Shareholders who are active in the business will receive common stock that will be entitled to one vote per share and may be voted by the shareholders themselves.  

2.    Board authority: The board will consist of seven directors, at least four of whom must be independent (i.e., not employees or otherwise affiliated with the company). (Therefore, even though the active shareholders have a greater influence over who serves on the board, there will always be a majority of independent directors.) The president will always be one of the directors and the chair of the board. One independent seat will always be filled by the preferred shares (to compensate for their lesser voting rights per share). Any shareholder who has been redeemed but not fully paid may appoint an observer to the board (to give the redeemed shareholder, as a debt holder, some advance notice if the company is taking actions that may impair its ability to pay off the redemption price). The balance of the directors will be elected by the common shareholders, voting cumulatively (to make it harder for one major shareholder to dominate the board). The board will delegate hiring and compensation decisions affecting shareholders to the personnel/compensation committee, which will be composed of three of the independent directors (so that insider or family hiring and compensation decisions are made by independent parties).

3.    Executive management authority: The officers/executives will consist of a CEO/president, one executive vice president for each of three product divisions, a CFO/treasurer, and a secretary. The duties, responsibilities, and authority of each position will be set forth in the bylaws, subject to elaboration by the board. A formal succession plan, approved by the board, will identify the presumptive successors in each of these positions. Each shareholder serving as an officer/executive will have an employment agreement that will provide additional compensation or severance benefits upon a change in control (to protect active shareholders who would lose their employment upon a sale of the company).  

4.    Beneficial interests: The preferred shares will be provided a five-percent cumulative dividend and 20 percent of the net proceeds upon liquidation or sale. (Again, this compensates them for their reduced role in electing the board and their lack of any role in managing the company.)  The common shareholders will be entitled to the rest of the net return. Debt holders will be paid in full ahead of any shareholders, but if there is a sale of the company within five years after they are redeemed, they may convert their debt to stock (to ensure that they received fair value for their shares). Employees who are shareholders will be entitled to performance bonuses each year that there is an increase in EBITDA or at the discretion of the personnel/compensation committee and will receive a bonus upon the sale of the company above a certain value.  (This creates an incentive for the active shareholders that has priority over the preferred dividends to be paid to the non-active shareholders.)  Tag-along rights in a buy-sell agreement require any person who buys a controlling interest in the company to purchase the stock of all shareholders at the same price and on the same terms, taking into account liquidation preferences for the preferred shareholders.  

This is just a basic outline of one of the limitless ways that the attributes of the four levels of ownership and control could be allocated and integrated in a business succession plan.  Some business succession plans may be simpler and some may be more complex, but an actual business succession plan would be much more detailed than the outline above and would be supported by all the documentation needed to implement it.

CHANGES

Each governing document and agreement that is used to implement a business succession plan should provide a mechanism for amending or terminating it so that the plan can be adjusted, but only to the extent and in the manner that the business owner intends. These provisions should be consistent with the plan's substantive provisions. For example, if the bylaws prevent the board from causing the corporation to issue additional stock without approval of two-thirds of share votes, the board should not be allowed to amend that provision of the bylaws without the same share vote approval.  

DISPUTE RESOLUTION

Litigation may arise in the corporate context due to the many and varied economic rights and relationships of the various parties. In addition, the fiduciary duties that the directors and officers owe to the corporation and its shareholders may give rise to direct or derivative claims brought by shareholders (whether those who vote the shares or those who have beneficial ownership). In addition to considering whether to exculpate or indemnify directors and officers/executives, it is important to consider whether binding arbitration should be considered instead of litigation to resolve all disputes of the parties and whether unnecessary disputes could be deterred by requiring the losing party to pay the prevailing party's attorneys' fees.

CONCLUSION

By considering each level of ownership and control separately and fully understanding its attributes and how those attributes can be changed or customized, a business owner can develop a business succession plan that equitably allocates the economic benefits of the business and provides a management system that will protect and enhance those economic benefits.