Managing Major Business ChangeChia-Li Chien, Ph.D., CFP®, PMP®, CPBC
Chia-Li Chien, CFP®, PMP® Mar. 22, 2016
John and Mary (not their real names) sold their successful sheet metal business and launched a new enterprise, a fabric business, about fifty years ago. At the time of the launch, they had no need for outside capital. Nevertheless, Mary’s family members insisted on being a part of John’s potentially successful venture. John made sure that he had control of the firm, with 57% ownership for him and Mary—leaving 43% to the rest of the family.
As predicted, John’s company performed really well. But each business, like every economy, goes through cycles. John’s company was no exception; it experienced growing pains. About ten years ago, the company expanded too quickly into China. John’s company proved unable to cash out the capital it had invested in China. Moreover, John’s China division did not achieve a desirable profit margin. In fact, the division became a losing proposition. That struggle notwithstanding, John’s company limped along for a long time, using John’s own capital to keep the lights on in China. Because of the capital shortfall, the company was also forced to stop issuing dividends to its family shareholders.
Ted, the son of one of the company shareholders, was a freshly minted Finance graduate working for a top-tier financial institution. He decided to file a lawsuit against John and Mary on behalf of other family-member shareholders. The suit claimed that John and Mary had provided false financial statements and defrauded those shareholders. In addition, it demanded that John and Mary pay back a share of dividends plus damages for emotional distress.
At the preliminary hearing, the judge recommended that Ted’s group drop the case. Judge True (not his real name) reviewed previously audited financial statements and concluded that John’s company had been an incredible investment for the family shareholders. The plaintiffs should, in the judge’s opinion, cut John and Mary some slack, since the company was not doing well financially at the time of the lawsuit. Judge True urged the parties to reconcile and settle out of court. Ted refused, however, and he proceeded with the case.
Ivy was one of the shareholders and had worked for John in his Accounting department. During the lengthy trial interrogation of each party, Judge True found Ivy had misrepresented the facts in portions of her testimony. Based on that evidence, Judge True warned Ted’s group to stop its nonsense. Ted’s group persisted, despite the fact that Ivy had apparently lied under oath. Rather than dismiss the case, Judge True asked John and Mary to counter sue Ted’s group. And for her perjury, Ivy could have been sentenced to up to eight years in jail, with no bail and no right to early release for good behavior.
Eventually, Ted’s group withdrew its suit against John and Mary. Afterward, John decided to buy back the remaining 43% of the company at four times the original invested price. At the time of this buyback, the company was not worth even the value of that original investment. And yet, with a forty-year pattern of consistent dividends, the shareholders had long before achieved their return on investment—by year three, in fact.
Unfortunately, due to the losses in the China division, John did not have enough personal capital to execute the buyback. Therefore, both John and his son #1 Shawn took out personal loans to buy back the remaining company shares.
Managing Major Business Change by Chia-Li ChienShawn and his wife Jane have been operating the business with John for the past 20 years or so. Shawn knows the business inside out, and Jane is the top salesperson for the company.
Family businesses can present difficult succession issues. In John’s case, unnecessary attorney fees and emotional circumstances distanced family members from each other. To prevent such unnecessary heartache for shareholders, it is wise to review your operational agreement and carefully monitor your succession strategy. With the help of an attorney, CPA or financial advisor, owners can take care of these needs. Yet, having a conversation about the future with family shareholders is actually much more difficult than drafting a revised operating agreement.
If John had wanted to retain company control without a buyback, he could have authorized the issuance of non-voting shares of stock. That would have allowed John to raise revenue without jeopardizing his primary role in the company.
Shawn respected his dad and thus had kept the awkward conversation about succession issues to a minimum. But, we know John is not Moses, and won’t live forever. There will be certain events that trigger changes in the Operating Agreement of his business. And, because of inheritance laws, son #2, Barry, will enter the picture at some point.
You are the owner of your company; do the right thing before it’s too late. Please consider the following:
- Review your wishes and take inventory of what your business is currently worth.
- Identify potential trigger events such as divorce, lawsuits, personal liabilities, revocation of required professional licenses (C.P.A., J.D., ISO 9001, etc.), disability, death, etc.
- What is the appropriate course of action when each of the trigger events occurs?
- If shares need to be bought out, at what price level or levels? And what method will be used to determine the fair market price?
- Have a conversation with the people whom you wish to transition to—your successors in the business.
These steps may take a while to accomplish, but any progress toward your goals can help keep your family together. Ideally, you will have an attorney, a succession strategist to facilitate the conversation. What you think is fair may not be, especially to parties who are not currently in the business—like son #2 Barry above. Without a clear and clearly understood succession plan, Barry or other family members may take unnecessary actions and distance the entire family. Do the right thing for your business. This is more than a question of ownership; you have customers to service and employees to take care of. Any disruption will impact your business not only emotionally, but also financially. Perhaps most importantly, such business developments could negatively affect your family.
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